Ethical index jettisons Tesla
Elon Musk has been railing against move online, but many factors to consider in terms of fossil fuel and investors
Elon Musk has taken to the social media platform he is buying to rail against the injustice of his company Tesla, which is doing more than most to push the combustion engine to extinction, being ejected from an ethical investing index. He further complained that Exxon, the US energy giant, is included.
The billionaire entrepreneur tweeted that ESG investment, which screens stocks based on environmental, social and governance criteria, is “a scam”, which has been “weaponised by phony social justice warriors”. He’s right — although maybe for the wrong reason.
Energy prices have soared in recent months. Analysts are predicting the cost of oil and gas will remain high for years as the world attempts to wean itself off Russian fossil fuels. Oil majors are churning out profits and have, in the words of BP chief executive Bernard Looney, become “cash machines”.
You would therefore expect the share prices of these companies to be going through the roof. They’re not. BP’s stock is up about 23 per cent so far this year but it is still roughly 27 per cent below its prepandemic highs. Shell is up about 41 per cent for the year to date (it didn’t take as big a hit as its rival to get out of Russia) but shares are still about 12 per cent off where they were trading before Covid.
This pattern is more or less replicated throughout the sector and the world. Global energy companies are currently valued at a staggering 10 per cent free cash flow yield, according to analysis by Saxo Bank. This means that in the midst of an enormous energy crisis and when they are delivering a whopping return on equity of 18 per cent , global energy stocks are cheaper than they have been at any time in nearly three decades.
What’s going on? Three letters: E, S and G. Exxon’s appearance on the S&P 500 ESG index that has irked Musk is an outlier. Overall, the ethical investment style has, in the words of Saxo’s Peter Garnry, “drastically distorted capital allocation in equity markets”. Is that a good thing? An ESG evangelist would probably argue that it is. In fact, it’s potentially disastrous — both for investors and for our best hopes of managing the energy transition successfully.
There are essentially two core components of the ESG mantra. The first is that ethically sound companies will perform better in the long run. The second is that disinvestment creates the economic pressure for change. Both claims are unproven at best.
It is, of course, true that companies often stumble if they focus on maximising shareholder value to the exclusion of all else. And given a long enough time horizon, social good and financial interests will converge: your portfolio is likely to underperform if mankind is wiped out by climate change or a nuclear war.
It is also true that, in recent years, ESG funds have tended to outperform. But this is almost certainly because they are skewed to tech stocks.
The top 10 ESG stocks in the US as ranked by the non-profit Just Capital are Alphabet, whose shares are down 21 per cent this year; Intel (-18 per cent); Microsoft (-22 per cent); Salesforce (-37 per cent);
Bank of America (-23 per cent); PayPal (-59 per cent); Apple (-20 per cent); Nvidia (-40 per cent); Verizon (-6 per cent) and Cisco (-21 per cent). The first part of the ESG sales pitch — that investing in “good” companies will result in better returns — is being tested to destruction.
The counterargument will be to extend the time horizon of the investment. However, even if ESG made logical sense, there’s an old saying about the markets remaining illogical longer than you can stay solvent. And ESG doesn’t make logical sense. The bald fact is that it places constraints on investments and will therefore underperform compared to those funds that are not constrained in the long run.
The fund management industry will perform any number of contortions to obscure this fact for another very simple reason: the economics of their business is driven more by their assets under management than it is by the return those funds achieve. And nothing is sucking in money faster than slapping an “ESG” title on an investment product.
Assets are set to balloon from around US$35 trillion now to US$50 trillion by 2025, according to estimates from Bloomberg. But what about helping drive change? Also dubious. While the future is for a variety of reasons likely to be greener, it is equally obvious that the route to decarbonisation will take a while and not be in a straight line. There will, as now, be periodic surges in demand for fossil fuels; petrol is likely to remain an important transition energy source for years to come.
Lots of the oil majors have bowed to activist pressure by scaling back their exploration activities and reducing reserves. But these are being snapped up by private equity at knock down prices. You can be fairly sure they will have fewer compunctions about how those reserves are exploited. We can already see how “distorted capital allocation” might
result in skewed behaviours and policy mistakes. For example, those energy companies with languishing
share prices that suffered big losses last year have been rewarding investors with increased dividends.
This has contributed to the rhetoric about them profiteering from high energy prices, which has in turn led to calls in the UK for a windfall tax. Such a retrospective levy would likely lead to an even lower share price and the need for management teams to cough up even more of their cash flow in payouts — rather than investing in traditional exploration or new technologies.
Such a cycle could therefore potentially undermine both energy security and the transition to clean energy. And here’s the rub: a repudiation of ESG is not a denial of the very real problems it seeks to solve. Rather, it stems from a realisation that the current investment mania may, at best, be unable to deliver its stated goals. At worst, it could actually be counterproductive.