Rethinking ESG Investing: Embracing Brown Firms for a Greener Future
ESG investing refers to Environmental, Social, and Governance criteria that investors use to screen investments. Environmental standards include a company’s policies addressing energy use, waste, air and water pollution, and natural resources. Social criteria consider how a company manages relationships with employees, suppliers, customers, and the communities they operate in. Finally, governance concerns executive compensation, procedures for leadership selection, board independence, and responsiveness to shareholders.
Investors are increasingly using these non-financial factors to determine investment choices. In less than two decades, for example, ESG investing has developed into a global phenomenon, attracting more than $40 trillion in assets. By 2025, assets are expected to grow to $50 trillion.
But what happens to the environment when all this capital floods into green companies? The answer is not what the ESG movement intended.
ESG investment strategy
When ESG investors sell their shares in brown firms (high greenhouse emission companies) and invest in green firms (low greenhouse emission companies), the message is clear. Environmentally friendly companies are rewarded, and the unfriendly are punished.
Yet the strategy does not produce the anticipated environmental impact. Green firms do not become greener; they are already green. That's why ESG investors support them. Green firms deploy additional capital to grow their usual, low-polluting activities.
In other words, ESG money supports companies that don't pollute or don't pollute much, such as services like banks, insurance, and entertainment. Therefore, the environmental impact of large capital investments in green firms is negligible.
Brown firms
More troublingly, by disinvesting in brown firms, ESG investors drive them to become more short-term oriented. Distressed brown firms care much less about complying with ESG standards or switching to green technologies and care more about immediate survival. They may drop ESG efforts altogether or cut corners on environmental regulations.
Brown firms can choose to invest in green production methods and strictly observe pollution-abatement regulations, but these options are costly and cut into profits. Clearly, these options are not popular nor prudent when access to capital is difficult.
Brown firms, therefore, continue to do what they do best. They remain brown or become browner.
ESG mistakes
Ironically, the pattern of investing advanced by ESG advocates incentivizes bad behavior. Capital loss does not motivate brown firms to start clean energy programs; it compels them to focus on the bottom line.
ESG investors misconstrue the basic fact that brown firms emit substantially more pollutants than green ones. Typically, brown firms pollute 260 times as much as similarly sized green firms. This, of course, motivates ESG investors to withdraw capital from brown firms.
However, it's the sizable differences in emissions that should be the primary motivation to invest in brown firms. Cutting brown firms emissions by just a small percentage would be much better for the environment than a green firm cutting its entire emissions.
In addition, most brown firms possess large engineering groups and significant resources that are well-positioned to develop new green technologies. But once again, if brown firms face bottom-line challenges, they are unlikely to explore green solutions.
Finally, ESG supporters discount the crucial roles that brown industries play in our society. Agriculture, transportation, building materials, and rare metals extraction are a few of the vital brown industries. Punishing them to the point of bankruptcy does not help anyone. Rather, it makes more sense for ESG supporters to invest in brown firms and help make them greener.
If saving the planet is the objective, investing in brown firms is the way to go.
Keep the politics out
Brown firms represent the greatest potential for carbon reduction. Starving them of capital does not exploit that potential. Investing in them can.
Blind commitment to a fully green portfolio is naïve and reminiscent of the strong political loyalties that threaten to pull the country apart. Too many in the ESG movement believe disparaging brown firms is an effective way to help the environment. They don't want "evil" firms in their portfolios.
However, like in politics, demonizing brown firms motivated the forces of backlash. It harmed ESG more than it damaged brown firms. ESG investors have not thought through the impact of their actions.
It does not have to be this way.
Instead of vilifying brown firms, ESG investors should engage them, talk to the management, and work together to devise ways to restructure the firms to limit emissions or eliminate emissions entirely.
That would be a win-win for investors, companies, and the planet.