Ethical investment is about morals not markets

Here is a story that shows how very fuzzy the boundaries can get when you attempt to define what is a “green” or “socially responsible” investment. 

It involves a large US private equity firm and, yes, an oil company based in Texas. 

The hydrocarbon producer, Clearly Petroleum, has operations in the state alongside the Brazos river, where, thanks to more extreme weather events in recent years, the watercourse has become increasingly prone to heavy flooding. So the company’s owner, the buyout firm Carlyle, supported it in building flood barriers around its storage tanks and elevating electrical equipment, protecting the works from inundation.

Pretty sensible you might think. At least if the plan is to pump oil. It doesn’t obviously do much for the planet. Yet, despite the fossil fuel bit and lack of any obvious carbon abatement, Carlyle claims that this is a green investment.  

The firm says that achieving impact “isn’t just about putting money into companies with strong records on environmental, social and governance factors”. “It’s also about making sure portfolio companies are in a good position to deal with the effects of climate change that are happening right now,” it says.

You might argue that if that’s “green”, almost anything could fit the description. But Carlyle isn’t the only one applying questionable definitions when it comes to ethical investment. Let’s take another example: the mushrooming green bond market, which reached €660bn this year and is estimated to reach €2tn by 2023, according to research by NN Investment Partners.

Among the bond issues that left investors with doubts about their green purpose is one by Saudi Arabia’s fossil-fuel guzzling electricity monopoly to raise money to install smart meters. Another is the trend for car companies issuing green bonds to fund the development of electric vehicles. As one fund manager, Tom Chinnery of Aviva Investors, put it: “That’s business as usual. Every car company on the planet should be doing this.”

The explosion of ESG finance has led to predictable cries about “greenwashing” and the need for tighter rules around what can be termed an ethical investment. A veritable alphabet soup of standard-setting bodies has called for better disclosure and reporting to help the market work by separating the virtuous from the sinful.

But it’s worth asking if the problem lies rather deeper, and how effective market mechanisms really are at delivering these goals. 

“Impact” investment only has real meaning if it means funding activities that would not otherwise happen. Otherwise, where’s the impact? You are simply dressing up “business as usual” investments that would be made anyway. 

That does not so much help the planet as provide a decent income to the rubber-stamp merchants and those investment firms charging high fees for running ethical portfolios.

The ESG industry counters that it is possible “to do well and do good” both at the same time. But there is no reason that doing good should deliver superior returns. If anything, it should be the opposite. Remember that impact investors should be funding something that does not seem sufficiently lucrative ex-ante to be backed by conventional financiers. Logically, then, you would expect them to receive “concessional”, or lower-than-market, returns.

Accept that premise and it points to a very different way of looking at impact investing. As the Oxford academic Ludovic Phalippou points out, it should not be viewed as a route to superior financial performance, but rather the fulfilment of a moral imperative. 

After all, why does everyone want decarbonisation, fair wages or the encouragement of diversity on boards? Not because they raise returns but because they are the right thing to do.

Stocks with high ESG ratings may have performed well during the Covid-19 pandemic — not least because tech companies make up much of the indices. But what would happen if they underperformed at some point? Would “destroying the environment and mistreating people become the right thing to do?”, Mr Phalippou asks.

The confusion surrounding ethical investment is unlikely to be solved by more auditors and standards. Such steps will just drown investors in paper, while not getting the world much further along the desired ethical path.

There is a only one way to achieve moral imperatives such as decarbonisation and diversity: establish laws and rules that deliver the outcomes you wish to achieve.

Jonathan.Ford@ft.com