One of the world’s most respected valuation experts, Professor Aswath Damodaran of the Stern School of Business at NYU, has cast a critical eye over ESG in a recent blog post (available here). His rather sceptical view acts as a useful counterweight to some of the fluffier opinions on the subject. However, his own take on ESG lacks a broad enough perspective, at least in my view.

He fires various arrows at ESG. He rightly points out that amalgamating simple ESG indicators into any single index is inevitably imprecise and potentially confusing, a point highlighted recently by no less than the Chairman of the Securities and Exchange Committee, Jay Clayton. Abstracting from such measurement problems, Damodaran’s main thrusts focus on ESG, company valuation, and portfolio selection.

At the most basic level, corporate valuation is driven by the fundamentals of prospective cash flows and the cost of capital. It is not inevitable that markets will reflect the impact of higher or lower ESG credentials in higher or lower valuations – ‘good’ may or may not be rewarded in capital markets, and ‘sin’ may go unpunished. Ultimately, the connection between ESG factors and valuation is an empirical issue.

Damodaran’s view is that the available evidence does not lead to easy conclusions, but with ‘E’ possibly offering the strongest potential link to valuation, and ‘S’ the weakest. The correlation appears to be related principally to a cost of capital effect (‘sin’ stocks including those from carbon-intensive or polluting industries, penalised by a higher weighted average cost of capital). In my view, this will become even more important in the future, as society reassesses the importance of Nature for our very existence. So, I can largely agree with the importance of ‘E’.  

On his fairly dismissive view of ‘S’, the truth, in my view, probably lies closer to former Premier Zhou Enlai’s observation on the significance of the French Revolution - it is too soon to say. Many ‘S’ arguments require deep secular shifts that are unlikely to be evident in recent data. That does not make them unimportant. The coronavirus suggests ‘S’ factors will play a crucial role in longer-term economic development, confirming the inevitable mutuality between the state, its values, and the corporate sector.

"In our world of constant change and intractable uncertainty, there can be no presumption that ESG exclusions imply a risk penalty."

On other areas, I part company with the great professor. He considers that ‘exclusion strategies’ (i.e. leaving ‘bad’ ESG stocks out of a portfolio) cannot lead to a superior risk/return portfolio than the Market Portfolio itself – otherwise there is no value to incremental diversification. That sounds logical, but only as long as you accept the axioms of the Capital Asset Pricing Model (CAPM). It is that model that underpins the proposition that the fullest possible diversification yields optimal risk benefits.

But CAPM is half-baked at best. To listen to it exclusively is to turn off half our brains, as the philosopher Iain McGilchrist might put it. Uncertainty is not captured by risk metrics based on normal distributions as CAPM requires, and markets are never in the timeless equilibrium the theory assumes. In our world of constant change and intractable uncertainty, there can be no presumption that ESG exclusions imply a risk penalty. Indeed, the only sensible objective for investors is not an optimum defined by the risk calculus of CAPM, but the more mundane goal of investment survival. As one example, ESG is well-positioned to yield important insights into avoiding disaster risk.

The conclusion – add some real-world untidiness to capital market theory and there is plenty of room for ESG to play a series of important roles in investment decision making. Damodaran’s concern about the cynical misuse of ESG is relevant. However, some of the contradictions he sees in ESG are not contradictions at all. Relying uncritically on over-simplified models is not the way forward for investors – at least ESG proponents have got that bit right.