Elon Musk vs. ESG

It's the end of the beginning for ESG

May 23, 2022

In this post you will learn:

  • What is ESG

  • Why investors care about it

  • Elon Musk vs. ESG: ESG given a reality check

  • How the ESG brand needs to evolve in the future

What is ESG

ESG stands for environmental, social, and governance. The ESG brand has been gaining popularity in the investing community over the last twenty years.

The idea is that companies that create higher stakeholder value will ultimately create higher shareholder value.

On the surface this makes a lot of sense. For example, a company that hires a diverse workforce and participates in charitable giving will attract more customers and retain top talent.

Let’s unpack ESG a little further. In general, here is how E, S, and G apply to many companies:

  • E: Organizations that reduce environmental impacts through carbon reduction, recycled waste, or other energy efficient operations (e.g. the lights they use in corporate offices)

  • S: Give back to the communities they operate in through Corporate Social Responsibility programs (CSRs) and charitable donations, as well as the emphasis they put on Diversity, Equity and Inclusion (DEI)

  • G: Implement guard rails to ensure fraudulent and unethical behavior does not persist internally. This could include certain policies, standards, and risk management operations implemented across the firm.

Why investors care about ESG

Many investors and fund managers have ESG mandates when investing in companies. They have criteria and score companies based on their E, S, and G initiatives

  • Companies who are considered ESG, get included in ESG stock indexes

  • Index fund managers will then purchase the stock to meet their benchmark

  • More shares bought = higher share price

Therefore, businesses would:

  • Launch ESG initiatives that would boost their profile

  • And convince fund managers they were worthy of being included in the index

  • and ultimately create shareholder value

By including any company with strong ESG marketing into ESG indexes, Wall Street has subsidized ESG initiatives for many companies.

The roadblock with ESG for many companies is that projects labeled “ESG” are either:

  1. Costly OR

  2. Hard to quantify an ROI

For example, environmentally friendly technology (e.g. solar panels) could be more costly than a less energy efficient technology. However, if those solar panels will increase your firm’s ESG rating in the eyes on investors, there could be an increase in shareholder value. The water is very murky.

How murky is the ESG water? Well, last week Tesla was kicked out of the S&P500 ESG Index but ExxonMobil remained.

It’s not that ExxonMobil is an environmentally friendly business (it’s not) or that Tesla has increased it’s own carbon emission (it didn’t). The reasoning behind the removal was due to Tesla’s efforts on the Social and Governance fronts.

Even still, one could make the argument that if Tesla gets kicked out of the index due to their “S” and “G”, then ExxonMobil should get tossed out for their “E”.

ESG’s Reality Check

Elon Musk called ESG a scam after his company was kicked out of the index. Celebrity investor Cathie Wood called it “ridiculous”. Regardless, the move put ESG’s credibility in the Wall Street spotlight.

Tesla stock dropped Friday morning after the announcement that the stock was removed from the S&P500 ESG index Thursday evening.

The spotlight only adds more skepticism to the already heavily questioned practice of ESG investing.

How can we fix this:

  • Companies must prove that ESG projects are relevant to their business strategy (e.g. would we get more customers by installing solar panels?)

  • ESG projects should be purposeful with a tangible outcome

  • Progress against ESG goals should be reported and shared with investors and stakeholders

Where do we go next

Part of the problem of the ESG brand is that the E, S, and G are radically different but woven together. It’s not clear how scores are calculated and weighted in these three categories and what the ROI is for each category independent of the other. As a next step, organizations focused on ESG should:

  • Un-bunch the E, S, and G

  • Publish scoring criteria

  • Demonstrate true economic returns

Whether you believe in ESG investing principles or not, one thing is certain – that it’s the end of the beginning. ESG programs will evolve, and that’s a good thing for investors.