Looking for the “S” in ESG: The Dangerous Consequences of Green Index Funds
In a rare alignment of the stars, investors and environmental activists alike have reasons to celebrate. So-called ESG funds, which invest their capital based on environmental, social, and governance (ESG) principles, have become staggeringly popular in recent years. Surprisingly, they have weathered the COVID-19 pandemic exceptionally well. On top of that, a recent study shows that these funds also achieve higher returns than comparable conventional funds, as investors scramble to shield their investments from climate and pandemic risks. On these terms, it finally appears that environmental concerns can be reconciled with tangible financial returns.
Alas, the good news ends here. If one looks behind the mostly well-meaning façade of ESG exchange-traded funds (ETFs)—which exclusively track assets with good environmental, social and governance scores—one rarely finds the "S." Sandwiched between its more popular peers, the environmental and governmental elements, the social component, more often than not, vanishes—with conceivably dangerous consequences.
The “S” quantifies how an investor can assess a company's responsibility towards the people involved in its business, its employees, the community around it, or its suppliers. The past few months of economic lockdown have increased public awareness of the inadequate working conditions and low pay for key workers in essential positions to sustain the economy. The pandemic has proven that employees’ working conditions are particularly important, and the social governance of a business cannot further be ignored.
However, the "S" loses its meaning if a company hardly employs any people. Because, a second glance at the companies that registered price increases in green index funds reveals that they have a natural bias against companies with numerous employees. The fewer people a business employs, the better its ESG rating and the higher the gains in its share price. In other words, having more employees depreciates a company's environmental and governance ratings.
The explanation for this phenomenon is as simple as it is alarming: employees have to commute, causing pollution. Companies without employees have no strikes or problems with their unions. There is no gender pay gap if all the work is done by genderless robots. Biotechnology laboratories or social media platforms, in which a few highly-skilled researchers look for a new vaccine or find the next ground-breaking algorithm for data collection, have negligible ecological footprints. Furthermore, these highly-paid employees do not have many reasons to strike against corporate governance and unfair remuneration. Such companies tick all boxes on the corporate governance checklist because they duly adhere to the “E” and “G”, while the “S” simply does not meaningfully exist.
ESG investments were originally conceived as a reaction to the increasingly visible problems of the capitalist economic system in order to harmonize the profit-oriented motive with socially and ecologically desirable goals. Paradoxically, these ESG filters are now increasingly and unintentionally rewarding the greatest injustices of post-industrial societies: “winner-take-all” capitalism and the concomitant disappearance of jobs for ordinary people with average education in clerical professions and those with less education working in manual jobs.
Recent history has demonstrated that the widespread loss of jobs usually concentrate in certain geographical areas (for example, the Rust Belt, a former industrial and manufacturing cluster in the northeastern United States that has seen a dramatic decline in economic activity and social mobility in recent decades) and societal echelons (low- versus high-skilled workers). This phenomenon has devastating social impacts, such as higher rates of unemployment, school drop-outs, drug addiction, and suicide. This, in turn, fuels discontent with the political establishment and ignites support for fringe political parties, imperiling the liberal and democratic institutions of the Western world. Such political deterioration must not be exacerbated by so-called sustainable investments. On the contrary, ESG index funds should counteract this, especially in these times of crisis.
This is not to discourage investors from ESG index funds. They are important vehicles to drive capital markets and the underlying companies into a sustainable future. ESG ETFs are, too, profitable investments. However, as is true for many environmental policies, measures on sustainability must not proceed at the cost of social and human well-being. Stable and decent jobs are the bases of a prosperous society and a healthy economy that caters to the needs of all people. This is also not to say that automation, digitization, or the rise of the knowledge economy should be reversed, or in any way abandoned. However, ESG must not become synonymous with promoting only highly-skilled workers, thus widening the already yawning inequality gaps that have come to define our economies, with all their ugliness .
As long as ESG funds do not pay close attention to the “S” in ESG, in particular a company’s employees’ well-being, investors themselves ought to take a closer look and find out whether such an investment can inadvertently destroy long-term jobs by diverting funds from companies that still employ real people to companies that do not. With the growing profitability and popularity of green index funds, the search for the “S” has officially begun.
