Opting Out: A Modest Proposal

I was speaking at Credit Suisse’s Annual gathering of Conservation Finance professionals in New York a few weeks ago (a quick aside: there are some REALLY smart, innovative people doing some REALLY smart, innovate work in the field of conservation finance… which — if you appreciate things like wetland preservation, sustainable timber harvesting, agricultural land rehabilitation, riparian zone restoration, apiary habitat and an astonishing range of related strategies — should make you feel just a wee bit better about our collective future).

Late in the day, during a panel on Green Bonds, one of the true luminaries in the world of sustainability-focused fixed income management spoke of his fund’s Environmental, Social and Governance (ESG) research capabilities, and their deep track record in applying it. He was informed. Wicked smart. Thoughtful. Contemplative. Analytical. A bit nerdy, but in just the right way. Precisely the kind of guy you’d want managing your bond portfolio. The focus of his talk was the benefits to be derived from focusing on non-financial metrics when performing due diligence and constructing portfolios. And the results were unambiguously positive.

Anyone who has been around this space for a while would recognize the reasoning: de-risking a portfolio’s carbon exposure and environmental risk; gaining visibility into governance issues that inform credit worthiness; exposure to things like health-care cost liability for pension beneficiaries; etc. And he demonstrated, convincingly, that on a fully risk-adjusted basis, portfolios that emphasized this approach outperformed – if only marginally – his firm’s conventionally managed portfolios. (For context, the firm manages approximately $21billion, of which $1billion is managed specifically against this more stringent set of criteria. So he is not just tossing around a few bucks and calling it a strategy.)

So I raised my hand during the Q&A, and asked him why, if the approach and results were as productive as his slides proclaimed (and I have no reason to doubt him), did his firm not simply apply the same depth of ESG criteria to all of the portfolios they managed? Put more bluntly, I asked him why, with the empirical evidence at his disposal, didn’t his firm require conventional investors to opt-out of the ESG analysis? After all, investment professionals fight hammer and tong every single day for the slightest performance edge. Entire careers are made or broken on a few percentage points. His presentation made it sound like their ESG approach equated, simplistically, to free money.

It was as if I had suddenly broken out singing “I Like To Be In America”. In Klingon.

He simply didn’t understand the question. He started rattling off a battery of data relating to re-rating the credit risk, purchasing at internal spreads that reflect different pricing dynamics, etc. etc. Which was fascinating, but entirely beside the point. I cornered him later in an attempt to reframe my question, feeling that I must have simply asked it poorly… but his reply was the same authoritative, comprehensive, confident and totally missing-the-point finance-ese. It was as if I had asked him for the time and he told me how to build a Patek Philippe. Which was kinda cool. But also really annoying.

Listening in increased bewilderment, I tried to understand why he seemed unable to answer my question. But as I machete’d my way through a thicket of cognitive biases, I realized that we were not only speaking different languages, we were actually looking at the question through entirely different lenses.

So I dropped it.

Then at the i2 Capital conference in DC last week (I was on a panel providing an “overview of impact investing” to a roomful of professional investors, policy people, large foundation executives and the usual rabble of conference attendees), the same thing happened. A mucky-muck from Rockefeller Advisors – who are incredibly important and powerful players in the impact investing world – gave a presentation on ESG integration into public equity portfolios. He trotted out a quite compelling series of PowerPoint slides clearly demonstrating, along several ESG axes, financial outperformance. (Again for context, Rockefeller stewards approximately $11billion, of which somewhat less than $1billion is managed with an ESG mandate. NOT chicken feed.)

So I asked him the same question… and received pretty much the same response, cloaked in a bit of financial presentation legerdemain. Surprise… and proof that, to misquote Lord Acton’s famous dictum: “Power corrupts, and PowerPoint corrupts absolutely.”

So on my flight home I found myself musing on this oft-visited-regularly-disproven-but-never-quite-dispelled notion of financial performance, trade-offs, etc., etc (about which I have written extensively herehereherehere, and here to scratch the surface) and came to a startling realization: if we, collectively, were to simply make ESG investing the opt-out proposition, that would change the game instantly and completely.

Imagine asking someone, for example, if they would like to invest along a special set of investment criteria that treated with utter disregard the environmental and social consequences of their capital. We would be required to disclose that by doing so, the investable universe would be limited. And of course, as a result, volatility would increase and the result would likely be a performance sacrifice. On the plus side, this approach would represent an excellent values-alignment exercise (so long as their values included environmental degradation, a willful ignorance to the hardening science around climate change and tacit support for the increasing levels of wealth and income disparity that we see not only in the US, but also throughout the world).

A cynical framework, I know, but… I wonder if anyone would select that option?

Your only rarely, but currently, bewildered scribe,