The puzzle of sustainable investing: What smart investors should know2024. Lukasz Pomorski. Wiley.
In , Lukasz PomorskiSenior Vice President at Acadian Asset Management and Adjunct Professor at Columbia University, Pomorski presents a group of essential tools for the sustainable investor to navigate the highly competitive topic of environmental, social and governance (ESG) investing. He analyzes the channels through which sustainability influences corporate decisions and discusses many practical examples and case studies that provide a succinct summary of the industry’s most vital issues. Pomorski deftly discusses the great, the bad and the unknown sides of sustainable investing, but acknowledges that the reply to among the critical questions is the dreaded “it depends.”
Based on an easy thought experiment, Pomorski appropriately concludes that ESG characteristics are a source of data and a few of that information will be helpful in pursuing financial goals, no matter what investors take into consideration ESG investing on the whole. Therefore, by an easy logical leap, the ESG-aware portfolio can have a better Sharpe ratio than the ESG-unaware portfolio. ESG integration (incorporating ESG considerations into one’s views on risk and return) is a superb thing because it could possibly help investors construct higher portfolios.
However, because ESG investors also construct constraints into their investment process, this may result in the creation of a “sin premium,” or relatively higher expected returns from holding securities with poor ESG rankings, akin to tobacco or fossil fuel corporations. These higher returns are usually not compensation for risk or poorer quality of future money flows, but quite a direct results of investors’ tastes and preferences. Pomorski presents an ESG efficient frontier of a carbon-conscious portfolio, showing that reducing carbon emissions to 30% of benchmark emissions reduces financial attractiveness by almost 5%, and reducing them to 10% of benchmark emissions costs about 15%. This chart illustrates the risk-return tradeoff of reducing a portfolio’s carbon intensity and financial attractiveness.
Maritime refers to a brand new paper[1] Pomorski analyzed hundreds of stocks traded in 48 different countries and assessed ESG rankings from seven different providers. Based on the principles of market efficiency, he supports the report’s conclusion that there could be very little evidence that ESG rankings are related to global stock returns. Later within the book, he discusses that any outperformance must likely come from investing in corporations that show improvements in financially material ESG aspects. However, Pomorski supports the claim that ESG rankings can provide insights into the riskiness of the underlying corporations. For example, a portfolio tilted toward stocks with strong ESG rankings will contain relatively safer stocks than the stocks in an otherwise similar portfolio tilted toward poor ESG rankings as a substitute.
Three case studies on Engine No. 1 and ExxonMobil, green bonds, and constructing net-zero portfolios are discussed as an instance the positive impact of investment portfolios. As an actual estate financier, I discovered the green bond case study probably the most insightful. Since ESG-motivated investors are willing to pay a premium for labeled bonds (green bonds), this “greenium” signifies that investors are willing to offer cheaper capital to the corporate provided the proceeds are used for green projects. Green bonds have impacts through the financing cost channel, while within the ExxonMobil example, the impacts are through the control channel.
Finally, Pomorski examines how short selling and commodity futures will be used as a part of the toolkit in an investor’s ESG integration process.
In summary, this can be a thoughtful and practical book with thorough research supporting a lot of Pomorski’s conclusions. Milton Friedman In 1970, he formulated his shareholder primacy theory, and since then we now have seen an evolution in the way in which we predict in regards to the role of corporations and corporations in American society. Although global sustainable capital flows turned negative for the primary time in history within the fourth quarter of 2023, probably the most pessimistic assessments of sustainable assets suggest that a minimum of $3 trillion is currently invested in sustainable strategies.
[1]R. Alves, P. Krueger and MA van Dijk, “Drawing Up the Bill: Is ESG Related to Stock Returns around the World?”, Working Paper, University of Geneva (2023).
