Is Aswath Damodaran right in his criticism of ESG?

Sep 24, 2021
Leslie Norton, Morningstar's editorial director of sustainability, explains that while Damodaran raises some good points, he’s mostly wrong on his key assumption.

Professor Aswath Damodaran, a well-regarded New York University finance professor, has always denounced Environmental, Social, and Governance, or ESG, investing.

Last year, he wrote about its “social goodness standing” in Sounding Good or Doing Good?This year’s salvo was along the same lines in The “Goodness” Gravy Train Rolls On.

Damodaran asserts that sustainable investing is based on expectations that it can measure “goodness” in companies, despite widespread disagreement on ways to define and measure goodness. “Goodness is in the eyes of the beholder, and what you perceive to be a grievous corporate sin may not even register on my list, as a problem,” he writes. It’s borne out, he says, by the fact that ESG ratings, can vary wildly depending on which ratings agency you look at.

But most ESG isn’t about “goodness,” which is a strain of an older version of sustainable investing called Socially Responsible Investing, or SRI. Today’s version of sustainable investing is about measuring and managing financially material risk--and aligning values isn’t, in fact, the intent of most ESG investors. Sustainable investing is about managing risk, not "goodness".

Sarah Newcomb, director of behavioural science at Morningstar, in Damodaran’s Twitter feed.

Good ESG metrics are an attempt to improve equity valuation and account for the risks posed to businesses from climate change and human resource regulations, are they not? I know you are more expert in equity evaluation than I am, but focusing on the squishy concept of 'goodness' avoids the more practical task of carefully measuring the cost of social and natural resource use, and including those costs in estimates of value.

Jon Hale, head of sustainability research for the Americas at Morningstar.

He rejects the idea that sustainable investing is mainly about excluding investments such as tobacco or, in Damodaran’s lexicon, “buying only good companies.” Sustainable investing is much more: “It’s about evaluating how a company handles its material risks and opportunities and assessing its broader impact on the world.”

Hale anticipated Damodaran’s charges in this piece.

The wide range of ESG ratings, Hale says, represents a continuum that helps investors compare companies. Indeed, they’re a “proxy for the more qualitative, but abstract, concept of company sustainability that more investors today think of as important in developing a more complete understanding of a company. ESG ratings of a single company, therefore, should hardly be expected to always agree,” he writes.

Jon Lukomnik, founder of Sinclair Capital, who once advised the New York City Pension Funds and is co-author of Moving Beyond Modern Portfolio Theory: Investing That Matters.

“The starting point for ESG is that value and risk are created in the real world, not the capital markets, and therefore you have to deal with real world sources of risk” that eventually affect the capital markets, says Lukomnik

Consider a service company trying to improve diversity practices. It isn’t simply “being good,” to borrow from Damodaran’s lexicon. Instead, “It’s measuring employee turnover and dealing with human capital risk” that eventually affects corporate valuation, Lukomnik says. “It’s a question of being risk-aware.” Such notions aren’t lost on executives coming up the management chain, who are personally interested in sustainability and aware that customers are interested in it, too.

For perspective...

  • An evolving sustainability ecosystem will continue to face criticism.

It wasn’t so long ago that sustainable investing was a backwater in the investing landscape. That’s no longer the case: Investors are snapping up sustainable funds: In the second quarter, they set a new record of $8.4 billion. A further spurt of growth may lie ahead as the Biden administration takes a climate-friendly approach and, potentially, expands the ability of retirement plans to wade into sustainable investing.

  • Divergent ESG ratings do exist.

Divergent ESG ratings should converge as disclosure improves and as investors gravitate toward particular ratings providers. Charges of poor returns are increasingly misguided: A Morningstar analysis found that, globally, there is no statistically significant evidence that investors needed to sacrifice returns when they invest in good ESG companies globally compared with bad ESG stocks.

The hope is that many of these criticisms are resolved as ESG gets better, as disclosures improve, and common standards are adopted.

Critiques fail to understand what ESG has accomplishedSimon MacMahon, head of ESG and corporate governance research, Sustainalytics, believes that critics a) blur the lines between risk and impact, b) fail to acknowledge what ESG has accomplished, and c) failto recognize that we are in the early innings of the adoption of ESG with many innings yet to play.

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