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It is undisputed that when a company is poorly managed and acts in an antisocial manner or damages the environment it is not a suitable investment. Thomas Mayer pleads for common sense. ESG regulations do more harm than good.

In 2004, a group of private and public financial organisations published a report entitled "Who Cares Wins", at the invitation of UN Secretary-General Kofi Annan. The aim of the report was to develop guidelines and recommendations on how environmental, social and corporate governance aspects could be better taken into account in asset management, securities trading and financial research.

The report states: "A better inclusion of environmental, social and corporate governance (ESG) factors in investment decisions will ultimately contribute to more stable and predictable markets, which is in the interest of all market actors"

No common-sense financial analyst or business leader could have objected to the proposition that a business which is badly managed, behaves antisocially and systematically harms the environment is not an attractive investment in the long term and should therefore not enjoy a lasting right to exist on the market. Seen in this light, the call to consider "ESG criteria" when investing seemed like a call to invest with common sense. However, common sense is often an all too scarce commodity. The "ESG criteria" of the Annan Report have been narrowed down to partial aspects which produced mechanical rating systems and government bureaucratic monsters.

Rating agencies have developed various "ESG ratings" that measure environmental friendliness, social compatibility and proper management according to bureaucratically prescribed criteria. In doing so, however, the agencies go far beyond what can be measured quantitatively. Ratings were originally created to measure the probability of default on loans. Although qualitative factors also play a role, a quantitative statement can be made on the basis of key figures from the profit and loss account and the balance sheet analysis.

In contrast, the concept of sustainability is very complex and involves conflicting goals. Neither can it be defined without contradiction with the sustainability goals of the United Nations, nor can it be broken down to the three factors "E", "S" and "G". It is impossible to implement the sustainability goals without contradictions or converting the ESG criteria into a measure for "rating". Subjective and selective assessments dominate. Consequently, it is not surprising that the ESG ratings produced by the agencies are often inconsistent with each other.

Investment universe narrowed

In the capital markets, fund providers have promised their clients higher returns from "sustainable" ("ESG") investments. They may have been influenced by the assessments of the Annan Report. Indeed, ESG investments have at times outperformed the overall equity market. However, this was due to politically stimulated money inflows and not to higher earnings prospects for these ventures that would justify higher returns. In the long run, common sense says that investments selected according to ESG criteria must yield a lower return than the market as a whole; because if the investment universe is narrowed to ESG-compliant stocks, the investment universe is narrowed down to ESG-compliant securities and investment funds, this  concentration on a more limited selection of securities means lower returns are to be expected. In fact, the promises made by the providers have not been fulfilled either.

Especially after the Russian war of aggression on Ukraine, they must now answer uncomfortable questions: Why had many Russian companies received similar ESG ratings as comparable European companies? How was it possible that around 300 ESG Funds were involved in Russia and their investors have to reckon with losses of more than eight billion US dollars?

How was it possible that around 300 ESG funds were engaged in Russia?
Prof. Dr. Thomas Mayer

Aswath Damodaran, Professor of Finance at New York University's Stern School of Business, comments with a certain cynicism: "I think ESG is basically a feel-good scam that makes advisors rich while doing little or no good to companies or investors that they're trying to help, much less society. "This is because when investment money in public capital markets or bank loans are diverted from "brown" to "green" companies by policymakers, profitable investment opportunities in "brown" companies open up for private equity investors. The cost of capital in these companies increases only slightly and their production continues as usual.

Less sustainability

On the public side, the focus was on climate protection, which is mainly pursued by reducing carbon dioxide emissions. In March 2020, the European Union published a "taxonomy" that breaks down the climate and environmental impact of economic sectors in a catalogue of around 600 pages. On this basis, not only financial service providers should inform their customers about investments, but also banks should assess their credit risks associated with climate change. The European Central Bank also wants to make its monetary policy greener and thus more sustainable, even though this may entail risks for the safeguarding of price stability enshrined in its mandate.

On the one hand, the EU's extensive regulations are intended to provide more information that investors can include in their investment decisions. On the other hand, however, it also means that the analysis of investments is reduced to officially propagated formulas. So, resources are not used where they can be used most efficiently and contribute the highest added value to society, but where they are directed by rules and regulations. It is not difficult to deduce that not only the quality of investment decisions is reduced, but also the overall productivity of capital in the economy, which then leads to less "sustainability" instead of more.
Ultimately, "sustainable" in the field of economics and finance means "profitable in the long term". Of course, this is only possible if the basis of life is preserved, and the economy is run in a socially acceptable and efficient manner. However, it is not possible to create templates for this or to set timetables for achieving the goals.

Desire and reality

Protecting our livelihoods involves not only protecting the climate, but also protecting the free social order. This also requires weapons, which are often considered to be not "ESG-compliant". Also, climate protection is not sustainable through protective measures if they fuel social conflicts; or stem from inefficient administrative structures; or if regulations prevent innovation, as is to be feared from the  current "Green Deal" and taxonomy of the EU.

Profit is a prerequisite for sensible economic action for the benefit of all
Prof. Dr. Thomas Mayer

This article was first printed in the special publication "Prosperity for All" of the Ludwig Erhard Foundation. We would like to thank Dr. Frank-B. Werner and the publisher Holderstock Media for permission to publish.

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