Views on improving the integrity of global capital markets
13 May 2019

ESG and Sustainable Finance: Taking Climate Change Literally, But Not Seriously

Since my last blog on the issue, the topic of finance and climate change has risen to headline news, thanks to the Extinction Rebellion protests, including near the CFA Institute London offices at Bank Junction. While it is easy to make fun of the affluenza and hypocrisy exhibited by some of the participants, it is always good to take a critical look at oneself before someone else does it for you.

In my last blog I expressed concern about the increasingly widespread marketing of ESG products and/or “sustainable investing” as, first and foremost, “good for investors.” The reasons given for superior long-term performance are typically that investors are reducing their downside risk by reducing their exposure to stranded assets. For example, it may not be sensible to invest in oil companies if we know that ultimately their oil cannot be allowed to be extracted and used.

My concern is that product manufacturers and distributors are selling a narrative that is too good to be true. It seems a large proportion of the growing ESG “industry” views ESG integration as simply a new revenue stream for data providers and investment product manufacturers. CFA Institute has consistently called for ESG integration in the investment process, which we believe is necessary to ensure all material information is considered. However, it appears that ESG and sustainable finance are becoming shorthand for finance’s ‘leading’ role in addressing climate change. This is unlikely to succeed without a change in attitude because ESG is the wrong tool for the job, as the remainder of the blog illustrates.

Don’t worry about getting rich if you are trying to save the planet.

First, I want to point out that I am using “ESG” in this blog as a proper noun, as I think in the public consciousness the terms ESG, ESG investing, ESG integration, and sustainable finance are all largely synonymous with “finance industry addressing climate change.” My personal opinion is that whatever industry insiders think, the ESG “branding message” has been overtaken by facts on the ground – nobody is gluing themselves to the London Stock Exchange to protest for one-share-one-vote !

Next, I wish to reiterate the skepticism in my previous blog about the “sustainable investing is good for investors” narrative the industry has adopted in promoting ESG integration. Cliff Asness notes that, in some sense, if sustainable finance or ESG integration (perhaps we can define a ‘climate finance’) delivers better returns, it has failed. The fundamental motivation of climate finance, if it is to have any internal logic, is to reduce carbon output. This, at some point, means that investment in the production of carbon-intensive resources and products must decrease if ESG integration is to have any impact beyond virtue-signalling. This is essentially a socially-driven supply-side investment shock to these industries and companies. Basic economics suggests that if a significant proportion of the investment population refuses to lend or invest in a particular sector, that sector will offer higher returns to attract investment. At some point in this negotiation, some less morally-driven actor will surely take this deal and, by definition, earn better returns due to the very fact that the ESG-focused investment population is abstaining.

This is a fairly reductionist example, and whether it turns out to be true in the real world can be debated, but the point is that the idea that ESG investing is automatically a positive for investors seems wishful thinking of the highest order. My conclusion in the last blog was that if one believes addressing the climate problem is important, one should be supportive of ESG investing, a priori, and if ex-post the returns are not terrible, or even good, then so much the better.

Hardware is hard.

Now, let’s get back to why I think ESG is the wrong tool for addressing climate change.

I believe a significant blind spot is arising in the ESG debate, one that centers on not questioning the economic and technical/engineering fundamentals behind what we are trying to achieve in addressing climate change. There is a widespread technological ignorance in much of finance at the moment that we can observe in the excessive hype afforded to blockchain (still without any significant commercial deployment) and artificial intelligence (see here for a reality check), and now it seems to be affecting the ESG topic.

Investment management has always necessitated that advisers had both the business/management competence to understand how a given company is run and what prospects it has, as well as some technical/engineering competence to understand that company’s products as, ultimately, the main driver of its future performance. However, previously this technical/engineering competence could be compartmentalized to specialists covering a particular sector. The challenge that ESG poses is that it necessitates the overlay of the very complicated scientific and technical issues of climate science on top of all industry sectors.

It seems to me that the response of many in finance to this challenge is a “vorsprung durch technikshrug of the shoulders and a belief that the finance industry will simply guide the money to virtuous industries and the boffins will do the rest. I believe the sudden rise of the iPhone and its app ecosystem has given us a misplaced faith in the speed at which technology and industry can move to change the world. The reality is that the smartphone is an exception to the rule. While the iPhone was a paradigm-changing product that, relatively speaking, appeared overnight, this does not mean that everything else can be as well.

Specifically at fault here, in my opinion, is the idea that software would take over from hardware as the most important part of any industry and thus increase the pace of change and innovation across all industries. This is true to a point. However, software will do nothing whatsoever to decarbonize the heating systems of tens of millions of homes that currently rely on gas or heating oil. One’s gas boiler cannot be updated over-the-air.

Let’s look at the example of aviation (simply because I am a casual enthusiast) to see why ESG is not going to be the solution to the climate problem on its own and why we should be wary of treating ESG as anything other than a third-best Band-Aid, and not let it distract policy makers and lobbying efforts from the more effective solutions of a carbon tax and cap-and-trade carbon trading markets.

Plane to nowhere.

First, it is important to fully internalize the following reality: The atmosphere doesn’t care about how much economic activity is produced per ton of greenhouse gas emissions, or the per-capita emissions, or the fact that the “West” was able to develop with unlimited emissions and now the developing world is being asked to reduce its own while still developing. It is only the absolute amount that matters. It is not obvious to me that a company that produces 15% fewer emissions than a peer would be 15% less exposed to future draconian regulatory restrictions in response to a climate crisis.

This is a problem for aviation, in particular, which is responsible for around 2% of all human-induced COemissions. While relatively minor today, it is expected this share will rise dramatically as other industries decarbonise and air traffic continues to grow. The aviation industry always counters arguments about its contribution to climate change by showing — justifiably — how efficient it is at transporting:

1) humans (using the “per passenger-kilometer” metric) and

2) goods (in terms of the economic “value” of goods — e.g., perishable goods — rather than quantity, which is obviously dominated by shipping).

Again, it does not matter that a single transatlantic flight transports 400 or so people and valuable cargo across an ocean to facilitate economic activity that generates positive welfare. The only thing that matters is that it consumes around 70 tons of fuel. It is true that airplanes are more efficient than before; for example, the 2017 Boeing 737 MAX-9 with 180 seats burns 15% less fuel per kilometer than its equivalent predecessor, the 2006 737-900ER. Further, planes are anywhere up to 2/3 more fuel efficient than the first jets of the 1950s. However, this is more than offset by growth in aviation. In Europe, for example, the average fuel consumption per passenger in 2017 was 24% less than in 2005, but traffic had grown 60% for a 16% rise in emissions of CO2.

The reality is this: there is no technical solution to airplane efficiency that will yield the kind of significant fuel efficiency improvements demanded by the Paris Agreement at current atraffic levels, and the task is completely hopeless if you assume growth in airline transport. Evidence for this can be observed in the International Air Transport Association (IATA) Technology Roadmap, which shows how the airline industry is planning to meet COreduction goals. The bulk of the work in reducing future emissions, according to the aviation industry body, will be done through “biofuels and radical tech.”

First, let’s abstract from the many caveats and unintended consequences that stem from the idea that biofuels are carbon neutral. They are, at best, less “carbon positive” than fossil fuels, and even that depends enormously on their production method. In any case, the rate of development of jet biofuels is less than glacial. Refining capacity has not been developed since the first commercial demonstration flights from a decade ago and is probably decades away from being sufficient to supply the jet fuel market.

Second, “radical tech” should be treated with suspicion considering the slowing pace of aviation innovation and the long lead times for fleet renewal. It took the aviation industry 66 years to go from the first flight at Kitty Hawk to the first flight of the Boeing 747. The Boeing 747 is still being produced in more or less the same guise 50 years later. Today, “radical tech” is likely to mean battery electric technology. However, unlike electric cars, where the fuel’s energy density is a “nice to have” feature, so that you get a lot of range before recharging, in aviation unless you have a sufficiently high energy-density fuel, you do not fly at all. Current lithium-ion battery technology is nowhere near energy dense enough to power anything more than a two-seat training aircraft for about an hour (an interesting application nevertheless). Long-promised solid-state batteries are better but still not enough for large-scale commercial aviation.

To reiterate: There is no known, realistic, alternative to jet fuel on the horizon.

There are improvements in jet engines being developed, even beyond the latest geared turbofan engines. Technologists are promising low double-digit efficiency gains. However, these will be dwarfed by projected traffic growth and the slow pace of fleet renewal. Other technologies regarding aerodynamic efficiencies such as laminar flow are not game changers either despite being very difficult. The much-hyped hybrid and distributed propulsion jet/electric combinations are not showing much promise in early development.

The beatings will continue until COemissions stop.

So, what is a sustainable, ESG-integrating investment manager meant to do with the airline industry? There are zero technical solutions in the foreseeable future if airline travel is to resemble anything like it does today. Does it matter for the climate that Norwegian Air is 33% more fuel efficient than the industry average on the transatlantic route, while British Airways is the least efficient, 22% below industry average? According to IATA’s own projections of CO2 reduction paths, the answer is no.

The obvious solution is a draconian reduction in air travel. While “flying shame” is apparently gripping Sweden, and the climate “Joan of Arc” Greta Thunberg completed her recent tour of Europe by train, other countries and people may need to be coerced. Will Norwegian Air be 33% less affected by regulatory limits on flying than the average, and British Airways 22% more affected? Possibly, but this feels to me like a competition of who is the prettiest horse in the glue factory.

While it is easy to say this is a pointlessly provocative statement, the direction of travel is clear to anyone willing to look outside their Overton window. Draconian reductions in air travel are exactly what were proposed in the Green New Deal by Alexandria Ocasio-Cortez and her supporters. The plan (paraphrased) is to replace air travel with high-speed rail. Ironically, California’s high-speed rail line project was cancelled soon after.

Although here I have talked about aviation, broadly similar concerns apply to many other industries. Shipping is a significant challenge. The world’s largest 16 (not 16 hundred or 16 thousand, but just 16) container ships emit more sulfur dioxide than all of the cars in the world combined (this is not strictly a climate change problem, rather a pollution problem, but gives a sense of scale). Again, ironically, the receding Arctic ice cap is opening up the Northern Sea Route between Europe and Asia, which could slash CO2emissions on this trade route by around 40%. The meat industry is a similarly big elephant in the room.

My goal in this section is to simply point out the physical, scientific, technical, and engineering realities and the scale of the challenge presented by climate science and to burst the bubble of all those who think slow progress toward a standardized EU “green” taxonomy by 2021 is particularly meaningful. In this context the selling point that “ESG investing is good for investors” seems trite.

Wrong hammer for the wrong nail.

The investment management industry, through its embrace of ESG, is underestimating the challenge ahead. ESG will not be simply about generating interesting new revenue streams of data according to various sustainable taxonomies and allocating marginal investment flows to wind farms. Instead, incredibly harsh technical and engineering facts on the ground are going to create enormously difficult trade-offs that ESG will not be able to manage because it is the wrong tool for the job.

The technical innovation needed to address climate change is so multidimensional and distributed that it should be internalized at the company level through a price on carbon that would accurately reflect the externalities generated by the firm’s production processes in its supply curve. This is basic economics that is taught at all universities and in the CFA curriculum. The next-best strategy would be carbon quotas that could be traded between firms. We have seen examples of this in action with FCA — an EV laggard — paying Tesla to use up its emissions allowance. But as in all markets, what is needed is depth and liquidity, and these markets have been slow to develop and have not had any significant public mindshare for what seems like a decade. Examples of such markets working quietly, efficiently, and effectively, can be found in the old cap-and-trade schemes for Acid Rain pollutants in the 1980s and 1990s, described in detail in the CFA Institute Research Foundation booklet “Environmental Markets: A New Asset Class

A world that relies only on ESG investing will do nothing to solve the aviation, and other, challenges because there are no obvious technical solutions that are waiting to be unlocked via targeted funding. These kinds of problems could, however, be ameliorated via carbon markets that would allow the aviation industry, for example, to fund the decarbonization of other industries in lieu of the technical limitations of its own activities. A carbon tax would incentivize the entire travel ecosystem to develop new modes or attitudes to travel — perhaps a return to viability for slow-travel airships?

In comparison to these incentive structures, ESG more closely resembles central planning where an enlightened set of elites (e.g., institutional fund managers) attempt to direct resources to their best estimate of the social good. This tends to work badly both on a technical level (see Europe’s ill-fated bet on “clean diesel”) and a social level (see France’s gilets jaunes protests sparked by climate-motivated fuel duty increases).

This blog is meant as a reality check to the groupthink that is starting to arise around ESG, particularly the self-serving idea that it is a satisfactory and sufficient response, and, a priori, good for investors. Implicit in this conceit is an assumption that everything will remain essentially as per the status quo but with Big Oil replaced by Big Sun and Big Wind, and Big Auto replaced by Big EV. I recently learned about a Freudian concept — Verleugnung — which I think applies here, and I can loosely paraphrase as: appearing to accept the existence of a concept or reality, but internally being in total denial of its implications.

Photo Credit: ©Spencer Platt / Staff

About the Author(s)
Sviatoslav Rosov, PhD, CFA

Sviatoslav Rosov, PhD, CFA, is Director, Capital Markets Policy EMEA at CFA Institute. He is responsible for developing research projects, policy papers, articles, and regulatory consultations that advance CFA Institute policy positions, focusing on market structure and wider financial market integrity issues.

3 thoughts on “ESG and Sustainable Finance: Taking Climate Change Literally, But Not Seriously”

  1. Charles Blore says:

    I think the mechanism by which ESG investing is meant to effect change in the “E” of ESG is by reducing the cost of capital for the “cleanest” companies, and increasing it for the “dirtiest”. I’m not sure you’ve dealt with that in your piece here. Instead you seem to be implying that it’s meant to stimulate technical progress. That would be a theoretical offshoot of the cost of capital point, but hardly the main goal. If a wind farm builder can raise capital easier and fund more projects because they score well on ESG metrics, this is ESG effecting real change on the environment. And conversly a coal plant builder is unable to fund projects because their cost of capital has become prohibitively high, the same is true.


    It is sadly not as simplistic as just providing low cost or even free capital to the wind farms with high E’s. One of the side effects we are witnessing of the same is renewable energy companies and projects with very low G’s still benefiting from the high E status and the blind influx of capital into the same. The first ever green bond that was issued in Europe was from a solar power company called Abengoa which filed for bankruptcy two years later due to governance and accounting issues. So while the appreciation of environmental contributions is key, a holistic approach to balancing the E-S-G efforts is crucial as well. The same overreaction on sectors and companies that score low on the E factor but very high on the S and G effects exists as well and that needs to be balanced too. The last thing we need is an investment portfolio of overvalued windfarms run by dodgy developers claiming government subsidies while avoiding well run airlines flying fuel efficient aircraft and with strong governance practices.

  3. James Dent says:

    You make some valid points, however I’m sceptical of some of the logic. If we accept aviation is going to increase, we can presume CO2 will also increase as a result. Then if we take a transatlantic trip whereby Option A emits 33% less CO2 than the average. If the majority of transatlantic trips are taken by Option A in the future, then there is a net reduction in CO2 from a scenario where Option A is not the most common carrier. As such if we have a target to ensure overall CO2 emissions are kept below a certain level, these targets are more likely to met if CO2/km factors are incorporated into the flight decision making process; thus ESG metrics must be beneficial.

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