ESG is not an investment strategy and can lead to business valuation errors, Damodaran argues

BVWire–UKIssue #31-1
October 5, 2021

BVWire—UK is not the only source questioning whether ESG rankings have a role in valuation theory or practice. “I believe ESG is not just a mistake that will cost companies and investors money, while making the world worse off. It creates more harm than good for society,” Aswath Damodaran, professor of finance at Stern School of Business at New York University, wrote on his blog “Musings on Markets” late last month.

As two small examples of the expensive institutionalisation of compliance and reporting programmes based on ESG, the UK Competition and Markets Authority (CMA) released its new “greenwashing” codes last week. Meanwhile, the Financial Reporting Council (FRC) published FAQs on 23 September about how to set additional sustainability standards.

There’s a further analysis of this problem in an article in the new October issue of Business Valuation Update titled “Warning to Business Valuers Looking to Use New ESG Ratings.”

Damodaran’s concern echoes those expressed in “Unhedged,” the FT blog written by Robert Armstrong, who is even more concerned that ESG ratings are counterproductive for both business valuers and investors.

When I say that environmental, social and governance investing does the world harm, people assume I’m exaggerating for effect; that what I write is clickbait. Nope. I’m sure the ESG investing industrial complex is well intentioned, but I am equally confident that the world would be a better place without it. To use Tariq Fancy’s analogy, the industry is selling wheatgrass juice as a cure for cancer: it won’t help; it reduces the chance the patient will seek the right treatment; and it’s not cheap.

As if to prove the expense point, SPGI announced a new suite of ESG data tools 1 October that provide additional analytics but are only available to their Pro platform customers.

ESG rating schemes are not correlated, and there’s little transparency or consensus on the key issues (climate change, supply chain transparency, shareholder rights, and executive compensation), Armstrong says. Furthermore, high ESG ratings may drive outperformance once, but, thereafter, cost of capital differentials must mean underperformance as investors anticipate lower expected returns.

Back to Damodaran, who last month repeated “I am more convinced than ever that ESG is not just overhyped and oversold, but it’s become a gravy train for all the people who make money on ESG, and none of those people are in the groups that ESG is supposed to help.” You can read Damodaran’s post and watch his video on ESG here.

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