HH The Contradictions And Complications Of ESG Investing

Complicated. Contradictory. Complex. Whatever your preferred word of choice is for describing a process that’s far from straightforward, environmental, social, and governance (ESG) investing fits the bill. We don’t say this lightly, either, given that the bar for complexity around most investment matters is typically quite high. But when it comes to incorporating ESG factors into an investment process, the complexities involved can rise to a new level.

To understand why this is so often the case, let’s walk through a few examples.

Example #1: Oil

The environmental element of ESG investing looms large for many investors today. As the world continues to warm at an unprecedented pace, more and more investors are clamoring for increased exposure to alternative energy sources in their portfolios—whether it’s solar, wind, or water—and trimming back exposure to fossil fuels, including oil and gas (O&G) behemoths.

Despite momentum toward a clean-energy transition, the cost of oil remains cheap in comparison to the price of most alternative fuels, such as hydrogen, biodiesel, electric batteries, or fuel cells. This can present quite the dilemma for ESG investors, because in order to encourage the widespread use of alternative fuels, oil prices may need to climb higher for these options to become more attractive—on a cost basis—to businesses and consumers.

Yet rising oil prices would be beneficial for oil companies. In other words, logic suggests that higher oil prices, while helpful for reducing demand for fossil fuels, may be associated with an outcome exactly opposite of that desired by an ESG investor—increased profits for the O&G industry.

However, such a scenario is not the only way to make alternatives more cost-competitive. Consider a case where rising prices are driven by carbon taxes. In this scenario, higher prices don’t mean more revenue for oil companies, but rather companies and individuals are charged a tax for goods or services based on greenhouse gases emitted.

The potential for a carbon tax, which has been floated, and in some cases implemented, by governments around the world is one rationale behind reducing an investor’s exposure to carbon-intensive companies. Here, the basic idea is that because the largest carbon emitters would have to pay the most in taxes, their profits would take the biggest hit.

This now sounds like a win-win for the ESG-conscious investor. Prices are higher, thereby reducing demand, and companies are not directly profiting from the price increase.

Not so fast. It’s unclear who, precisely, will bear the burden of the tax: the company or the consumer. This will depend on the elasticity of carbon—that is, the degree to which the demand for carbon goes down as costs increase. If demand for carbon-intensive products is inelastic, meaning demand is relatively unchanged by rising prices, an energy company would likely be able to pass on the increase in costs to consumers.

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