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A little logic, please

No surprises, therefore, about the findings of a global survey by management consultant McKinsey, who asked 550 company bosses and investment professionals last summer about the importance of ‘ESG’ (that’s anything linked to the environmental, social and governance activities of a company). Answers to the survey, which the consultant announced earlier this month, showed that, almost to a neatly-manicured, orthodontically-perfect person, the bosses reckoned ESG would contribute more to shareholder value in five years' time than today.

Granted, that headline finding is suitably vague. Even so, comparing 2019’s survey with one that McKinsey did 10 years earlier shows that bosses say they now take ESG more seriously in almost every way and the results are consistent with teeming numbers of reports from consultants, think tanks, pressure groups and just about anyone who feels obliged to have an opinion on this fashionable subject.

If it’s ultra in vogue, if discussion of ESG is ubiquitous – and I wrote this before Amazon’s Jeff Bezos promised it a $10bn boost – if there is consensus that observance of ESG’s strictures will improve a company’s performance, then you might also think that the essence of ESG has been thought out and is clear. No such luck. Almost by definition, ESG is a mish-mash. Its very title lumps together separate matters that have developed over the past 30 years on the question of how companies should conduct themselves.

First came corporate governance, the ‘G’ in ESG and probably the best understood of the three elements. It is about the internal practices, controls and procedures a company uses to govern itself. Formalising corporate governance grew out of the need to curb the corporate excesses of the 1980s. Arguably, however, it has proceeded to place form above substance and, in doing so, has lent a veneer of legitimacy to the rent extraction at which so many company bosses excel.

Next came corporate social responsibility – the ‘S’ – which is perhaps the vaguest and fluffiest of the three. It acknowledges the serious point that companies – especially listed ones – have a big impact on the people they employ and the places where they do business, and that, therefore, they have duties beyond their legal obligations. What that means in practice has kept legions of consultants in employment, has added ‘stakeholders’, ‘social accounting’ and ‘greenwashing’ to the lexicon of business terms, but arguably has not achieved much.

That leaves the ‘E’ for the environmental impact of a company’s activities, especially the energy it uses and the waste it discharges; increasingly, however, this aspect has been highjacked by the issue of anthropogenic climate change.

Fuzzy though its definition may be, ESG has so much attention and money coming its way that it is a theme investors should want to pursue (and many do). That good corporate citizens prosper more than corporate sinners – or so we keep being told – only reinforces this notion. Yet, consistent with that fuzziness, ESG funds exclude some groups of companies – and include others – on tenuous grounds.

Take probably the simplest and cheapest ESG fund available on the London market – iShares MSCI Europe ESG (SAEU), an exchange traded fund that screens out companies from various disapproved industries. One of these is most defence suppliers. Yet one can seriously ask why? Go back to first principles and it is uncontroversial to argue that the first obligation of the state is to defend its citizens from threats both internal and external. That requires a defence capability which, in turn, requires defence suppliers. So defence suppliers perform a vital role and one that, in other ways, does not prevent them from fulfilling ESG requirements. Why, therefore, exclude them? Presumably because what they do – however necessary – is nasty.

Something similar might be said about the exclusion of tobacco companies and the inclusion of gambling and drinks companies from ESG lists. Nothing stops companies in these industries from being upstanding corporate citizens; indeed, many are at pains to point out their virtue. Of course, we all know their major shortcoming – they sell addictive products and services that mix misery with the happiness they offer and sometimes that includes illness and death. Since that charge includes companies from all those industries – and it does – then why exclude only tobacco suppliers other than because they fail a sort of middle-class popularity contest while the others still pass it? That may be understandable, but it’s hardly logical.

True, investors could say that if ESG shares do outperform their non-ESG equivalents, what does it matter if there is a hole in the logic? There might be something in that. Since the MSCI Europe ESG index was launched three years ago, it has risen 21.4 per cent compared, with 18.7 per cent from the wider – and underlying – MSCI Europe index. Something similar has happened in the UK where the FTSE4Good UK index has outperformed the All-Share index over the same period – up 7.8 per cent against 5.9 per cent. Sure, those margins are narrow, but, if compounded long term, their effect will matter. Perhaps with smart logic, however, their outperformance would be even wider.