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The paradox of ESG investing

Summary:
ESG definition: Environment. What kind of impact does a company have on the environment? Social. How does the company improve its social impact?Governance. How does the company’s board and management drive positive change? John Cochrane has a good post on how it effects change: The point of ESG investing is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment. If it works, it raises the cost of capital to non-ESG firms, which lowers the Net Present Value (NPV) of their investments (because they have higher discount rates). As a consequence, non-ESG firms get very picky, and invest only in projects with higher rates of return. On the other side of the coin, NPV investing lowers the cost of capital to ESG firms,

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ESG definition:

  • Environment. What kind of impact does a company have on the environment? 
  • Social. How does the company improve its social impact?
  • Governance. How does the company’s board and management drive positive change? 
The point of ESG investing is to lower the stock price and raise the cost of capital of disfavored industries, and therefore slow down their investment.
If it works, it raises the cost of capital to non-ESG firms, which lowers the Net Present Value (NPV) of their investments (because they have higher discount rates). As a consequence, non-ESG firms get very picky, and invest only in projects with higher rates of return. 

On the other side of the coin, NPV investing lowers the cost of capital to ESG firms, which raises the NPV of their investments (because they have lower discount rates). As a consequence, ESG firms get less picky and invest in more projects with lower rates of return. 

The paradox: "if you don't lose money on ESG investing [relative to non-ESG investing], ESG investing doesn't work. Take your pick." 

The paradox is also easy to see by thinking of constraints: if you limit yourself to only a subset of potential investments, you will have a lower rate of return than if you don't.

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