German state blacklists US Treasuries over ESG rules
Weekly Newsletter (8 June 2023)
Happy Thursday! Welcome to this week’s Q-ESG newsletter.
Here are some key developments and learning resources to help you on your ESG finance journey.
What’s happening?
[1] German state blacklists US Treasuries
The German state of Baden-Württemberg, home of Mercedes-Benz Group AG, adopted a law this year that blacklists investments that fail certain ESG criteria.
Why this matters: US Treasuries, one of the most popular investment instruments worldwide, ended up in the blacklist due to the US’s failure to “ratify a number of treaties in areas including women’s rights and controversial weapons”. While this has little practical implication given the state’s insignificant holdings, it highlights the widening gap between Europe and the US in approaching ESG issues. Read more here.
[2] Don’t just divest from fossil fuels, invest in renewables too: Goldman Sachs
ESG strategies have led to a 25% decline in energy spending compared to 2010-2014, which have been damaging to the “economically vulnerable”.
Why this matters: According to Goldman, too much focus has been on divestment from fossil fuels instead of investment into renewable energy. Divestments led to a slower increase in energy capex, which is not enough to “fill in the gap of 10 years of under-investment”. That could mean insufficient energy supply especially in times of rising inflation, leading to higher energy prices. Read more here.
[3] Indian fund did well betting against ESG
One Indian fund has beat its peers despite holding shunned names such as ITC (tobacco) and Coal India (coal).
Why this matters: The Parag Parikh Flexi Cap Fund bought some of these names at low valuations three years ago, when other large investors may have balked at them. Those bets helped the fund deliver a return of 14% so far this year, outperforming 90% of its peers. Read more from Bloomberg here (account may be required). However, don’t write off ESG so quickly and rush to buy tobacco and coal names now, because we also see headlines like these: ESG jobs in India sees 223% increase since 2019.
Explain to me like I am an eight-year-old
Nature-based solutions
Nature-based solutions use the power of nature to solve problems. It’s like asking nature for help instead of relying on man-made inventions.Let's say your town has a problem with floods. Instead of building big walls or dams, you can use nature-based solutions. You can plant lots of trees along the riverbank.
Books/papers/learning resources
Measuring Business Social Irresponsibility: The Case of Sin Stocks
(by Hamid Boustanifar and Patrick Schwarz)
Excluding “sin” stocks is one of the oldest and most common ESG investing strategies. Traditionally, investors use industry classification (IC) method to label these sin stocks, but this may not be very effective.
Instead, the authors propose using textual analysis1 (TA) of companies annual reports to measure companies’ exposures to sin activities.
The correlation between these two methods is 0.69, with TA able to identify twice as many sin stocks as IC.
This paper highlights the shortcomings of the traditional IC method of labeling sin stocks. In particular, the IC method generates several “false positive and numerous false negative sin stocks” and random time-series variation. There was also no specific industry code for companies that are hard to define, such as the ones operating in adult entertainment or pornography.
The TA method improves on this and is able to identify more sin companies. On top of that, it also moves beyond just a binary definition (under the IC method, a company either is or is not classified as a tobacco firm) and investors can now classify a company’s “sinfulness” based on the frequency of sin words found in its annual report.
The authors also show that a sin-weighted portfolio (where a more sinful company receives a higher weight in the portfolio) is able to earn an “annualized Fama-French 6-factor alpha of 4%”.
That is, they were able to prove that the “sin premium” exists and more sinful stocks have higher expected returns. My guess is that probably because these companies are generally shunned by investors and thus led to attractive valuations — see news item [3] above for an example from the Indian stock market.
Read the full paper here.
Programming note: There will be no Monday post next week (Jun 12).