ESG Devours Capital: Confirmed

AlphaValue agrees with an opinion piece in the FT by Aswath Damodaran (ESG is beyond redemption: may it RIP (ft.com); paywall) wherein ESG advocates are criticized for failing to recognize that ESG does not help investment decisions and starts with higher costs.

Surging ESG costs and ESG-related capital intensity has been a consistent concern at AlphaValue whose tracking of ESG key data has been organized (15 years ago already) to be systematic, simple and across all the universe on a one-size-fits-all principle so that one can sell say L’Oréal on an ESG issue and buy Glencore instead, based on comparable ESG metrics.

One essential aspect of ESG/Sustainability consistent metrics is to rely on capital employed as an essential equalizer: a CO2-spewing industry is likely to have a capital intensive business and conversely. This works well and helps build up consistent data series.

The following two charts help summarize the European situation (defined as a universe of c. 500 European large caps).

The first observation is the steady drop in total CO2 emissions. It is a steady effort by the listed corporate world. Probably not quick enough but it is happening. It is likely that this would have not happened without regulations forcing corporates to be clear about their environmental impacts.

* 466 European corporates under AlphaValue coverage with consistent data. 2022 inferred from trend on 350 issuers with actual data

The second chart shows that ESG/Sustainability costs an arm and a leg. Total CO2 emissions fall because carbon intensity falls (defined as CO2 (t) divided by Capital Employed). This happens because capital employed increases at a fast pace. European issuers are meeting expectations by tying up more capital. Obviously that effort was helped by a low cost of capital context meaning that it is unlikely that the pace seen in the chart will last with risk free rates at 4% or more. ESG do-good ambitions are bound to run into a cost of money hurdle, as simple as that.

It remains that ESG/Sustainability ties up more capital while it is not clear that this capital gets remunerated for the effort. The inflation driven earnings of 2022-2023 are presumably hiding the issue for now.

AlphaValue is reiterating its earlier position: greening up is needed but is blooming expensive.

The dynamic for equity investors is quite simple:

ROCEs are bound to edge down as NOPAT are driven down by higher ESG-induced costs that cannot be passed through and Capital Employed goes up out of necessity (new plant, same volume, less carbon).

WACCs are bound to trend up as ESG is introducing time horizons well beyond investment procedures, is exposing to regulatory uncertainty, is leading to the discovery of unsuspected risks, is leading to the conclusion that modelling of the future is nigh impossible, is exposing investments to technology shocks, and is akin to an endless discovery process.

A greener planet can be summarized as a loss of value for all shareholders as Nature no longer comes for free.