Investing 'Ethically'? Prepare to Lose Your Shirt

It’s starting to look as if the world is emerging, albeit slowly and reluctantly, from the utopian dream of halting and reversing climate change by policies based on almost exclusively on mitigation rather than on adaptation. These two approaches have always been the practical choice between real-world alternatives. A mixture of the two leaning mainly towards adaptation is probably the best approach since the costs of mitigation—as in achieving Net-Zero carbon emissions—are huge and its benefits either modest or unachievable.

For reasons outside the scope of this short commentary, however, the world’s governments and global agencies have placed all their money on the mitigation approach. I write carelessly “their money.” It is, of course, other people’s money. And we are gradually discovering just how much of other people’s money they are investing in climate change mitigation. Prepare to be shocked.

Recently the Financial Times reported as follows:

Thirty of the world’s biggest asset managers, which collectively oversee $9tn, have set a goal of achieving net zero carbon emissions across their investment portfolios by 2050 in a move expected to have huge ramifications for businesses globally. The group, which includes Fidelity International, Legal & General Investment Management, Schroders, UBS Asset Management, M&G, Wellington Management and DWS, said they would work with their clients to cut emissions across their investments.

That attracted the attention of National Review’s Andrew Stuttaford (full disclosure: an old friend) who devoted his regular weekly column on finance to examining how and why Wall Street decided to plunge so wholeheartedly into green ink investments. It’s a real humdinger of a column because it solves a financial mystery.

Nowhere to go but down.

After all, the purpose of investment institutions is to deliver the best return on the money that they are lent by savers and pensioners. If an investment house says that it intends to make mitigating climate change one of its main aims, it’s also telling you that your money will be getting a lower rate of return than it otherwise might. That’s a clear betrayal of the fiduciary duty that agents owe to their principals—unless they level with them and admit the likely loss.

That’s exactly what happens with other ESG funds, and I’ve no doubt that this admission will appear in the middle of the voluminous fine print which warns purchasers that socially conscious investments are likely to perform less well than the average. At the same time all the great and the good of the financial, political, and regulatory world from Al Gore to Mike Bloomberg to Mark Carney are bent on assuring nervous investors that they are making a prudent decision in going green.

Their argument boils down to claiming that any investor risks from green investments are trivial compared to the risks of investing in fossil fuels which are likely to prove unprofitable investments in a world moving towards Net-Zero and which might make those companies vulnerable to expensive lawsuits and regulatory restrictions.

The fallacies embedded in that argument were challenged by me in February last year in the first column I wrote for The Pipeline—which was a criticism of Mark Carney’s strident advocacy of strong measure of financial regulation to direct investors into the “right” green companies.

Yet if these climate forecasts are either exaggerated or simply uncertain [as they are], what is the test which would tell us with some reliability that the market demand for fossil fuels is likely to fall along with the value of companies that extract them. It cannot be the additional stress tests or capital requirements that regulators may want the banks to impose on energy companies, for then the regulators would be using their own interventions as the justification for intervening. As yet, however, non-official market participants can’t seem to see spontaneous causes for this threat to the energy sector.

But my tentative point is made more vividly and powerfully by the economist John Cochrane (quoted by Stuttaford) in an address to the European Central Bank in a reply to one of its senior executives:

Let me quote from ECB executive board member Isabel Schnabel’s recent speech. I don’t mean to pick on her, but she expresses the climate agenda very well, and her speech bears the ECB imprimatur. She recommends that,

‘First, as prudential supervisor, we have an obligation to protect the safety and soundness of the banking sector. This includes making sure that banks properly assess the risks from carbon-intensive exposures. . . .’

Let me point out the unclothed emperor: climate change does not pose any financial risk at the one-, five-, or even ten-year horizon at which one can conceivably assess the risk to bank assets. Repeating the contrary in speeches does not make it so. Risk means variance, unforeseen events. We know exactly where the climate is going in the next five to ten years. Hurricanes and floods, though influenced by climate change, are well modeled for the next five to ten years. Advanced economies and financial systems are remarkably impervious to weather. Relative market demand for fossil vs. alternative energy is as easy or hard to forecast as anything else in the economy. Exxon bonds are factually safer, financially, than Tesla bonds, and easier to value. The main risk to fossil fuel companies is that regulators will destroy them, as the ECB proposes to do, a risk regulators themselves control. (My italics.)

“A risk regulators themselves control.” I hesitate to accuse a former governor of the Bank of England, a former Vice President of the United States, and a former Mayor of New York of financial legerdemain, but I think there are laws against stock manipulation of that kind—though I doubt legislators ever envisaged fraud on the scale of nine trillion dollars.

My own advice to investors and pension fund managers is to fight shy of the “watermelon investments” recommended by the great and good. They are written in Green ink today, Red ink tomorrow.

Consider tobacco companies instead. They survived the legal and regulatory onslaught, and today they’re nice little earners.

Fiduciary Responsibility, Charity, and Other People's Money

Mark Carney leaves his job as Governor of the Bank of England in March, stepping easily into several new positions: notably, U.N. Special Envoy for Climate Action and Finance and special advisor to the British Prime Minister for the Glasgow COP26 conference on climate change in November. More broadly, Carney is moving from the world of central banking and high finance into that of international political activism on climate at the highest U.N. level.

That’s also a move from a world in which he had sustained success and a high reputation—with one significant misstep to which I’ll return—to one in which he wields less expert knowledge and yet is taking on a much more controversial task. And he clearly relishes this more adventurous role in which he seeks to use his experience as a banker to get the international financial system, both central banks and private financial markets, to become engines of climate policy.

In fact he’s been auditioning for this role since his early days in the Bank of England. In 2015 he established an industry-led task force on the disclosure of climate-related financial risks under Michael Bloomberg (a useful ally) under a mandate from G20 ministers. His particular concern has been to seek to persuade, “nudge,” even compel banks, corporations, and other economic actors to integrate climate risks into our understanding of fiduciary duty; managers must incorporate these risks into their prudent management of their clients’ money. Carney himself has warned several times that managers may in future be held to account for energy investments that turn out badly for their clients because they underestimate the market failures of fossil fuels. And he has used his banking leadership to encourage banks and others to write down the values of fossil fuels in their portfolios.

Now, this is a sophisticated version of an argument that has been going the rounds for about fifty years. That argument begins as a claim that managers and markets should take a wider range of factors than profitability and shareholder value into account when making investment and other decisions. What makes Carney’s argument more sophisticated than my crude version here is that he disguises an essentially ethical argument as long-term prudent investment advice (plus warnings that managers who ignore him may face shareholder suits for losing money.)

Milton Friedman was an early critic of this kind of thing when he attacked the highly respectable concept of corporate charitable giving. He was misinterpreted, of course, by those who believed (or pretended to believe) that he was advocating a capitalism red in tooth and claw that was contemptuous of compassion and idealism. One critic at the time dismissed his argument as “romantic brutalism.”

In fact Milton was a kind and beneficent man, but a realist first. His target was what we now call “virtue-signaling” or, to be even more romantically brutalist, virtue-signaling at the expense of other people. If corporate managers wanted to give money to poor villagers in the Third World, or local symphony orchestras, or National Public Radio, they should write cheques to those causes on their own accounts. Their wives could then legitimately boast about these donations at the Annual Planned Parenthood ball.

What they were not entitled to do was to give money belonging to their shareholders to causes of their own choosing. Friedman was not dissing compassion here. Their shareholders might be feeling generous too, conceivably more generous, but towards causes like Wounded Warriors, Mother Teresa’s missions, or Adoption Services. They would have less to give to their favored causes if the corpocrats had siphoned money from their dividends into the Philanthropy Department. (Please switch donations between corporate managers and shareholders if it makes you feel happier with the outcome and with my argument.) And, after all, the money belonged to them.

Managers in corporations, like managers of pension funds vis a vis pensioners, have a fiduciary duty to act in the interests of their shareholders. That obligation is a key restraint which prevents managers looting the funds entrusted to them. It is clear and has legal force. Corporate executives find it irksome, however, because it restricts their freedoms to allocate funds as they might wish. Hence their attraction towards the idea that vaguer responsibilities to several classes of “stakeholders” should replace this clear fiduciary duty to shareholders. With one bound they would be free.

Such notions rest on highly dubious ethical foundations. The Victorians, who invented the Joint Stock Corporation, saw this very clearly. Half of their popular melodrama depict a villainous guardian who seeks to marry a well-endowed ward (no sniggering at the back) in order to get control of her fortune, conceal the fact that he has embezzled half of it, and benefit from the rule that a wife cannot give evidence  against her husband. A Victorian audience would hardly have been soothed if, after his exposure, the villain had stepped forward to explain that he had merely redistributed her fortune on charitable grounds that left her comfortably off and lifted scores of the poor out of dire poverty. We can’t justify spending other people’s money on our favored causes because we think the causes are virtuous.

Carney would object here that in expanding the notion of fiduciary duty, he’s not favoring a cause but giving prudent advice that will save investors from foreseeable losses. For that to be true, he would need to have some ability to see the future better than the market. Does he possess that faculty?

That question brings me to my earlier reference of a misstep in Carney’s career. He has been seriously mistaken twice in his forecasts of how the UK economy would perform following Brexit. The first occasion was when he predicted prior to the 2016 referendum that the economy would be badly damaged merely by a No vote in the referendum. In fact, the economy improved and has performed better than its EU neighbors since the vote.

The second occasion was in 2018 when the Bank of England issued predictions on how Brexit itself might damage the UK economy. Paul Krugman, a strong opponent of Brexit, expressed some considerable skepticism about what struck him as exaggerated forecasts in successive tweets. I quote from Krugman's tweetstorm:

  1. As best I can tell, the big results depend on assumed relations between trade/FDI flows and productivity. It’s really important to understand that this channel does not follow from basic trade theory and comparative advantage; it’s a black-box story. And:
  2. What we have are correlations between trade and investment flows and productivity that don’t really follow from standard models. Are these causal? There is surely room for skepticism . . . So I’m worried. And:
  3. Again, I’m anti-Brexit, and have no doubt that it will make Britain poorer. And the BoE could be right about the magnitude. But they’ve really gone pretty far out on a limb here.

These judgments were a win for Krugman over Carney. The Bank’s forecasts were adjusted heavily to make them less Brexit-phobic a short time later.

If Carney lacks a general infallibility, then we need to look at the plausibility of his particular forecasts. He makes two sets of forecasts in this debate. He forecasts that the rise in temperatures is proceeding at a very rapid rate and that the markets for fossil fuels will fall: As the Guardian reported:

Carney said [Greta] Thunberg was right to point out that climate science showed that the world had only eight years of emitting carbon at its current rate if there is to be a 67% chance of limiting the increase in global temperature to 1.5 degrees. “That’s a legitimate point to make,” he said. “There have been many positive contributions from Greta Thunberg.”

That forecast seems to be considerably more precise than most official forecasts of carbon emissions and temperature increases -- a field already distorted by activist scholarship and political alarmism in the direction of exaggeration. UN forecasts themselves offer a range of possible outcomes which indicates uncertainty on the part of forecasters. To assign these kind of numbers -- eight years of continuing carbon emissions leading to a 67 % chance of holding temperature increases to 1.5 degrees -- all this about a process fed by innumerable factors reminds one of the difference between getting something roughly right versus precisely wrong. Such calculations are taking place, moreover, in a public atmosphere in which the speeches of a young adolescent woman are accorded undue weight by policy-makers. As in earlier controversies, such as Lysenkoism in the Soviet Union, we should subject them to firm skepticism.

Yet if these climate forecasts are either exaggerated or simply uncertain, what is the test which would tell us with some reliability that the market demand for fossil fuels is likely to fall along with the value of companies that extract them. It cannot be the additional stress tests or capital requirements that regulators may want the banks to impose on energy companies, for then the regulators would be using their own interventions as the justification for intervening. As yet, however, non-official market participants can’t seem to see spontaneous causes for this threat to the energy sector.

Recently, I wrote an article on Greta and the rise of the Crankocracy here. It concluded:  "Could you have a better illustration of the coming crankocracy than the assembled leaders of the world nodding solemnly and applauding timidly as a 17-year-old adolescent condemns them angrily for not halting the medieval plague about to descend on them unless they replace their business suits with sackcloth and ashes?"

I would be distressed to see Mr. Carney join their flagellant ranks. If he does, though, don't ask him for fiduciary advice.