The Great ESG Paradox

New research has uncovered a paradox. Energy firms have been, by far, the most prolific producers of “green” innovations and patents. But those are the stocks that are routinely shunned by environmental, social and governance (ESG) investors. Are ESG investors’ goals aligned with their dollars?

The academic research, including studies such as the 2019 paper, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance,” has found that companies that adhere to positive ESG principles have lower costs of capital, higher valuations, are less vulnerable to systemic risks and are more profitable. The result is that companies with low ESG scores will tend to have higher costs of capital, putting them at a competitive disadvantage. Thus, one positive result of the popularity of ESG investing is that it is causing companies to focus on improving their ESG scores to lower their cost of capital.

Lauren Cohen, Umit Gurun and Quoc Nguyen contribute to the sustainable investing literature with their October 2020 study, “The ESG-Innovation Disconnect: Evidence from Green Patenting.” They investigated which companies produce green patents, which are the most influential of these green patent producers, and whether investors who desire to allocate capital toward ESG objectives do end up investing in these producers. To identify the universe of green patenting activity, they used two large datasets (Patent Citation and Patent Assignment databases, and environmental score data from the Sustainalytics ESG Ratings database) that captured the complete universe of patents from 1980 through 2017. Their focus was on publicly traded companies.

Following is a summary of their findings:

  • There is a strong empirical pattern in green patent production, with a sizable percentage of recent green patenting driven not by highly rated ESG firms (firms commonly favored by ESG funds) but instead by firms that are explicitly excluded from the ESG funds’ investment universe: Of the top 50 green patent producers, seven (14%) were energy firms. Collectively, the seven produced almost 7,000 green innovation patents.
  • Oil, gas and energy-producing firms (firms with lower ESG scores and thus often explicitly excluded from ESG funds’ investment universe) are key innovators in the green patent landscape.
  • Energy producers have a significantly higher percentage of innovative efforts than the average firm active in green patenting, and a higher percentage than highly rated ESG firms. They have nearly three times the relative focus on green innovation as the average industry. And their patents are significantly higher rated (more frequently cited). In addition, they are also significantly more likely to produce “blockbuster” green patents than other firms.
  • A significantly large percentage of the energy industry’s innovation efforts go specifically toward alternative energy innovation.
  • Energy firms get less credit in terms of incremental ESG scores for each green patent they are granted.
  • While green funds overweight green patenting companies in general, they underweight green patenting energy sector firms.