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Professor Aswath Damodaran suggests people working in the ESG space were either ‘useful idiots’ or ‘feckless knaves’. We argue that sustainable investing is about more than just "goodness" - it's about managing risk and preparing for the modern world's challenges, from climate change to data breaches.

Much criticism has been pouring in for ESG investing off late, serving as a reality check and leading to course corrections where needed. A round of cyclical underperformance in 2022, ESG rating downgrades and the war in Ukraine uncovered hidden ESG trade-offs and led to the numerous stinging criticisms. Right from Tariq Fancy – former CIO of Sustainable Investing at BlackRock – labelling it a ‘dangerous placebo’, to Stuart Kirk’s “nut job” speech to NYU professor Aswath Damodaran suggesting people working in the ESG space were either ‘useful idiots’ or ‘feckless knaves’. More recently, Damodaran went even further to suggest retiring ESG and leave it to governments to sort the real-world challenges. Amidst the deluge of criticism, we find contrasting views where Damodaran believes in climate urgency whereas Kirk is a climate denier.

While we understand the criticism, which is on account of some deceitful ESG flag bearers whose compromised agenda emanates from their greed as opposed to their belief in sustainability. For many, ESG investing is just a marketing gimmick rather than a way to make real impact. While it’s important to address these concerns, having a myopic view just based on valuations and other traditional investment metrics and disregarding many of the real-world risks of today can probably result into an investment error. One may argue that you can price those risks, well not really unless you are measuring them well through a robust ESG framework.

To be clear, Sustainable investing is not just about exclusions, but much more: It’s about evaluating how a company handles its material risks and opportunities. It is not only about assessing the impact the company’s operations have on the world but also how the changing world impacts the company’s sustainability. Changing climatic conditions, rising sea levels could disrupt operations in impacted regions and if the company isn’t prepared to mitigate those risks, it will lead to losses for unprepared investors. Research-intensive companies that neglect their workforce might eventually lose their intellectual capital and thereby pricing power. Data breaches, cyber security, water stress, consumer preferences are all modern world challenges that will cause distress to investors focused on just the bottom line and unaware of such risks.

Thus, Sustainable investing is about managing risk, not "goodness". It is therefore in investors self-interest to monitor many of the evolving ESG risks rather than being in for an unpleasant surprise.

Damodaran has been vocal of his reservations, let’s try to look at his arguments and our views on them:

Damodaran does not trust corporate CEOs. We need to trust governments, he said, and trust the institutions that should be enforcing proper regulations.

Sustainability is a long-term agenda which can go beyond government tenures and hence if left to governments, it may not be a priority unless it starts impacting during their tenure . Whereas corporations (not CEO’s), survive longer and are better placed to address ESG issues and incorporate sustainable practices. Sustainability should be part of the corporate culture, a board level agenda for it to survive beyond CEO tenures.

Investors can put pressure on companies to achieve ESG goals, but Damodaran is sceptical it will work. Unless consumers cooperate, investment-side pressure won’t work.

Changing consumer behaviour would take a long time. Investor action accompanied by right regulatory nudge would go a long way to ensure sustainable production and thereby sustainable consumption. Also, today’s youth is making sustainable choices which will further pressure companies to make better choices.

“They put the ‘S’ in the middle of ESG. Name one social issue that there’s a consensus on?”

Like beauty and Value, ESG lies in the eye of the beholder. Everyone has a rationale and a threshold to measure different metrics, particularly when it comes to non-scientific social factors. Some may look at how aligned the business is today to their metrics, one may look at incremental changes being made in the right direction. However, the idea is to see if the factor is material, and then try and bring it into assessment.

The logical argument is that an organization that privileges one race, gender, religion, sexual orientation, or national origin over another reduces the pool of talent it can draw on to staff and manage the operation. We are in an economy where intellectual capital signifies strength. The real value addition, competitive edge and profitability are in the organizations that are creative and innovative. A less diverse organization tends to stimulate insularity and group think. Being aware of the value of diversity is an indicator of management excellence.

While there may be little consensus, the intent is very clear to see progress towards being more resilient.

Damodaran said there are core ideas as part of ESG that are good, such as trying to deal with climate change and reducing carbon footprints. The problem is bundling those initiatives with other issues in an “ESG” wrapper. “We need to take each individually. Pick the issues that matter the most and have disclosure on what matters the most,” he said.

We agree that materiality should decide whether an adverse factor makes that business non investible. We try to look at the intent, progress on data as the evidence of intent and whether there is an assessed plan to make meaningful changes over the short and long term to determine the merit of investment. It also depends on companies’ willingness to engage that helps us evaluate its plans better and make informed decisions.

There may be better ways to evaluate sustainability risks, may be singularly or in combination as ESG. But the fact remains that you can no longer afford to ignore them. Warren Buffett’s famous quote, “Only when the tide goes out do you discover who’s been swimming naked,” also applies to ESG risk.

Another issue for Damodaran is that ESG is primarily applied to public companies, not private ones. “There’s a whole set of companies that are untouched,” he said. “Private companies, or private-equity owners or companies in countries that aren’t pushing ESG. Are we just pushing bad behavior to other places?”

Like we have alluded before “you can stop a virus from entering your country, but you can’t stop GHG emitted in emerging markets like India from entering your back yard”. We agree that an ESG investor needs to spread her wings across borders, more so in emerging markets to have a real impact on the climate change agenda.

Given the fact that private companies in emerging markets also have some linkages to the formal economy, there are indirect ways to bring most corporations into the ambit of sustainability. Looking beyond the publicly listed businesses into their supply chains will make many of the private companies accountable to their ESG impact.

Mr. Damodaran, while we may agree to disagree on most of your concerns, we do agree that there is a need for standardized metrics:

We reckon that the problem with ESG investing is the absence of generally accepted sustainability metrics. Then there are other concerns in many corners of the ESG universe. The world is racing to embrace electric vehicles (EVs) without building sustainable electricity generation needed to recharge these vehicles or finding sustainable ways of producing the precious metals needed for EV batteries. Yes, EVs are better for the environment than fossil-fuel-powered vehicles, but there won’t be a net gain in the war against climate change without green electricity and batteries.

Environmental goals cannot be pursued in a vacuum. They are not achievable without assessing the net social impact and applying the best practices of good governance. This appears to be a critical point that has escaped much of the corporate world.

Building resilience is key…

Nevertheless, the effort to manage organizations by paying attention to ESG risks is an indication of careful and thoughtful management. For instance: Modern organizations with instant communications, and high-speed transmission of information are correctly expected to move quickly to respond to disaster. The absence of capacity to interact with the local community is another indicator of terrible management. Careful, prudent management should measure and seek to reduce all unnecessary organizational risk. These organizations tend to be successful over the long term.

Investors can make the difference…

Investors have a key role to play in building a future that prioritizes resilience, social mobility and the environment alongside economic growth. We think there is another wave in the evolution of ESG which is extremely current right now. That is the growing pressure to be genuine about ESG and cut out ESG-washing, EHG as we call it. Not just in the superficial “dressing up” of funds as being ESG focused but also highlighting a gap between words and actions at leadership levels.


Prof. Damodaran, see the “Value” in ESG

25 May 2023 | Responsible Investing

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