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ESG: Is the Bubble About to Burst?

Investment

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5.5.22 |

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The hype, the backlash, and the future of sustainable investing

ESG investing has been hugely popular in recent years, with investors pouring trillions of dollars into funds which focus on environmental, social, and governance factors.

It's been hailed as a game-changer, a revolutionary approach that promises not only financial returns but also a positive impact on the world.

But is ESG all it's cracked up to be?

There has been a growing backlash against ESG investing, with critics arguing that it's nothing more than a greenwashing exercise that's more about political correctness (sometimes now called being “woke”) than financial performance or doing anything good.

Does this mean ESG might be on the brink of downfall?

ESG Investments

Before we dive into the nitty-gritty of ESG's potential downfall, let's take a moment to understand what ESG is all about.

ESG is the acronym for Environmental, Social, and Governance, and it represents a set of criteria that investors use to evaluate potential investments.

E stands for Environmental factors, which include a company's impact on the environment, such as its carbon footprint, use of renewable energy, and waste management practices.
S stands for Social factors, encompassing aspects like labour practices, diversity and inclusion, and community engagement.
Finally, G stands for Governance aspects, evaluating a company's leadership, ethics, and overall corporate governance structure.

Companies that score high on ESG criteria are considered to be more sustainable and responsible, making them appealing to socially-conscious investors.

On the surface, ESG seems like a noble and forward-thinking approach to investing, aligning your money with your values. However, there are cracks in the ESG framework.

The Honeymoon Phase

ESG investing has experienced a meteoric rise in popularity over the past decade.

Investors, both institutional and individual, flocked to ESG funds and portfolios, driven by the promise of making a positive impact while potentially reaping financial rewards. Companies touted their own ESG merits with well-polished marketing teams dressing up even the most unethical business models.

ESG became a buzzword in boardrooms, financial institutions, and even in casual conversations at dinner parties. But as with any financial trend, the honeymoon phase can’t last forever.

The Downfall Begins: ESG’s Flaws

As ESG gained popularity, so did the scrutiny of its underlying principles.

While ESG was once “the darling of Wall Street”, ESG started facing a “perfect storm of negative sentiment”, Robert Jenkins, head of global research at financial data provider Lipper, told CNN.

“I think ESG was overly trendy and it got caught up in itself,” Jenkins told CNN.

The total US-domiciled assets under management using sustainable investing strategies grew from $12.0 trillion at the start of 2018 to $17.1 trillion at the beginning of 2020, a rise of 42 percent. However, by the end of 2021, the total US assets under professional management was just 13 percent – or one in eight dollars – totaling $8.4 trillion in assets under management, according to The US SIF Foundation.

Key Criticisms of ESG

ESG was never flawless, and these issues are beginning to cast shadows over its once-shining reputation.

Lack of Standardisation

One of the most significant challenges facing ESG is the lack of standardised criteria.

Each rating agency and fund manager may use a different set of metrics to evaluate ESG performance, leading to inconsistencies and confusion.

This lack of uniformity makes it difficult for investors to make informed decisions. It’s also led to ridiculous situations, such as tobacco companies like Philip Morris possessing vastly higher ESG scores than electric vehicle pioneer, Tesla. At face value this suggests cigarettes, which kill about eight million people each year, are a more ethical investment than electric cars. This led Elon Musk, the founder and head of Telsa, to state:

“ESG is the devil.”

There is a growing movement to standardise ESG factors and several organisations are working to develop standardised ESG frameworks. However, there are challenges when trying to standardise anything, let alone such a multi-faceted area. There’s no single definition of ESG, and different investors and rating agencies have different criteria for what they consider to be ESG factors. ESG data can be incomplete, inconsistent, and difficult to access.

A Review of Finance Study found, “ESG rating divergence is not merely a matter of varying definitions but a fundamental disagreement about the underlying data.” This can make it challenging for an investor to trust the data and make an informed decision.

Here in New Zealand, a Financial Markets Authority (FMA) review of 14 KiwiSaver and other managed funds claiming to be ethical, responsible, sustainable, or similar considered ESG-oriented, found that ESG fund managers need to improve their disclosures to help investors make informed decisions about ethical investments.

Research by the FMA found that 68% of New Zealand investors prefer their money to be invested ethically and responsibly. However, only 26% have selected a fund manager based on ethical credentials.

“While investors want these products, our research suggests they find decision-making difficult. This underlines the need for industry to provide accurate and high-quality information to explain and support any ESG claims,” Paul Gregory, FMA Director of Investment Management, said.

Greenwashing

Critics argue that companies use ESG to create a facade of environmental and social responsibility, capitalising on the sustainability trend while lacking genuine commitment to ESG principles.

This is supported by research, including A Common Wealth report, 'Doing Well by Doing Good’?, which found ESG funds are not necessarily as green as you may think.

The research found a third of the climate-themed funds held oil and gas producing companies as of their recent filings (Q1/Q2 2020), of which three had stakes in ExxonMobil.

The report also found the ‘Big Three’ passive asset managers, BlackRock, Vanguard and State Street, control a significant portion of the market, raising questions about competition and transparency.

“While these findings don’t necessarily suggest any misconduct or false advertising on the part of the providers, they do indicate the need for greater transparency and regulation, and beg the question: how much do ‘sustainable’ funds really have to do with the climate crisis and rapid transition to a sustainable economy?” the report said.

A report by the University of Otago’s Climate and Energy Finance Group found sustainable investing is largely driven by expected value, not ethical values. Researchers for the report ‘In Holdings We Trust: Uncovering the ESG Fund Lemons’, surveyed asset managers of global equity funds available to Australasian investors to understand how they integrate sustainable practices within the investment decision-making process.

“Responsible investing by fund managers is driven mainly by performance value and attracting investors, not ethical values and responsibilities,” the report says.

Only half of the asset managers surveyed reported their portfolios' carbon intensity, a basic measure of carbon risk in an investment portfolio. Of those that did report these metrics, around half underreported and many did so by a large extent.

Is Your Fund Delivering on its Targets?

A recent study by ESG Book warned investors to “check the label” before investing.

According to Reuters, the study analysed 515 climate and ESG funds and found that 73 of them had a higher emissions intensity ratio than the average of all investment funds.

Additionally, 15 of the funds exceeded 400 tons of carbon dioxide equivalent per million dollars of revenue, more than twice the average, the report said.

"If you are an investor in a fund, you can see your daily financial performance, but hardly anybody tells you 'is the fund actually delivering on (its) climate targets?'," ESG Book CEO Daniel Klier told Reuters.

ESG Book also discovered 95 climate funds invest in fossil fuel and mining companies, including Shell and ExxonMobil.

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Political Backlash

ESG investing is a contentious political issue in the United States, with some Republicans arguing

it is a form of "woke capitalism”.

The Financial Times (FT) reports that US politicians are accusing asset managers including BlackRock, Vanguard, and State Street, of failing to honour their fiduciary duty by applying ESG to business decisions and compromising financial returns. The evidence to support this is mixed.

FT reports that BlackRock was called out by Republican state treasurers from several states, including Texas and Florida, who withdrew billions of dollars from its funds.

State lawmakers in the US have passed several laws this year that target ESG investing.

New Zealand has also weighed in, passing a law that requires large financial institutions to disclose their climate-related risks and opportunities in 2023.

Larry Fink, the CEO of BlackRock, one of the world's largest asset managers, was one of the biggest proponents for ESG when it first emerged.

Speaking at the Aspen Festiva of Ideas, Fink says he still believes in "conscientious capitalism", but he is "ashamed" of the political debate over the term ESG, saying the term has been “weaponised”, and that he doesn't want to use it anymore, according to Time.

This will be a huge blow to ESG investing. But BlackRock is not alone.

BlackRock and StateStreet have both been ditching ESG funds in the US this year.

A survey by RBC Capital Markets also found 56% of sustainable-fund debuts this year have been called “thematic” instead of “ESG”.

“RIP to ESG,” Anne Simpson, global head of sustainability at the asset manager Franklin Templeton, told Time.

“Not because we think this is an end to this, but because it’s a beginning.”

Conflicts of Interest

Critics say ESG can also lead to conflicts of interest, with ESG rating agencies reluctant to give low ESG ratings to companies that they have financial ties to.

The European Commission is set to introduce new regulations targeting ESG rating agencies to address conflicts of interest in the ESG rating industry.

Under these rules, ESG rating agencies, including those outside the EU, will need to gain certification from the EU's financial regulator, and divest from any conflicting activities, such as consulting or providing insurance to the companies they rate, or risk fines of up to 10% of their annual turnover.

In its draft proposal, the EU said the “current ESG rating market suffers from deficiencies and is not functioning properly, with investors and rated entities’ needs regarding ESG ratings are not being met and confidence in ratings is being undermined”.

ESG Underperformance

One of the criticisms of ESG investing is underperformance. Some critics argue that ESG factors are not financially relevant, and that investing in ESG funds can lead to lower returns.

The performance of ESG funds has been mixed. Some studies have shown that ESG funds outperform traditional funds, while others have shown that they underperform.

Recent Pitchbook research has questioned if ESG investors are underperforming.

Addressing a data gap, Pitchbook wanted to compare the performance of funds raised by Principles for Responsible Investment (PRI) signatory asset managers, meaning those who are committed to ESG factors in their investment analysis, decision-making, and ownership practices, with those raised by non-signatories. “The initial results were mixed.”

Alternatives to ESG Investing

There are several alternatives to ESG investing that investors may want to consider. These include:

Value investing: Value investors focus on finding companies that are trading below what they're probably worth. This type of investing can be particularly attractive in times of market volatility (when price increases or decreases are more common than usual).
Dividend investing: Dividend investors focus on investing in companies that pay high dividends. This type of investing can be a good way to generate income and build wealth over time.
Index investing: Index investors invest in index funds, which are baskets of stocks that track a particular market index, such as the S&P 500. Index investing is a simple and effective way to invest in the stock market.

The Bottom Line: Do Your ESG Research

ESG investing is a complex issue with no easy answers.

Investors should carefully consider their own values, investment goals, and risk tolerance before deciding what ESG approach might work for them. A part of this is looking through the slick marketing spin used to describe the operations of nearly all major corporations.

The future of ESG remains uncertain. The ESG hype may fade, but what is clear is the need for sustainable, long-term thinking about investments will endure.