It’s long past time we faced a hard truth: despite a historic surge in popularity, ESG (environmental, social, and governance) investing will not tackle our generation’s urgent environmental and social challenges. Consider the battle against climate change: Estimates are that humanity will need to invest an average of $3.5 trillion annually over the next 30 years. Unfortunately, these trillions are not the same trillions that are presently invested in assets managed according to many forms of ESG investing — those are dedicated to assuring returns for shareholders, not delivering positive planetary impact.
The separation of profit and planet is by design. ESG ratings which underlie ESG fund selection are based on “single materiality” — the impact of the changing world on a company’s profits and losses, not the reverse. They also bear no connection to natural boundaries. According to Bloomberg, “[ESG] ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.”
Yet it’s hard to blame casual observers for believing that investing in an ESG investment fund is helping to save the planet. Marketing materials of ESG funds often make lofty statements about social or environmental aspirations, but the fine print reveals that the real goal is to assure shareholder profits. For example, a prior statement from State Street’s ESG Investment Statement mentions the need to encourage a “transition to a low-carbon, more sustainable, resource-efficient and circular economy,” but later it defines ESG issues as “events or conditions that, should they occur, could cause a negative impact on the value of an investment.” According to Henry Fernandez, CEO of the leading ESG ratings provider MSCI, ESG doublespeak has confused most individuals, many institutional investors, and even some portfolio managers.
This confusion has proven convenient when marketing some ESG products. For example, when BlackRock launched its U.S. Carbon Readiness Transition fund in April of 2021, the exchange-traded fund raised $1.25 billion in one day — a record. Among other things, the fund promised “broad exposure to large and mid-capitalization U.S. companies tilting toward those that BlackRock believes are better positioned to benefit from the transition to a low carbon economy.” That sounds good, but there is no mention of driving the transition and the fund holdings seem remarkably standard: Exxon, Chevron, and Conoco Phillips are among the fund’s top 100 holdings. According to a recent podcast interview with integrated reporting expert Robert Eccles, “If you read some of [the] prospectuses [of ESG funds] they use the word sustainability a bunch of times, [but] you really don’t have any sense as to what the criteria are that they are picking.”
The problems with ESG investing go well beyond hype. Acknowledging and clarifying all of ESG investing’s shortcomings will help pivot to more productive and urgent pursuits:
It Confuses Investors:
ESG funds are based on unregulated ESG ratings. ESG ratings, in turn, are built on comparative rankings of industry peers not on universal standards. This is why fossil fuel companies can have better ESG ratings than makers of electric vehicles. In addition, the data underlying ESG ratings are incomplete, mostly unaudited, and often dated. As a result, even those who are responsible for these data have little faith in their accuracy. According to a recent study, more than 70% of executives surveyed across multiple industries and regions reported that they lack confidence in their own non-financial reporting. There are multiple ongoing efforts to standardize ESG reporting, but, for the foreseeable future, ESG investors will not have access to comparable, accurate measures, making it nearly impossible to attribute results or make impact claims.
It Doesn’t Deliver Meaningful E or S Impact:
Almost all ESG fund types invest in securities that trade in secondary markets. As a result, even if planetary welfare were a principal objective of ESG investing, measurement of impact would be unfeasible. To determine if each fund’s investments were making an impact, it is necessary to demonstrate additionality — defined as “that but for this investment, the measured outcome would likely not have occurred, thereby creating impact.” For equities bought in the secondary market, “most economists agree that it is virtually impossible for a socially motivated investor to increase the beneficial outputs of a publicly traded corporation by purchasing its stock,” argue the Hewlett Foundation’s Kelly Born and Standford Law professor emeritus Paul Brest in a 2013 paper.
It has Yet to Prove that it Delivers Better Returns:
Asset management firms tout the potential for ESG investing to deliver superior financial returns. They cite a host of reasons for potential outperformance including that high ESG firms boast better managers, have lower costs of capital, and deliver better margins and attract and retain a more engaged workforce. But is this true? Thousands of studies by academics and asset managers have sought to conclusively demonstrate the relationship between high ESG companies and equity returns. More than two thirds of such studies show at least a non-negative correlation between ESG and financial returns. However, no study has proven that ESG causes higher returns and recent research has called into doubt the link between ESG and outperformance, including a paper by one of us (King) that found that “the totality of the evidence suggests that there is little reason to infer that [ESG criteria]…reliably predicts stock returns.”
It Costs More:
One of Wall Street’s motivation for the frenzy of ESG product creation and overselling of planetary impact is the fees associated with ESG products. According to BCG, as passive funds have continued to grow in popularity, asset management revenues as a percentage of AUM have fallen by 4.6 basis points over the past five years. ESG funds typically charge fees 40 percent higher than traditional funds making them a timely answer to asset management margin compression. All too often these higher fees are unwarranted given that ESG funds often closely mirror “vanilla” funds. Vanguard’s largest and longest standing ESG fund, its ESG U.S. Stock ETF, was .9974 correlated with the S&P 500.
It Perpetuates the Fantasy of Market Based Voluntary Action:
Most importantly, the boom in ESG investing helps to create the impression that the trillions of dollars needed to finance the transformation to a low carbon economy are on the way. This misconception likely relieves pressure on necessary regulatory reforms and the massive public private partnerships that are required to avert building threats to environmental and social welfare. If so, this deferral would represent the latest installment of a 50-year trope positing that market based voluntary action can supplant the need for public regulation of private externalities. As but one illustration of the limits of voluntary action, consider Coke’s voluntary efforts to reduce one of its most material ESG risk factors: water usage. After years of effort and NGO partnerships in close to 100 countries to save and replenish local watersheds, Coke declared itself “water neutral” in 2015 — five years ahead of its self-selected target. In part as a result, Coke’s ESG rating via MSCI is “AA,” or market leader. However, Coke’s chosen boundary for water neutrality is the water used in manufacturing, distribution, and cooling, not the more than 90 percent of water it estimates that it uses in its agricultural supply chain, primarily in the fields to irrigate farmed sugar.
Its Misapplication is Leading to Backlash:
Confusion about ESG has also led to criticism within the investment community. According to hedge fund manager Sir Chris Hohn, “ESG for most managers is total greenwash and investors need to wake up to realize that their asset managers talk but don’t actually do.” Earlier this year, Morningstar, an investment research and advisory firm, removed the ESG tag from more than 1,200 ESG funds managing over $1 trillion in assets because the funds did not “integrate [ESG factors] in a determinative way in their investment selection.” Removal of Tesla from the S&P 500 ESG index led Elon Musk to call ESG “the devil incarnate.” Even critical supporters of ESG seem to be rethinking its value. According to ESG reporting expert Eccles, “we would be better off if ESG investing would just go poof” and non financial considerations were integrated into the traditional investment research process.
Where to Focus Instead?
The confusion and exaggeration surrounding ESG investing detracts from its real potential. Measurement of non-financial factors has already been mandated for thousands of EU public companies and been proposed by the SEC for carbon emissions for U.S. public companies. At the same time, scrutiny will likely lead to regulation of ESG ratings. These are positive developments that will amplify the quality of non-financial inputs to equity valuation. That said, according to social investing pioneer Steve Lydenberg, “it is important to recognize that integration of ESG data into stock valuation models and portfolio risk management is not enough to drive systemic change when the greatest risks of the day, such as climate change, are at stake.” This is because fighting climate change is entirely different than measuring and assessing the climate risk to a firm’s profits.
While ESG investing might be a way to measure risks to corporate cash flows, it is no way to advance planetary sustainability. Instead, decarbonization and planetary welfare would be better advanced by spending time on the following:
Acknowledge Systems Structure and Incentives:
Asset managers are trained, measured, incentivized, and bound to maximize their client’s returns. It is naïve and unreasonable to expect corporate executives or investors to put public interests ahead of private interests when tradeoffs are present. Fifty years of evidence and mounting environmental challenges ought to suffice to retire fantasies that voluntary based market pressure will adequately address externalities. Accelerating meaningful Wall Street engagement on planetary challenges requires continued shift in incentives to better align private profit and social welfare.
The SEC has received over 5,000 comments to its proposed disclosure requirement for carbon emissions. At the same time, the EU has spent eight years finalizing its Corporate Sustainability Reporting Directive mandating non-financial reporting. We can’t afford more dithering. Given the need to achieve never before reductions in carbon emissions (on the order of 7% a year for the foreseeable future), regulatory action must shift from input-based disclosures to outcome-based impacts. For example, California’s carrot and sticks policy to shift heavy duty transport from diesel to electric and the Netherlands capping flights from Schiphol airport at 12% lower than pre-pandemic levels are regulations that mandate outcomes and create cost certainty. This, in turn, will spur investment and innovation in lower carbon solutions.
Spur Private Investment:
From the first half of 2020 to the comparable period last year, U.S. investment in climate tech is up over 200% year on year with deal size quadrupling. Investments in essential and unsettled key technologies ranging from fission to low duration battery storage to ag tech are accelerating. At the same time, the current scale of global investment required to make the transition to a low carbon future is insufficient — at less than one quarter the rate required. Transitioning away from fossil fuels in hard to abate sectors including air transport, steel and aluminum and buildings will require unprecedented and creative public private partnerships to incentivize continued investment and discovery.
Address High-Leverage Points:
Equal efforts by all companies to decarbonize will not yield equal results. Investment by a software company to halve its emissions, while laudable, will not contribute much to our shared challenge. The recognition, according to SVP of Sustainability at Aspen Skiing Company Auden Schendler, that “a problem like climate does not get solved by cleaning up the home office could help corporate leadership throw in the towel on a 30-year failed strategy of addressing climate” and instead “steer companies towards power wielding and movement building.” Were this transition to happen, it would be unconscionable for the Chamber of Commerce and the Business Roundtable to publicly denounce the Biden administration’s Build Back Better bill to address climate change. It also wouldn’t make sense for asset managers such as BlackRock to oppose the Scope 3 climate disclosure provisions in the SEC proposed disclosure rule.
None of these recommendations are straightforward. None will occur absent concerted civic engagement, global coordination, and a redistribution of power. At the same time, none rely on convenient confusion to oversell market based voluntary solutions. Though ESG investing is oversold, it is not the “devil incarnate.” The addition of ESG fundamentals to traditional investing might someday allow investors to better predict returns and risks, but it will not save the planet. Expecting it to is akin to asking an electrician to cook a gourmet meal. Instead, let’s focus on setting appropriate boundaries for capitalism and letting the best of the market innovate to help solve our global challenges and advance planetary welfare.