Where to now for ESG investing?

In an earlier post, we examined the growing skepticism surrounding the value of environmental, social, and governance (ESG) investing. Eighteen months later, the category has fallen out of favor and has become increasingly politicized.

As the Financial Times (FT) reported, Morningstar Direct data found 55 ESG funds launched in the first half of 2023 and this fell to just six in the second part of the year. The ESG label has also been removed from other funds.

Why the change? Increased scrutiny of sustainability claims and a slip in performance are among the factors driving this development. We look at the causes and ramifications of ESG’s current decline.

Weaknesses of ESG as a yardstick for responsible corporate behavior

Investors who put their hard-earned money into ESG funds typically expect the companies within the portfolio to live up to a certain standard of corporate responsibility. In reality, just being a part of an ESG fund is a poor predictor of actual corporate behavior. ESG ratings do not even measure what the average investor likely thinks they do. “[ESG] ratings don’t measure a company’s impact on the Earth and society,” according to Bloomberg. “In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.”

CNN Business reports that Robert Jenkins, Head of Global Research at Lipper, “hated the term ESG for years, and so have others in the space. Combining three separate components — environmental, social, and governance — into one rubric is unwieldy and simplifies a complicated investment strategy...”

A conflict with fiduciary duty?

Still, others see an inherent contradiction in a company’s duties to its shareholders and the idea of environmentally and socially responsible corporate citizenship. In fact, the Economist suggests a shift in the focus “from words to deeds” laid those issues bare, resulting in the current contraction of the growth in ESG investing: “It is the mission of companies to generate long-term value for their investors. That might sometimes align with the aim of decarbonisation. Unfortunately, it will often be more profitable for a business to dump costs, such as pollution, on to society than to bear them directly.”

Harvard Business Review (HBR) spells out that contradiction between what investors think ESG funds are for and what they actually do even more clearly: “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.’”

Questions still abound about what it means to invest in ESG funds and whether or not they live up to their names, giving potential investors pause. Meanwhile, some politicians have ESG in their crosshairs, leading to another set of problems for this once-popular investment strategy.

ESG gets political - especially in the U.S.

Like so many other things in the current political climate, especially in the U.S., ESG has found itself squarely in the center of a culture war. U.S. politicians have attacked the idea of ESG as “woke” and have passed laws in over a dozen states restricting investors from considering ESG factors when investing public funds.

On one side, Vinson & Elkins reports that states like California have implemented “new climate disclosure laws [which] will require large companies ‘doing business’ in the state to disclose and verify their full scope GHG emissions (Scopes 1, 2, and 3) and prepare public reports on their climate-related financial risks and efforts to mitigate them. The first reporting required under the laws will be due in 2026.” Across the globe, the European Commission has the Corporate Sustainability Reporting Directive. However, more than a dozen U.S. states have adopted legislation on the other end of the spectrum, mainly due to the emphasis on divesting from fossil fuels. Oil and gas companies spent over $124 million lobbying in 2022 alone.

Despite the uphill battles that ESG investing faces, some alternatives may prove more effective in the long run.

The alternatives: Impact investing and thematic investment

Impact investing has, at times, been synonymous with ESG. However, it’s now emerging as one of the logical successors to the struggling ESG approach. As defined by Investopedia, “Impact investing is an investment strategy that seeks to generate financial returns while also creating a positive social or environmental impact.” Moreover, it aims to make a measurable impact. Notably, the same article points out that over 88% of impact investors reported investments met or exceeded expectations.

Thematic investing is also emerging as a way for individuals to put their money where their mouth is. Rather than focusing on the overall effect of the investment, this strategy focuses on specific areas of investment. Societe Generale explains, “For example, in thematic products in the water sector, companies are selected and financed that operate globally to improve access to water, to save it, to make it drinkable, etc.”

Technology aids ethical investment

As ESG funds fall out of favor with investors who feel duped by intentionally misleading language and are targeted by lawmakers with ulterior motives, impact and thematic investing have emerged as more straightforward alternatives.

Importantly, technology has made it easier than ever for individuals to find and manage investments that align with their values, making the political support of the fossil fuel industry by targeting ESG funds an increasingly futile process.