The inevitable backlash against environmental, social and governance (ESG) strategies that we have seen in 2022 is now giving way to more practical reflections about the way forward for sustainable investment. A new industry paper provides a possible framework.
Up until 2021, just about every media article about the ESG movement was about its inexorable rise. In the year to date, it seems every story has focused on its inevitable decline as disillusionment and cynicism about its methods and outcomes set in.
To be fair, the sustainable investing backlash was always going to happen. The wonder is the turnaround has been so sudden. It was only last October that sustainable fund assets globally hit a record $3.9 trillion, according to Morningstar.
But the wheels appeared to be coming off earlier this year when Morningstar dropped the sustainable investment label from more than 1,200 European-domiciled funds amid suspicion that managers were making unfounded claims about their products.
Compounding the bad publicity for ESG was the resignation of the CEO of Germany’s top asset management firm DWS Group after police raided the company’s Frankfurt offices, claiming evidence of widespread greenwashing.
Politics, practicality and performance
In the US, a political backlash against sustainable investment has been growing. Republican Party politicians have been fanning a culture war, describing ESG as “woke capitalism” and an attempt to undermine the free market.
At a more practical level, there are questions about the methodology, contradictory ratings systems and clashing regulatory codes . After Standard & Poor’s dropped electric car maker Tesla from its ESG index this year while retaining Exxon Mobil, chief executive Elon Musk famously described ESG scores as a scam.
Compounding the political and methodological questions are performance issues. Many ESG strategies beat the market in recent years, thanks largely to their underweight to poorly performing energy and utility companies and overweight to technology heavyweights, which typically have a lower carbon footprint.
In 2022, that formula has gone into reverse. Tech companies have fallen back to earth, while environmentally dirty fossil fuel companies have been on a tear, a reflection partly of the war in Ukraine and its effect on coal and gas prices.
Where to now?
So where to now for sustainable investing? The cynical view is that the ESG movement was a bubble inflated by fund managers exploiting a growing public awareness about climate change and socially trendy issues to corral assets. The evidence of greenwashing would tend to support that case.
On the other hand, there is solid evidence that the public embrace of sustainability is real enough. The fundamental problem, however, is that the financial services industry has struggled to keep up, with most of the issues it faces due to inadequate definitions, a lack of agreement about measurement and conflicting goals.
This is a case made by global business consultancy EY in a new paper, which points to a lack of standardisation, regulation and common purpose as the chief threat to trust in what is a real and growing sustainability movement.
The report, entitled The Emerging Sustainability Information Ecosystem, argues that many of the current challenges facing ESG are simply a product of its relative infancy. Sustainable investing is really only two decades old, and the industry infrastructure to support it is still developing.
EY points to five core areas that must be addressed to build greater trust in ESG:
- Increased transparency over ESG ratings
- Increased understanding of the varying uses of sustainability information
- Enhanced reporting standards and rigour, similar to financial reporting
- Agreed language to prevent confusion on what is considered sustainable
- Reduced barriers to entry for those from emerging economies
“The extraordinary growth of the ESG movement is threatened by a lack of alignment and agreement on foundational concepts and, in worst cases, growing claims of greenwashing,” says Steve Varley, EY Global Vice Chair — Sustainability.
“ESG is facing a make-or-break moment and requires a whole system approach. Sustainability is everybody’s business and more work must be done to encourage open collaboration and trust-building among those who shape the industry.”
Put the focus on emissions
This is a view shared by The Economist magazine, which devoted a recent issue to a leading article story entitled ESG: Three Letters That Won’t Save the Planet in which the publication’s editors call for a rethink about sustainable investing.
While lauding attempts to make capitalism better account for the external costs of its activities, The Economist says ESG has simply become scattergun in trying to account for too many issues at once, instead of focusing on the Big One — climate change.
“Closing down a coal mining firm is good for the climate but awful for its suppliers and workers,” the magazine says. “By suggesting that these conflicts do not exist or can be easily resolved, ESG fosters delusion.”
The better approach, The Economist says, would be to focus on the issue which represents an existential threat to life on earth — a rapidly warming planet — and that means making firms’ carbon emissions the primary standard for ESG strategies.
“By revealing more accurately which firms pollute, it will help the public understand what really makes a difference to the climate,” the magazine’s editors argue.
“A growing number of altruistic consumers and investors may choose to favour clean firms even if it costs them financially. And even if they can get away with polluting today, many firms and investors expect that tighter regulation of carbon emissions will eventually come and want to measure their risks and adapt their business models.”
Ultimately, public concern over man-made climate change is not going away. As unprecedented temperatures bake much of Europe, while much of the east coast of Australia is deluged by repeated “once-in-a-century floods”, that much is clear.
Likewise, the public demand for more sustainable investment is unlikely to moderate. That puts the onus on the financial industry to standardise measurement, increase transparency and stop the pretence that ESG can fix all the world’s problems at once.
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