Proponents and critics of ESG claim it can change society. Both will be disappointed.

Aug 31 2023 · 6 min read

Sustainable Investment · Sustainable Finance · illuminemX

Flooding from torrential rains recently led Vermonters to kayak through the streets of the state capital. A month later, Hawaiians were forced to flee to the ocean to avoid devastating blazes. All the while, toxic smoke from wildfires has imperiled the health of Americans across huge swaths of the country. All these alarming environmental developments hurt economic activity. Yet many political leaders seem preoccupied with banning investors from considering the impacts of the fast-changing environment on business.

These fervent objections to the longstanding use of environmental, social, and governance (ESG) criteria in investing are a recent political chimera emanating — at least in part — from the overselling of an ill-defined concept. ESG investors include nonfinancial factors in their decisions to buy or sell a security or private asset. ESG does not, however, prevent them or anybody else from purchasing the stocks of fossil fuel companies, nor does it contribute essential primary capital to develop solutions to avoid the worst impacts of climate change.

And yet, amid record global temperatures, the House Committee on Oversight and Accountability and the House Financial Services Committee devoted hearings to the propriety of an investment strategy that takes account of how companies’ P&Ls will be impacted by changing ESG factors. The playbill for these hearings sought to expose the “woke” agenda of asset managers, thereby protecting retail and institutional investors from misuse of their capital.

Prior to the hearings, presidential candidate Ron DeSantis helped shape the script by unveiling a plan to shield his state’s residents from the “woke ESG financial scam.” DeSantis characterized asset managers as “elites” who use “arbitrary ESG metrics” to “circumvent the ballot box to implement a radical ideological agenda.” A memo from the ESG Working Group of the Financial Services Committee similarly decries “progressive activists who are using our institutions to force far-left ideology on Americans.” The memo outlines numerous concerns, including the undue influence of proxy advisory firms, the Securities and Exchange Commission’s exceeding its authority by mandating carbon reporting, and the prevalence of ESG-related shareholder proposals.

Before ESG was co-opted for political purposes, it was an opaque investing approach. Conceived decades ago by a United Nations-convened group of financial institutions, ESG investing aimed to achieve two often contradictory goals: measuring and evaluating nonfinancial factors to enhance shareholder value, and contributing to the “sustainable development of global society.”

Despite, or perhaps because of, the confusion associated with its dual mandate, ESG investing caught on over the past five years. By the end of 2022, global ESG funds had attracted more than $2.5 trillion in assets. According to New York University finance professor Aswath Damodaran, “Never has an investing concept grown so fast and gotten so much of the establishment on its side.”

What explains ESG investing’s meteoric ascension?

Certainly not left-wing ideology or anything particularly radical. ESG investing is mostly a repackaging of older approaches, adapted to current circumstances. In the U.S., ESG investing adds environmental, social, and governance factors to the list of risks and opportunities that potential investors use to screen stocks. This is why many ESG funds are weighted toward less resource-intensive healthcare companies.

One claim, often voiced by those who stand to gain from the higher fees of ESG funds, is that ESG investing delivers outsize investment returns. For example, John Streur, CEO of Calvert Research and Management, now owned by Morgan Stanley, noted that “the linkage between financially material ESG performance, profitability, and stock prices is strong. It has been documented by thousands of studies.”

Yet, to my knowledge, not a single study has demonstrated a causal link between ESG investing and equity returns. While some studies show that ESG investing and stock returns are positively correlated, others have shown no relationship or a negative relationship. Not surprisingly, then, the sector weighting of ESG funds may lead to outperformance one year and underperformance another. According to Morningstar, 75 percent of ESG funds outperformed the market in 2020, and almost the exact same percentage of ESG funds underperformed traditional funds last year.

Another illusion is that ESG investing will improve planetary welfare. As but one illustration, MSCI, the largest ESG ratings firm, promises to help asset managers build “better portfolios for a better world.” This type of marketing, paired with the acronym itself, has had influence. According to a recent survey of more than 2,000 retail investors, almost half of those who buy into ESG funds do so for “ethical” reasons.

Despite the hopes of the UN ESG pioneers, the application of ESG investing will not consequentially advance environmental or social welfare. The ESG ratings that underlie ESG funds are designed to measure whether a company is well governed and resilient to prospective environmental and social changes — not whether it betters the world. For example, Tesla, an environmental trailblazer, failed to get high enough marks in transparency and governance and was dropped from the S&P 500 ESG Index last year, though it has since been reinstated.

Both proponents and detractors of ESG investing claim that it can change society — either by addressing climate change or by furthering a “woke” social agenda. But there is little chance of either outcome manifesting because that is not how investing works. Investing is principally about returns. Each time an ESG fund buys a particular stock, it purchases the stock from a willing seller. If ESG investors drive up a stock’s price, future returns will fall, and other investors will flee. The net effect on the planet or the company is likely to be negligible.

There is no expectation that the hearings in Washington will produce any bills that can pass both houses of Congress and get the signature of the president. At the same time, notwithstanding the political theater, asset managers will rightly continue to factor growing ESG factors into their investment processes, no matter how funds are labeled and marketed.

The hype about ESG investing and the political attacks on it amount to a lot of hot air. We would all be better served by devoting our collective energies to addressing the real hot air that is intensifying weather events, accelerating habitat destruction, and causing biodiversity loss.

This article is also published on Institutional Investor. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.

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