The broken concept of ESG investing

Cover Photo: Wind turbines in a field. Image credit: Wikimedia/Tom Corser

Volume 9, Number 2: December 2022 | Essay

Originally created as a system of selective disinvestment by ethically motivated investors to deter large companies from doing business with the apartheid regime of South Africa, Environmental, Social and Corporate Governance (ESG) investing has since morphed into an unregulated beast that promises an easy transition to ethical investing. Surging in popularity over the last 10 years as the concern towards the climate crisis and social inequality grows, ESG investing has grown to account for $35.3 trillion of all assets under management in major economies. However, this number vastly inflates its importance to financial markets. With around $25 trillion of that coming from ESG integration, which many claim has little to no real-world impact. This coupled with a lack of regulation and a high-profile investigation into German asset manager DWS’ alleged misconduct within their ESG fund has led many to denounce the practice blatant greenwashing.

However, despite the many criticisms of ESG investing, it provides the investment industry with an effective framework by which real world change could happen. With tighter regulatory pressure, capital markets will hopefully internalise externalities, rewarding companies for reducing their carbon footprints through higher asset prices and a lower cost of capital.

Drivers of ESG

The rapid growth of ESG investment funds in recent years can be attributed to two main factors. The first being the competition by big banks to market themselves towards the growing younger generation of investors who are looking to stash their money somewhere ethical and profitable. Being more aware of the long-term impacts of corporate negligence, young savers have sought out banks that market themselves as environmental and social champions of the industry. Being able to state that €459bn of a €793bn portfolio is invested into ESG integration funds like DWS did looks great in an advertisement and has the exact effect on consumers that they intend.

While the second and more significant incentive is the higher fees asset managers are able to change on ESG funds. A recent study found that investors in sustainable funds paid a “greenium” compared with those in mainstream funds. Average annual fees for sustainable funds sat at 0.61%, almost 50% higher than for traditional ones. This blatant greenwashing is providing banks with unregulated cash cow that deceives investors and only seeks to stoke the pockets of shareholders.  

Lack of Regulation

By far the largest issue with ESG investing is the lack of regulation when defining what constitutes an ethical company. Currently each investment firm has its own ways of defining whether a company meets its ESG requirements. Sometimes these metrics are defined in house, but more often than not a third-party rating agency is used. In a recent investigation it was seen that the rating agency used by DWS classified Wirecard, a German payments firm in which DWS funds were big investors, the second-highest rating for governance. At the time, Wirecard was embroiled in an accounting fraud that would shortly lead to its collapse. Such blatant contradictions extend to the industry at large, with ESG rating agencies being a model of inconsistency. A study of six of them found that they used 709 different metrics across 64 categories. Only ten categories were common to all—and they did not include fundamental ones like greenhouse-gas emissions.

To add to this confusion, index providers have been flippant on what companies make the cut for their ESG funds. In May the S&P Dow Jones Index kicked Tesla out of the ESG version of its S&P 500 index noting Teslas workplace and governance issues, while keeping oil giants like ExxonMobil in. While arms-makers, previously shunned by ESGs before the war in Ukraine, are now bemused to find themselves being feted as defenders of democracy. Leaving this crucial step unregulated and open to corporate subjectivity is an invitation for technocrats to influence markets and manipulate ESG funds to suit their needs.

Limitations of ESG funds

The claims being touted by big banks as to the current effectiveness of ESG funds have been called into question many times. Most notably Tariq Fancy, BlackRock’s the former chief investment officer for sustainable investing, issued a critique claiming that the profession is little more than “marketing hype, PR spin and disingenuous promises”. A key example of this are the exclusionary funds established decades ago with the aim of shunning sectors such as fossil fuels, tobacco or guns into behaving better. However, increasing evidence suggests that divesting from these industries simple shifts assets around within markets, creating no net benefit to anyone except those willing to hold onto these stocks.

The loudest criticism of ESG funds in general states that they simply provide policy makers with an excuse to avoid imposing what many see as the best way to respond to climate change: co-ordinated carbon taxes. Yet it is possible to turn this on its head. ESGs may be worth preserving precisely because taxes on externalities, such as carbon emissions, have proved so politically hard to push through.

Where to now

The clearest path towards the effective utilisation of ESG funds is simply through increased regulatory oversight of the industry and the ability for investors to have more involvement in the management of the funds themselves. Last year the EU introduced sustainable-finance disclosure regulation, requiring funds that claim to use ESG to categorise themselves in three ways, depending on their sustainability ambitions. However, this regulation was relatively loose and has led to fund managers reshuffling stocks to meet the criteria. While in the US, the Securities and Exchange Commission is hoping to increase oversight of climate disclosures for funds, with the hope of internalising externalities and shifting pressure to be sustainable away from funds and to the companies themselves. By forcing businesses to recognise the consequences of many of their activities, the theory is that they should then have a greater incentive to fix them. In the long run, more intensive regulation on environmental and ethical standards will seek to target the root of ESG issues, however for now the best course of action is to invest into independent funds that have high transparency and allow investors to be included in the management of the fund if they wish to be.