Discover the rise of ESG investing and the push for global frameworks for future growth, despite recent challenges.
Despite the recent setback, ESG investing is at an all-time high. Now is the time to create the global structures needed to support the next stage of its development.
If you have any connection to the corporate business world, you’ve no doubt heard the term “ESG.” The growing prominence of this acronym (which stands for environment, society and governance) is illustrated by Bloomberg Intelligence’s ESG Market Navigator survey for 2023, which shows that 85% of investors and companies plan to boost their ESG investing over the next five years.
As I outlined in my previous Spotlight article on ESG investing, the basic idea is simple. Rather than just considering financial returns, ESG investors also consider the impact of their choices in terms of the environment, society and governance. Their goal is to avoid harm in these three key areas and ultimately become a force for good.
The results of the Bloomberg Intelligence survey are consistent with those of other similar research. An asset and wealth management (AWM) report published by PwC in 2022 highlighted a similar increase in demand for ESG investments, stating that “ESG-related assets under management would grow globally at a much faster pace than the AWM market as a whole,” from $18.4 trillion in 2021 to $33.9 trillion by 2026.
Origins and Growth of ESG
It seems clear that ESG investing is gaining importance in the global economy. How does this translate into practice?
Considering the impact of investments beyond narrow financial criteria is not a new idea. The roots of ESG date back at least to the 1960s, when in response to major protests and political campaigns, some investors sought to make more socially responsible decisions. This included those who avoided investing in certain industries (such as tobacco production) or associating with particular governments (such as South Africa’s apartheid regime).
Of course, there were attempts to ensure that investments were ethically or religiously appropriate long before then. However, modern ESG principles only began to be formalized in the early 21st century, with the support of the United Nations (UN). A 2005 report by the UN Global Compact argued that in our increasingly complex and interconnected world, new challenges were emerging around “actively managing risks and opportunities related to emerging environmental and social trends, in combination with growing public expectations for better corporate responsibility and governance.”
The paper, developed after consultation with 18 financial institutions in nine countries, highlighted the importance of these issues for both companies and investment portfolios, and proposed recommendations for the financial sector to better integrate ESG principles. These included a call for investors to “explicitly request and reward research that includes environmental, social and governance aspects”, and to reward well-managed companies.
Since then, ESG investing has grown substantially and now forms a significant share of the overall market. A report by the Global Alliance for Sustainable Investment revealed that USD 30.3 trillion was invested globally in ESG-compliant assets in 2022. In Europe, Canada, Australia, New Zealand, and Japan, sustainable investment assets totalled USD 21.9 billion, representing 38% of total assets under management.
These investment trends support greater consideration of ESG principles across the corporate world as a whole. A 2022 study by McKinsey confirmed that organizations across industries, geographies, and sizes are devoting more resources to improving ESG. Now, more than 90% of companies in the Standard & Poor’s 500 Index and 70% of those in the Russell 1000 Index publish some form of ESG reporting. These numbers have likely increased further since the report was published.
As for the individual aspects of ESG practices, McKinsey says the environmental element can include consideration of climate change, air pollution and waste management. The social dimension addresses factors such as labour practices or health and safety. The concept of governance encompasses issues such as business ethics, supply chain management and organisational decision-making structures.
Reasons behind the change
So what’s really behind the growing focus on ESG? JP Morgan Asset Management highlights government policy as a major driver, pointing for example to the impact of the 2015 Paris Agreement and its aim to limit global warming to 2°C compared to pre-industrial levels, preferably to a maximum of 1.5°C. In line with this, more than 70 countries have set ambitious targets to reduce emissions. Meeting these will require a range of policy measures, such as financing, regulatory and tax initiatives. Governments are increasingly introducing ESG reporting obligations and corporate strategies are responding to rapidly evolving policies.
According to JP Morgan’s analysis, shifts in public attitudes are also influencing corporate actions. Consumers “voting with their wallets” in line with the values they espouse creates a bottom-up incentive for companies to act. At the same time, increased public scrutiny of governments about ESG puts pressure on them to implement top-down measures. According to the analysts, this situation creates attractive opportunities for investors to back companies that have responded to ESG concerns.
This includes social and governance considerations as well as environmental sustainability. Social movements have raised the prominence of social justice concerns, as have some ongoing global economic trends. JP Morgan argues that many years of low wage growth, coupled with the COVID-19 pandemic, have focused attention on workforce issues. As ADEC Innovations, a specialist ESG investment firm, notes, as supply chains become more complex, there is greater awareness of the social, labour and human rights risks they create for businesses. A feature of this new landscape is the growing corporate focus on diversity and inclusion, evidenced by the significant increase in the use of these terms in quarterly meetings between large companies, investors and analysts.
ESG issues are also increasingly becoming legislative and regulatory issues. Modern slavery laws in the UK, US, Canada and Australia, among others, require, for example, companies of a certain size to report on what they are doing to ensure that modern slavery and human trafficking do not occur in either their business or, more importantly, in their supply chains. This corresponds to the “S” in ESG.
What is driving ESG activity is not just a “ desire to do good ” – there are also sound financial reasons. There is ample evidence that ESG investments perform as well as others, or even better. A 2023 study by Kroll, which analysed data from over 13,000 companies, found that those with stronger ESG credentials achieved better financial returns. Companies classified as ESG “leaders” posted an annual return of 12.9%, compared to 8.6% of “laggards”, representing a performance premium of around 50%. This follows a 2021 study that examined over 1,000 research papers published in the previous five years. The researchers found that 59% of relevant studies showed ESG investments performed similarly or better compared to standard approaches, with only 14% finding negative results.
Therefore, in addition to being good for the planet and society, ESG consideration can have a positive impact on companies’ profits, reputation and resilience.
In this regard, rather than seeing ESG as a distraction, the growing consensus is, and should remain, to integrate it into mainstream thinking and practice. Larry Fink, CEO of the American investment firm Blackrock, advocated this approach in a letter he sent to CEOs in January 2020. Focusing in particular on environmental sustainability, Fink argued that the growing importance of climate change risks meant that “we are facing a fundamental reform of finance”.
In stating that “climate risk is an investment risk,” Fink explicitly aligned ESG concerns with best business practices. He reiterated his view that “purpose is the driver of long-term profitability” and warned that Blackrock will be increasingly reluctant to support the management of companies that are not making sufficient progress on sustainability.
Recoil
As is inevitable, as it penetrates the mainstream market, ESG is facing increased scrutiny. Some experts hint that the momentum behind the concept may have slowed and that scepticism is increasing. For example, Richard Stone, CEO of the UK-based Association of Investment Companies (AIC), has stated that a study by his organization “suggests that 2021 may have marked a peak in enthusiasm for ESG investing” and that the proportion of private investors considering ESG factors has shrunk over the past two years.
In 2021, almost two-thirds (65%) of respondents said they considered ESG factors when investing. The following year, this figure dropped to 60% and in 2023 it fell again to 53%.
Among the 47% who did not consider ESG factors, the top reason was prioritising profitability over ESG issues, closely followed by “not being convinced by asset managers’ ESG claims”.
The survey also revealed concerns about “eco-fake” – exaggerated or misleading claims about supposedly sustainable practices. 63% of respondents to the AIC survey said they were concerned about eco-fake. The proportion of investors saying they were “not convinced by asset managers’ ESG claims” has grown, from less than half (48%) in 2021 to almost two-thirds (63%) in 2023.
Recent high-profile allegations of corporate eco-shaming may have helped put this issue in investors’ minds. For example, in 2023 the NGO Global Witness filed a complaint against oil giant Shell with the US Securities and Exchange Commission alleging that the company had misled investors. Global Witness stated that although Shell claimed to allocate 12% of its annual spending on renewables and energy solutions, its analysis has revealed that the company has only allocated 1.5% of its total spending to solar and wind power generation.
In the UK, regulators have found a number of energy companies guilty of eco-scams. Shell was one of three fossil fuel companies whose campaigns were banned in June 2023 by the Advertising Standards Authority on the grounds that they misled the public about the environmental benefits of their products. It is not just oil and gas companies that are facing criticism. The UK’s Competition and Markets Authority (CMA) announced in December 2023 that it would investigate Unilever, which makes a wide range of consumer goods, as it suspected it was making misleading sustainability claims, as part of a wider probe into eco-scam. Sarah Cardell, CEO of the CMA, said the watchdog committee was “concerned that too many people are being misled by so-called ‘green’ products that are not what they seem”.
A green showcase
There are also concerns that some investment funds may have engaged in eco-imposture practices. In a recent blog by the Centre for Research in Economics and Policy (CEPR), academics from France’s EDEHC business school argued that there is evidence that “fund managers can play around with regulatory disclosure to disguise themselves as sustainable, while also including higher-yielding but controversial assets in their portfolios.”
Researchers point out that while sustainability ratings provided by industry analysts have increased transparency, the calculations are made based on fund disclosures that only have to be made a few times a year. This allows unscrupulous managers to strategically buy ESG stocks just before disclosure to boost their sustainability ratings, before moving back to higher-performing but less responsible assets when detection is unlikely.
More worryingly, the researchers found evidence suggesting this was happening in some cases when comparing the performance of ESG funds to major ESG stock indices. The analysis revealed that the correlation between the two dropped significantly just after mandatory disclosure when there was a sudden increase in correlation with the performance of high-emissions stocks. Based on these findings, the academics conclude that “some funds are presenting themselves with a green window.”
The results come amid continuing confusion over how ESG funds are classified, an issue that has been particularly prominent in Europe.
In July 2022, the European Commission (EC) published new guidelines on sustainable investment funds, leading to hundreds of funds having their sustainability status moved from the best “Article Nine” (where there must be an explicit sustainable investment objective) to the less stringent “Article Eight” category. According to Morningstar data, following the EC’s intervention, funds worth a total of USD 193 billion lost their “Article Nine” classification in Q4 2022. Following additional clarifications from the EC in April 2023, some 35 funds returned to the top category, but the numbers are still well below the previous mark.
Politicization
In addition to this confusion, the concept of ESG itself has come under political attack, especially in the US. In Florida, laws were passed banning the consideration of ESG factors in state and local government investment decisions, stating that they must be based solely on “pecuniary factors”. This follows laws limiting the use of ESG in other states, as the idea has become mired in cultural disputes. Florida Governor Ron DeSantis has accused corporations of injecting “an ideological agenda through our economy, rather than through the ballot” and said the state’s new laws will “reinforce that ESG considerations will not be tolerated in Florida.” This followed a similar criticism from Mike Pence, former US Vice President, who wrote that the ESG concept “empowers an unelected cabal of bureaucrats, regulators and activist investors” to impose their political values.
Whatever your view, it’s clear that ESG has become an increasingly politicised term, making some investors more wary of using it. For example, Blackrock’s Larry Fink, previously a vocal supporter of ESG, announced that he had stopped using the acronym because “it had become a weapon”. He did, however, state that his firm had not changed its stance on ESG issues and would continue to support goals such as decarbonisation in the companies in which it invests.
Rhetoric and reality
Given the various political and regulatory hurdles, it is not surprising that there are more and more questions surrounding the ESG concept. In my view, the growing criticism that ESG faces is an inevitable reaction to its coming of age and ultimately a positive sign.
After all, if it’s a sound concept, it should be able to withstand them. That scrutiny will inevitably lead to some less valid ESG claims being exposed as more attention is paid to cases of eco-imposture. I firmly believe it also means we can have greater faith in investments and initiatives that stand up to the increased attention.
To move forward with ESG investing, greater transparency and rigour are critical. I am therefore encouraged that this year the International Auditing and Assurance Standards Board (IAASB) announced proposals to develop new global assurance standards for sustainability reporting, with supporters including Norway’s sovereign wealth fund. This move is part of ongoing efforts around the world to tighten regulation around ESG investing. While in the short term, this may cause some difficulties, it should ultimately lead to greater clarity and confidence.
In recent years we have seen ESG investing sometimes be the subject of rather excessive claims, both in portraying it as a positive or evil force. However, in my experience, successful investors excel at seeing the reality behind the rhetoric. Anyone who looks honestly at the current situation can see that the environmental, social and governance challenges facing the global economy are very real. All indications are that ESG investing will be central to our financial future. It is up to all of us to ensure that it does so as successfully as possible.
