ESG Investing: A Dangerous Game
Authors: Faith Woon & James Lam | President & Project Consultant 2022
The ESG movement
What is ESG investing? Applying the focus to the environmental, social and governance aspects of a company, it is a massive movement that has catered to ethical investors all over the world, wanting to generate financial returns while ‘doing good’ for the environment and society. Long has the fiduciary responsibility of investors been to maximise returns, but there is now a shift in the initial reluctance to use their power to support ethical businesses. Today, ESG investing has taken the world by storm and bloomed into a US$35 trillion market. It’s predicted to reach US$50 trillion by 2025 – a third of all money invested globally.
This is good, right? Unfortunately, despite the hype, the rising trend of ESG investing has brought about massive implications, namely heavy greenwashing and overblown marketing. This is particularly prominent in certain sectors, with over 90% of Fidelity energy sector analysts saying their companies promote better ESG credentials than their actions justify. Amidst fierce competition, fund managers are also turning towards ESG labels to garner the interest of investors.
“ESG creates a fantastic revenue possibility for large firms... It’s fresh, feels good and new, but it’s not any different than anything else. These things aren’t more expensive to run.” – Dr. Wayne Winegarden, Senior Fellow at the Pacific Research Institute & Andrew Jamieson, Global Head of ETF Product at Citigroup Inc (source)
By capitalising on the ESG craze, fund managers are now able to charge a ‘greemium’ for their sustainable funds, with annual fees almost 50% higher on average. But beyond the guise of the ESG label, it is difficult to see how ESG funds are different from their traditional counterparts. Looking at the vast majority of ‘ethical’ ETFs on offer, their top holdings tend to be large tech and consumer companies like Apple, Microsoft and Amazon, sometimes even oil producers like ExxonMobil. Beyond a few rudimentary screens which exclude tobacco companies and the like, there is no guarantee that the companies they pick are actually contributing any tangible ‘good’ to society.
Let’s take a deeper look at some of the issues associated with ESG.
A flawed metric?
Firstly, there is the issue of how one should go about assessing how ethical a company is and determining how it complies with environmental, social and governance factors. Is it more important to align with the environmental component rather than social factors such as employee treatment? Earlier this year, S&P Dow Jones Indices made the decision to remove Tesla from its ESG index, stirring up significant controversy. Despite the company’s contribution to the ‘E’ of ESG, it was ultimately their poor governance and workplace practices that let them down, lowering their ‘S’ and ‘G’ scores.
In situations like this, ESG can be problematic as it encourages us to assume that a multitude of environmental, social and governance factors can be grouped under a singular label, when in reality these sometimes conflict. After everything Tesla had done to support the development of the electric vehicle industry, did they really deserve to be stripped of their ESG credentials? Allegedly not, according to Elon!
With reporting being voluntary, ESG ratings can also be manipulated so that companies are able to divert attention towards what they want the public to see while masking any suspicious activities. Major polluters can offset their environmental impact by pursuing more ‘social’ or ‘governance’ focused initiatives, for example investing in cybersecurity or spending a fraction of their profits supporting a local charity, which, whilst important, serves as a distraction from the more pressing problem at hand.
Moreover, the ratings themselves are arbitrary as companies are compared against their peers, rather than against an objective benchmark or set of ethical standards. To be recognised for their ESG efforts, they need only perform slightly better than their competitors, resulting in a lack of accountability across the industry and allowing companies to get away with the bare minimum.
The implications for society at large
All this creates a dangerous illusion that we are doing enough, that trillions of dollars are on their way to fund climate change, poverty, and so on. What most fail to realise is that ESG funds tend to be far more focused on avoiding harm rather than doing good, thus limiting their net positive impact on society. It is easy to fall into the trap of thinking that your money is directly contributing towards a good cause, amidst the clever marketing of so-called ‘sustainable’ funds and companies.
This promotes a dangerous sense of complacency. While investors are showing a substantial appetite for ESG-friendly investments, research suggests that the majority are not too concerned with how much impact their investment is actually making. Investment decisions are more often driven by the positive emotions associated with choosing a sustainable option, rather than a calculated assessment of the societal and environmental impact being created.
Ultimately, the issue stems from the inherently flawed nature of ESG. Despite what investors claim, ESG ratings were never intended to serve as a genuine assessment of a company’s impact. Framed as a way to promote good and responsible business, ESG has always been more about protecting companies from risk – whether it be increased public scrutiny, reputational damage or barriers to obtaining funding — hence the ratings are weighted on financial materiality rather than true indicators of social impact.
“[ESG] ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders.”
- Cam Simpson, Akshat Rathi, and Saijel Kishan.
For companies seeking to minimise their risk and promote responsible governance, ESG considerations are certainly important. However, for the socially-conscious investor, such ratings have limited usefulness.
This begs the question, how should we actually go about assessing impact?
The rise of impact investing
In April 2022, Utah’s State Treasurer Marlo Oaks blatantly criticised ESG for its political agenda but identified impact investing and socially responsible investing as viable alternatives – “legitimate strategies that operate within our capitalist system”. Tesla’s 2021 Impact Report echoed a similar sentiment, asserting that:
“Current ESG evaluation methodologies are fundamentally flawed. To achieve acutely needed change, ESG needs to evolve to measure real-world impact.”
– Tesla 2021 Impact Report
In light of ESG’s glaring flaws, impact investing has emerged as an investment strategy focused on creating both financial returns and measurable, positive impacts on the planet and society, often achieved by targeting sustainable themes like clean energy, accessible healthcare and biodiversity. Impact investment funds will often use one (or an adaptation) of the following impact measurement frameworks for due diligence and reporting purposes.
The Impact Management Project Framework: used by impact investment funds like Giant Leap and Tripple, the framework includes five dimensions of impact:
1. Who is impacted
2. What the problem is being solved
3. How much impact is being created
4. The contribution toward impact of the investment
5. The impact risks.
UN Sustainable Development Goals (SDG): one of the world’s largest private equity firms, KKR, is one of many to launch a Global Impact Fund that requires portfolio companies to be aligned with specific UN SDGs and to measure and report on specific impact outcomes
Global Impact Investing Rating System (GIIRS): created by the non-profit BLab, the GIIRS has been adopted by Bain Capital and many funds as a comprehensive system to assess social and environmental impact
Impact Multiple of Money (IMM): uses a singular metric to determine the impact of an investment in monetary terms for each dollar invested, before any funds are committed. This approach was pioneered by the The Rise Fund and The Bridgespan Group and builds off the Social Return on Investment (SROI) approach often used for program evaluation
At the core of any of these approaches lies the concept of additionality – the extent to which impact being created would have still occurred without the investment taking place. In other words, did your investment actually make a difference or were you just along for the ride?
What’s next?
In this current global environment, we are faced with a plethora of challenges. The threat of climate change, geopolitical instability and rising inequality sets us another step back from actively progressing towards an equitable and sustainable future. Investors – both individual and institutional scale – shouldn’t necessarily give up on ESG investing, but must shine a light on its limitations, as well as the threat of greenwashing and deceptive marketing that is rampant within the industry. We should look towards other strategies such as impact investing and active stewardship, to accelerate the transition to a better world that focuses on action, rather than mitigation.