Everything You Need to Know About ESG Investing And the Backlash to It

In a sense, defining “ESG” is easy: it’s an investment and finance approach focused on understanding the risks of environmental factors, social issues, and corporate governance issues. Sorting out the differences between ESG and similar, sometimes overlapping, approaches is more difficult, in part because ESG has come to mean different things to different people. That vagueness has helped fuel rapid growth in recent years, growth that is also due to increased scrutiny from regulators who crack down on banks and investment firms that make exaggerated claims. Meanwhile, in the US, ESG is facing backlash both from prominent Republicans who deride it as “woke up capitalism” and is coming under fire from some of the field’s early leaders who say it’s not creating the kind of real-world impacts it seemed. pledge. Here is a guide to the basics.

1. What is the big idea?

The broader umbrella term for the strategy that ESG is a part of is sustainable investing. Proponents say the goals of sustainable investing are to achieve social impact, align with personal values, or manage risk. And earn money along the way, of course.

2. Where does ESG come from?

The concept was developed at the beginning of this century by United Nations officials working with the financial industry. They argued that the use of ESG factors in financial analysis was consistent with investors’ fiduciary responsibilities: that the use of ESG data would help protect investments by avoiding material financial risks from things like climate change, labor disputes, rights issues. humans in supply chains and poor quality. corporate governance and resulting litigation.

Over time, the label has been applied to investments that run the gamut from predictable things, like owning renewable energy stocks, to things you wouldn’t expect, like funds that track benchmarks that contain oil companies or assets in autocratic nations. like Russia, or coal, steel and spirits companies in China, where ESG funds are growing rapidly.

Estimates vary based on what people count as ESG. According to Bloomberg Intelligence, global assets will rise to $50 trillion by 2025 from around $35 trillion now. That’s up from $30.7 trillion in 2018 and $22.8 trillion in 2016, according to the Global Association for Sustainable Investing.

In the US, Republican state officials have become strong critics of Wall Street’s ESG policies. They ridicule it as “awakening,” turning a term coined by progressives to convey awareness of the role of racism in society into an insult akin to “politically correct.” Florida Governor Ron DeSantis, a possible 2024 presidential hopeful, banned state pension funds from assessing ESG risks and said Wall Street firms were trying to “implement policies through the boardroom that Floridians reject at the polls.” Texas is trying to isolate financial firms that he says are hostile to the fossil fuel industry. A group of attorneys general from states largely controlled by the Republican Party sent a letter to BlackRock Inc., saying the world’s largest asset manager is pursuing ESG investment policies to the detriment of its state pension funds. Missouri recently launched an investigation into Morningstar Inc. and its subsidiary Sustainalytics Inc. over the company’s assessment of ESG issues. And conservative activists have stepped up efforts to introduce proxy votes with proposals to rein in ESG policies, taking a page from their liberal counterparts’ playbook.

6. What criticisms are coming from ESG supporters?

Some think that the term has become so broad that it has lost much of its meaning. Many point to the prevalence of greenwashing, which occurs when companies exaggerate the environmental benefits of their actions. Even the man who coined the acronym has said that the financial industry has sprinkled “ESG fairy dust” on products that don’t deserve the label. Other criticisms focus on the way fund managers rely on ESG ratings that rank companies based on their performance on ESG factors. There is a lot of inconsistency in those scores: in some cases, companies are ranked by the risks that ESG factors pose to them rather than, for example, the risks they pose to the environment and society. (Looking at both sides of the equation, the European Union has adopted an approach known as dual materiality, but not elsewhere.) Some sustainable investing advocates say it’s time to ditch the “ESG” label altogether because it has lost its meaning. . One academic has said that the industry should simply refer to the more mundane term, “material risk factors.”

7. What are regulators doing?

With the ESG label now widely used by money managers and bankers who sell everything from mutual funds to complex derivatives, European and US regulators are clamping down on companies they say are overstating their ESG in good faith. faith.

• In May, German authorities raided the offices of Deutsche Bank AG’s fund unit amid accusations that it exaggerated the role of ESG analysis in investment decisions.

• The following month, it emerged that US regulators were investigating whether ESG funds sold by Goldman Sachs Group Inc.’s asset management group failed to comply with claims made in marketing materials.

• The US Securities and Exchange Commission proposed a list of new restrictions in May aimed at ensuring ESG funds accurately describe their investments, and which may require some money managers to disclose greenhouse gas emissions of the companies in which they invest.

• These proposed rules stem from new laws in Europe, the Sustainable Finance Disclosure Regulations, where investments must be labeled in categories commonly referred to as “light green” and “dark green”, depending on the priority given to sustainability.

• In August, new European Union rules came into force that require investment managers to understand and act on the “sustainability preferences” of retail clients.

8. Where does ESG fit on the sustainability spectrum?

ESG’s popularity has depended in part on the belief that it will play a positive role in making the world a better place. But critics say that warm, fuzzy sentiment helps asset managers blur a key distinction: that ESG is primarily about using data to identify risks that could undermine investment performance or find opportunities to make money. That contrasts with some other branches of sustainable investing that sometimes go further:

• Values-Based and Ethical Investing: These are broad strategies that allow investors to avoid or invest in companies depending on whether they reflect their political, religious or philosophical beliefs and values. Its earliest practitioners were religious groups like the Quakers who avoided investments in things like alcohol, guns, and gambling. Church-affiliated groups in Sweden started the first ethics-based mutual fund in 1965. The Pax World Fund was founded in the US in 1971 by two ministers who did not want their church investments to support the arms industry .

• Socially Responsible Investing: Galvanized by protests against the Vietnam War, including consumer boycotts of companies that made napalm, and efforts to end apartheid in South Africa, a group of investors in the 1980s and 1990 sought to do good by not only avoiding companies that harm society but by investing in those who are improving their business practices. They may also focus on companies that are engaged in clean technology efforts.

• Impact Investing – While socially responsible investing tends to focus on publicly traded companies, impact investing focuses on private projects. It is a niche strategy in which investors target specific results that can be measured, such as the promotion of sustainable agriculture or companies that provide affordable housing.

• Systems-level investing: A nascent strategy that has yet to take off in a big way, but whose supporters hope to go beyond what they see as the limited impact of ESG. Systems-level investing involves making decisions that take into account the totality of one’s portfolio and how its elements intersect across all long-term assets. An example would be climate change: a systems-level approach would examine how it affects entire portfolios, from shares in energy companies and insurance to sovereign bonds and currencies. Systems-level investors are meant to work with other investors to collectively push companies to improve their business practices by creating industry standards, sharing data with other investors, and lobbying for public policy changes.

9. Does ESG really make a difference?

Some investors and academics complain that the impact of ESG has been far less than its supporters suggested. Of course, sustainable investors have made some progress, such as pressing companies to reduce their use of plastics, addressing worker rights, and conducting so-called civil rights audits. They also succeeded in replacing directors on the Exxon Mobil Corp. board to help the oil giant position itself toward cleaner fuels. Other advocates have said that if investors in UK Deliveroo Plc had taken ESG issues into account, they might have avoided losses after the company faced backlash for exploiting the gig economy and paying for gigs. workers last year. Still, critics say the idea that ESG investing alone is enough to tackle complex problems is proving to be wrong and that more government intervention is needed to tackle social problems like living wages and greenhouse gas emissions. greenhouse.

10. How are the returns?

Across three categories (Europe-focused, US-focused and global), ESG large-cap equity funds have outperformed their non-ESG peers this year, on average. While they have lost money, in line with the market sell-off, those losses are minor. Globally, ESG funds fell 11.7% this year through June 10, compared to a 14.8% drop in the MSCI World Index. But there have been some early signs that investors are resentful of ESG. For example, they raised a record $2 billion net from US exchange-traded funds in May, ending three years of inflows, according to Bloomberg Intelligence.

• Bloomberg QuickTakes on sustainable investing, ethical debt, ESG ratings, the ‘S’ in ESG, biodiversity and ESG stewardship.

• A story from Bloomberg on how ESG is everywhere in the capital markets.

• A Businessweek story on investing in ESG ETFs.

• The Freshfields report that launched the ESG strategy

• A Bloomberg investigation of the ESG ratings industry.

• A history of ESG investing by Morningstar.

More stories like this are available at bloomberg.com

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