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

In one sense, defining “ESG” is easy – it’s an approach to investing and finance centered around understanding risks from environmental factors, social issues and questions of corporate governance. Sorting out the differences between ESG and similar, sometimes overlapping approaches is harder, 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’s also come increased scrutiny from regulators cracking down on banks and investment firms making exaggerated claims. Meanwhile, in the US, ESG is facing a backlash both from prominent Republicans who deride it as “woke capitalism” and is being criticized by some early leaders of the field who say it isn’t creating the kinds of real-world impacts it seemed to promise. Here’s a guide to the basics.  

1. What’s the big idea? 

The broadest umbrella term for the strategy of which ESG is a part is sustainable investing. Proponents say the goals of sustainable investing are to achieve societal impact, align with personal values or manage risks. And make money along the way, of course. 

2. Where did ESG come from?

The concept was developed early this century by United Nations officials working with the finance industry. They argued that the use of ESG factors in financial analysis was compatible with investors’ fiduciary responsibilities — that using ESG data would help protect investments by avoiding material financial risks from things such as climate change, worker disputes, human rights issues in supply chains and poor corporate governance and resulting litigation.

3. Has that changed?

As time has passed, the label has come to be slapped on investments that run the gamut from predictable things such as owning renewable-energy stocks to things you wouldn’t expect, like funds that track benchmark indexes containing oil companies or assets in autocratic nations such as Russia, or coal, steel and liquor firms in China, where ESG funds are growing rapidly. 

4. How big is ESG?

Estimates vary depending on what people count as ESG. According to Bloomberg Intelligence, global assets are set to climb to $50 trillion by 2025 from about $35 trillion now. That’s up from $30.7 trillion in 2018 and $22.8 trillion in 2016, according to the Global Sustainable Investment Association. 

5. What is ESG backlash?

In the US, Republican state officials have become sharp critics of Wall Street’s ESG policies. They deride it as “woke,” turning a term progressives coined to convey awareness of racism’s role in society into an insult akin to “politically correct.” Florida Governor Ron DeSantis, a potential 2024 presidential hopeful, banned state pension funds from screening for ESG risks, saying that Wall Street firms were trying “to implement policies through the board room that Floridians reject at the ballot box.” Texas is seeking to isolate financial firms it says are hostile toward the fossil-fuel industry. A group of attorneys general from mainly GOP-run states sent a letter to BlackRock Inc., saying the world’s largest asset manager is pursuing ESG investment policies to the detriment of their state pension funds. Missouri recently launched an investigation into Morningstar Inc. and its subsidiary Sustainalytics Inc. over the firm’s evaluation of ESG issues. And conservative activists have stepped up efforts to file proxy ballots with proposals to rein in ESG policies – taking a page from the playbook of their liberal counterparts.

6. What criticism is coming from ESG supporters?

Some think the term has become so broad as to lose much of its meaning. Many point to the prevalence of greenwashing, which happens when companies exaggerate the environmental benefits of their actions. Even the man who coined the acronym has said the finance industry has sprinkled “ESG fairy dust” on products that don’t merit the label. Other criticisms focus on the way fund managers rely on ESG ratings that rank companies by how they are performing 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, say, the risks they pose to the environment and society. (Looking at both sides of the equation, an approach known as double-materiality, has been adopted by the European Union but not elsewhere.) Some proponents of sustainable investing say it’s time to jettison the “ESG” label altogether because it’s lost its meaning. One academic has said the industry should just refer to a more mundane term, “material risk factors.”

7. What are regulators doing?

With the ESG label now widely used by money managers and bankers selling everything from mutual funds to complex derivatives, European and US regulators are clamping down on firms they say are exaggerating their ESG bona fides.

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

• The following month, it emerged that US regulators were looking into whether ESG funds sold by Goldman Sachs Group Inc.’s asset management group are in breach of claims set out in marketing materials.

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

• These proposed rules come off the back of new laws in Europe, the Sustainable Finance Disclosure Regulations, where investments have to be labeled under categories commonly referred to as “light green” and “dark green,” according to the priority placed on sustainability.

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

8. Where does ESG fit in the sustainability spectrum?

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

• Ethical and Values-Based Investing: These are broad strategies that enable investors to shun or invest in companies depending on whether they reflect their political, religious or philosophical beliefs and values. Its earliest practitioners were religious groups such as Quakers who shunned investments in things like alcohol, weapons and gambling. Church-affiliated groups in Sweden began the first ethics-based mutual fund in 1965. The Pax World Fund was founded in the US in 1971 by two ministers who didn’t want their churches’ investments to support the arms industry.

• Socially Responsible Investing: Galvanized by anti-Vietnam War protests, including consumer boycotts of companies that made napalm, and by efforts to end apartheid in South Africa, a group of investors in the 1980s and 90s sought to do good by not only avoiding companies that harm society but investing in those that 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 centers on private projects. It’s a niche strategy where investors target specific outcomes 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 ESG’s limited impact. Systems-level investing involves making decisions that take into account the entirety of one’s portfolio and how its elements intersect across all assets in the long term. An example would be climate change: A systems-level approach would examine how it affects entire portfolios, from shares in energy and insurance companies to sovereign bonds and foreign exchange. Systems-level investors are then 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 pressing for public policy changes.

9. Does ESG actually make a difference?

Some investors and academics complain that ESG’s impact has amounted to far less than its supporters suggested.  Of course, sustainable investors have made some strides, such as pressing companies to reduce their plastics use, addressing workers’ rights and performing so-called civil rights audits. They have also succeeded in replacing directors on Exxon Mobil Corp.’s board to help the oil giant position itself toward cleaner fuels. Other proponents have said that had investors in UK’s Deliveroo Plc taken ESG issues into account, they could have avoided losses after the company faced a backlash over gig-economy exploitation and worker pay last year. Still, detractors say the idea that ESG investment alone is enough to address complex problems is being shown to be wrong and that more government intervention is needed to address societal issues such as living wage minimums and greenhouse gas emissions.

10. What are returns like?

Across three categories — Europe-focused, US-focused and global — ESG large-cap equity funds have done better this year, on average, than their non-ESG counterparts. While they have lost money — in line with the broad market selloff — those losses are smaller. Globally, ESG funds are down 11.7% this year through June 10, compared with the 14.8% slump of the MSCI World Index. But there have been some early signs that investors are souring on ESG. For example, they pulled a record $2 billion net from US equity 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 Bloomberg story about how ESG is everywhere in capital markets.

• A Businessweek story about ESG ETF investing.

• The Freshfields report that started the ESG strategy

• A Bloomberg investigation into the ESG ratings industry.

• A history of ESG investing by Morningstar.

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