Is There a Dark Side to ESG? (2024)

Introduced almost 20 years ago, ESG became the social responsibility yardstick of choice for money managers worldwide. Now, it has become one of the biggest controversies in finance.

Investing based on ESG ratings has been called a scam, a failure, an attack on fossil fuels, an example of “woke” capitalism, a mix of greenwashing and corporate deception, a dereliction of fiduciary duty.

What happened?

In the beginning, ESG set out a fairly simple idea: Rate companies on their ability to identify and respond to risks in environmental, social and corporate governance matters. Those three areas gave the approach its name.

Last year, at least $8.4 trillion of financial assets under professional management in the United States were invested directly on an ESG or sustainability basis. That’s about 12.6 percent of the $66.6 trillion in total U.S. managed assets, according to a study by the US SIF Foundation.

The Controversy

Over time, friction has developed between the idea of investing solely for maximum returns or producing optimum value for investors, and the concept of also investing to promote social and environmental goals.

Today, criticism of ESG includes these claims:

• Companies that devise ESG ratings keep their methodologies proprietary, making the process impossible to understand or evaluate.
• Because of company self-reporting, ESG is rife with greenwashing and false claims of social responsibility.
• ESG investing doesn’t go far enough in addressing key environmental and social problems, including climate change.
• ESG is an example of “wokeness,” an attempt to force a leftist worldview on finance and investing.
• Fundamentally, ESG investing is financial fraud, simply a way to generate revenues for ratings companies.

“The concept of investing in environmental-, social- and governance-centric products is not new. Institutional investors have long incorporated socially responsible themes such as clean air and water, diversity, human rights and workplace fair practices into their investment strategies,” said Steve Estes, U.S. advisory partner for professional services company KPMG in Houston.

“Market interest driven by socially and environmentally conscious investors has grown significantly, though, particularly over the past few years,” he added.

Estes said investment managers and ESG ratings firms are taking steps to address the criticisms, and investors themselves are now demanding comparable and coherent ESG information.

“In this environment, fund managers are adopting strategies to mitigate greenwashing,” he noted. “Companies are increasingly aligning on more common standards that bring consistent, comparable and decision-useful information to investors.”

Investor confusion is understandable. There are reportedly 600 ESG frameworks and standards globally, and more than 140 firms provide ESG scores in the United States alone.

Aswath Damodaran, professor of finance at the New York University Stern School of Business, is a noted and frequently cited critic of the utility of ESG. Damodaran said ESG investing “is an idea that is both empty at its core and toxic in its use. ESG services are confused or are being misleading about what they are measuring.

“If it is goodness, it is impossible to do, since goodness is personal and no service can centralize those yardsticks. If it is risk – and that seems to be the new pitch – my question is, ‘Where is the beef?”

ESG investing reflects the concept of corporate social responsibility, the idea that companies should consider social concerns in addition to profitability when making business decisions. ESG can be seen as an attempt to quantify and formalize CSR.

Other relevant terms include:

• Greenium: A premium people are willing to pay for a stock or other investment simply because it appears to be green. The greenium represents a value over-payment and reduces the prospects for future gain, expressed as a percent of the initial investment.
• Greenwashing: When businesses try to make their products or operations appear more environmentally friendly or less environmentally damaging than they actually are, often for marketing purposes.
• Social Responsibility Investing: Investing that equally considers both financial returns and support for social and sustainability goals. Also called “sustainability investing.”
• Triple Bottom Line: An earlier expression of responsibility investing, with a triple focus on profit, people and planet – profitability plus social and environmental concern.
• Woke Capitalism: An effort to inject “progressive” or far-left social and business goals into business decisions; used as a derogatory term.
• Woke-washing: When businesses try to make their products or operations appear more socially responsible or “progressive” than they actually are, or when companies publicize a commitment to social issues but take no action.

A Brief History of ESG

Two decades ago, leaders from the World Bank and United Nations began calling for more focus on responsibility investing. That led to a financial industry initiative and white paper report titled “Who Cares Wins.”

According to an issue brief from the International Finance Corp. of the World Bank Group, “Who Cares Wins (WCW) was initiated by the UN Secretary General and UN Global Compact in 2004 in collaboration with the Swiss government. The initiative was endorsed by 23 financial institutions collectively representing more than US$6 trillion in assets.”

While WCW gave ESG investing an early impetus, it also presented investment managers with a dilemma. They had a professional obligation – and in the United States, a legal obligation – to deliver the best possible returns for their clients while safeguarding investment capital. But there was no evidence a company would perform better simply because it met some arbitrary definition of “responsibility.”

So, they developed a workaround. ESG ratings would be based, not on “sustainable” or “responsible” operations, but on a company’s ability to recognize and deal with risk in ESG areas. And there was plenty of evidence to show that companies that handle risk successfully perform better financially than those that don’t.

This approach led to some confusion about what ESG ratings actually are. The Dow Jones Sustainability North America Index includes the top 20 percent of the largest 600 North American companies in the S&P Global broad market index, based on economic and ESG criteria.

Phillip Morris International, a major cigarette and tobacco company, is a component member of the sustainability index, according to its latest update. So are Halliburton, ConocoPhillips, Marathon Petroleum and Hess Corp. And also, Walmart, Lockheed Martin, Eli Lilly and fast-food giant Yum! Brands.

Reconsidering ESG

The broadest studies of investment returns have found that approaches incorporating ESG ratings perform slightly better than those that don’t, including studies by both NYU and market-data company Refinitiv. But those results have been challenged, in part because investment managers apply other criteria beyond ESG ratings in their investment decisions.

“Using Refinitiv’s own ESG scores and measures of risk – cost of capital and volatility – the only relationship between ESG scores and risk seems to come from the bias that scores have towards bigger companies that score higher than smaller companies, not ESG,” Damodaran observed.

Investing using ESG has been “widely sold – not widely accepted – and it was a favorite, because it allowed fund managers to charge more for ESG funds that were barely distinguishable from their regular funds. The gravy train enriched consultants, measurement services and fund managers,” he added.

In addition, those broad performance studies did not include the full year 2022, when energy investments, especially oil and gas stocks, significantly outperformed the general market. However, more recent monitoring by S&P Global found “since its establishment in 2019, the S&P Global 500 ESG Index has roughly tracked the standard S&P 500 index, slightly outperforming it since 2020.”

Russia’s invasion of Ukraine and the subsequent reaction changed the world’s energy-supply pattern, altered macroeconomic reality and put a new emphasis on energy security. That caused many investment companies to reconsider their reliance on ESG rankings.

“ESG has become a long-term imperative that most U.S. companies and their leaders recognize, especially as we continue to evolve to a low-carbon economy,” Estes said. “However, with current macroeconomic concerns, organizations are facing a critical decision point on ESG as they determine where they can pause or pull back investments.”

He noted that KPMG’s U.S. CEO Outlook last year included responses from more than 400 top executives who were twice as likely, at 70 percent, to report that ESG engagement improves financial performance, compared to a year earlier, at 37 percent.

“Yet this year, 59 percent of CEOs also indicated that to prepare for an anticipated recession, they’d pause or reconsider their organization’s ESG efforts in the next six months,” he said.

“This is a dial, not a switch. Sixty-five percent of U.S. businesses included in the survey said they still plan on investing between 6-10 percent of revenue in programs meant to make their companies more sustainable – well above the global average,” Estes observed.

In the United States, momentum for ESG investing has slowed significantly. According to an article from financial services firm Morningstar, “Flows into sustainable funds have fallen steadily since their all-time high in 2021′s first quarter. Much of this was driven by the broader market environment. In 2022, U.S. funds suffered more than $370 billion in withdrawals.”

The Vanguard Group, one of the world’s largest investment advisers with about $8 trillion in assets under management, announced in December it was leaving the Net Zero Asset Managers initiative, in a shift away from climate-based ESG investing.

ESG in Politics

Significantly, ESG has emerged as a flashpoint in U.S. political and social debate. Republican attorneys general from 25 states filed a lawsuit in a federal district court in Texas challenging a U.S. Department of Labor ruling that allows the use of ESG criteria in retirement-fund investment decisions. Both the U.S. House and Senate subsequently voted to overturn the ruling approving ESG, a move President Joe Biden then vetoed in late March.

Earlier this year, Florida Gov. Ron DeSantis announced a state legislative proposal to curb ESG investing and stated in part, “By applying arbitrary ESG financial metrics that serve no one except the companies that created them, elites are circumventing the ballot box to implement a radical ideological agenda.”

In regard to that statement, Damodaran remarked:

“I won’t claim to understand what any politician says, but ESG was about empowering corporations – and their CEOs – to make decisions on the environment and society that were defined as ‘good’ by ESG experts, but decisions that have consequences for the rest of us.

“Those big decisions are what laws and regulations are supposed to cover,” with “elected representatives and governments making those decisions, rather than a group of experts or top managers.”

With ESG investing facing criticism and challenges from multiple sides, there’s an emerging belief in the financial industry that ESG should transform into something more clear and coherent. Or if nothing else, that ESG ratings need to become much more consistent and understandable.

In a Harvard Business Review article earlier this year, authors Daniel Crowley and Robert Eccles wrote, “The key will be returning ESG to its original and narrow intention — as a means for helping companies identify and communicate to investors the material long-term risks they face from ESG-related issues.”

Over the past two years, the conservative backlash against ESG investing began to produce a backlash of its own. Financial observers note that U.S. states face increased borrowing costs and reduced investment returns when they refuse to do business with institutions that acknowledge ESG ratings – because those states end up rejecting large institutions with favorable rates.

According to a Wharton School study last year, Texas cities would pay $303 million to $532 million in additional interest on bonds due to the state’s ESG ban. A different estimate found that Florida would pay an extra $4.3 million for every $1 billion of bonds sold.

Another, more libertarian view has argued that free markets require freedom of choice, including ESG choices. This argument opposes the injection of state politics into investment decisions and says investors should be able to invest in whatever they want, for whatever reasons they want. It’s their money.

However, that sentiment skips past a central fact of ESG. Investment managers and advisers invest huge amounts of money on behalf of funds, corporations, university endowments, retirement plans and other clients, usually without customer input or direction. They aren’t investing their own money.

To what extent should they be required to maximize returns for their clients, and how much should they acknowledge and act on the idea that investment decisions have social, environmental and also energy-security consequences?

It’s a debate that has gone on for decades. Even if ESG does transform into some other type of responsibility investing, the debate seems likely to continue for years to come.