Investors around the world have an insatiable urge to invest in environmental, social and governance-orientated funds. Consider the numbers. Industry group Global Sustainable Investment Alliance estimates that global investment in sustainable assets rose to $35.3tn in 2020 from $22.8tn in 2016. That is an astonishing 35.9% of total global assets under management.
Such funds pursue strategies ranging from integrating ESG factors into financial analysis to corporate engagement, with exclusionary or positive screening in between. Yet whether they will deliver on the ESG promise is another matter.
Fund management groups have commercial imperatives as well as fiduciary obligations. That can cause them to overstate their sustainability credentials – a practice known as greenwashing.
Tariq Fancy, former chief investment officer for sustainable investment at BlackRock, the world’s biggest fund management group, has publicly denounced these funds as a marketing gimmick, noting that ESG products carry higher fees than non-ESG funds. He now believes that his efforts at BlackRock led the world into a dangerous mirage and that claims that ESG investing will deliver higher returns are dubious.
At the same time the whole area is beset by methodological and data problems. The International Organization of Securities Commissions recently complained that ESG rating and data providers are largely unregulated, lack transparency about their methods, offer uneven coverage and harbour potential conflicts of interest.
And at the OMFIF Sustainable Policy Institute symposium, ‘Revolutionising finance for net zero’, Ignazio Visco, governor of the Banca d’Italia, pointed out that there are neither widely accepted rules for ESG data disclosure by individual firms nor agreed auditing standards to verify the reported data. He pointed to intrinsic difficulties in deciding which indicators are relevant in assigning an ESG score, especially when compared to financial aggregates. He also highlighted estimates suggesting that 55% of funds labelled ‘low carbon’, ‘fossil-fuel free’ and ‘green energy’ have exaggerated their claims.
At company level there is extraordinary fragmentation in reporting standards on ESG issues. While there are initiatives to move towards a more coherent international framework – notably the establishment of the International Sustainability Standards Board – progress is painfully slow.
This matters because the enforced obsolescence of the global carbon-intensive capital stock that will be required to meet the emissions targets of the Paris agreement – and potentially the COP26 summit in November – will inflict huge damage on many corporate balance sheets and revenue accounts.
A Harvard Business School study has looked at the potential costs of bringing environmental externalities back into company accounts. Its Impact-Weighted Accounts Project found that of 1,694 companies covered, 15% would lose all profitability if external impact costs were included, while 32% would see profitability reduced by 25% or more.
Most companies do not report such information about the cost of shifting their business models onto a more sustainable basis. Few have made explicit commitments to net-zero emissions. A survey of 400 directors by consultant Ernst & Young found that more than half of directors surveyed said they were considering ESG issues only because compliance, disclosure obligations and shareholder pressure compelled them to do so. Small wonder few believe decarbonisation is efficiently priced in global markets.
In fact, there is evidence that the difficulty of securing the transition to a low-carbon economy may perversely be increased by ESG funds. Researchers at Edhec, a French business school, have found that passive exchange-traded funds tracking low carbon, climate change or Paris-aligned indices allocate little of their money to the greenest companies and habitually increase the weighting of companies with a deteriorating environmental performance. They also found that these ETFs were starving sectors that needed to make the biggest investment in decarbonisation.
Fund managers struggling in the ESG data fog place heavy reliance on ESG ratings providers. Yet the ratings are based on widely different methodologies which are, in the end, subjective. This results in weird outcomes. For example, rating firm MSCI currently assigns ExxonMobil a BBB rating (high average) while drug-maker Moderna has a BB rating (between average and high average). So a notorious climate change denier is rated higher than a global leader in providing vaccines for Covid-19.
In that well-worn but apt cliché, few ESG funds really do what they say on the tin. But they have been a fantastic business opportunity for the big fund management groups.
Clearly investors in ESG funds need to bring a more sceptical eye to the contents of ESG portfolios and to the voting records of their fund managers. Investment advisers and journalists should likewise bring a critical intelligence to bear on the sector. As the quality of companies’ reporting on the sustainability of their business models improves over time, this will become easier.
But the underlying assumption that institutional investors can play a key role in securing the transition to a low-carbon economy is highly questionable. Without a firm push by governments for more widespread adoption of carbon pricing, the greening of the global corporate sector will remain elusive.
John Plender is a Financial Times Columnist and was Chairman of OMFIF from 2014-17.