What began in 2005 as an invitation from then UN Secretary-General Kofi Annan to a group of the world’s largest investors (1), has turned into a global movement in “Sustainable Investing” with combined assets under management of over $17 trillion in the US alone. (2)
A part of that Sustainable Investing movement, Environmental, Social, Governance (or “ESG”) investing has quickly gained popularity in recent years, with ESG Fund inflows growing from just $5.4bn in 2018 to $21bn in the first quarter of 2021 alone (3). But what do asset managers actually mean by ESG investing?
ESG is an investment approach that considers environmental, social, and governance factors as part of the overall investment decision and does not just focus on financial rewards. For many investors, the belief is that their investment capital will be used to invest not just for pure economic profit, but for greater environmental and social good.
The reality, however, may not be so rosy.
For example, Blackrock’s former Chief Investment Officer for Sustainable Investing, Tariq Fancy, recently published an article saying the financial world was greenwashing the public regarding sustainable investing practices;
“Sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.” (4)
If you want to learn more, we highly recommend reading Tariq’s series of posts on Medium called The Secret Diary of a ‘Sustainable Investor’.
To combat some of these issues, in March this year, the SEC announced the creation of a Climate and ESG Task Force in the Division of Enforcement to proactively identify ESG-related misconduct (5). Click here to access the SEC Risk Alert - it actually provides a really good summary of the issues around the use of “ESG” strategies by fund managers.
Further, a study done by Gita Rao at the Sloan School of Management at MIT, found that the proxy voting records for ESG ETF funds often appeared to be at odds with their ESG objectives. The research looked at the voting records of the ESG ETFs of the three largest asset managers in the US; Blackrock, Vanguard and State Street (who between them control 20-30% of the US equity market) from 2006 to 2019.
Ms. Rao’s research showed that the Vanguard Social Index Fund (the oldest and largest ESG ETF fund in the US) voted against almost all environmental and social resolutions over the 14-year period of the study (including voting against every single resolution requesting disclosure of board diversity since 2006) (6).
The issues with ESG investing go beyond just the voting records of some of the biggest ETF providers on the planet; institutional investors usually rely on third party ESG Rating Providers like Refinitiv, Sustainalytics, Inrate etc. to provide corporate ESG ratings and increasingly there are questions around the consistency of these ESG factor ratings. According to a research piece published in the Financial Analysts Journal, the correlation between the different ESG Rating Providers for overall ESG ratings is 0.45, far lower than the 0.99+ correlation among credit ratings from the traditional credit rating agencies (7). So there isn’t even broad agreement on measuring a given company’s ESG factors.
Considering how difficult ESG factors are to measure however, the variance in ESG ratings across the different ESG Rating Providers is understandable. Take an environmental factor like Carbon Emissions. More and more corporates are committing to being carbon neutral (or even carbon negative in some cases) on a voluntary basis. As trees are natural carbon sinks, forestry and soil management are seen as one of the easiest options for pursuing negative carbon goals and so forestry projects are increasingly being used by big tech, the big banks, and big consumer facing companies as part of their voluntary carbon targets.
However, voluntary carbon offsetting is an area with very little regulation and oversight. This naturally enhances the risk of investing in projects that do not actually change the global carbon production horizon - e.g. a company purchases a forest to help meet its net zero emissions goals, however the forest would exist with or without the investment so nothing has actually changed. Meanwhile, the company may get the benefit of a high environmental factor score and would most likely be high up the list of an ESG ETF.
The purpose of this article is not to dissuade investors from considering ESG investments. Many worthwhile products have teething problems during the nascent stages of their development and the goals of ESG investing are noble. The purpose of this article is to make sure investors are aware of some of the current limitations around ESG investing and allow you to decide if investing in an ESG ETF will deliver the positive changes, beyond financial returns, you are expecting or whether you should be considering alternative direct impact investments instead.
If you would like to learn more about investing directly into the Louisiana Green Fuels project, a carbon capture and sequestration project that is anticipated to sequester 550,000 tons of CO2 each year (the CO2 equivalent of taking 120,000 cars off the road every year) and create close to 500 full time green sustainable jobs in an underdeveloped part of the USA, please contact me at: email@example.com