Stop the ESG Nonsense
Investment funds labeled “sustainable” or “ESG” for environment, social, and governance have enjoyed a rush of inflows in the last few years. ESG investing, depending on how you measure it, accounts for one-third of total U.S. assets under management. But recently there has been a backlash. Some of this backlash is on target; some of it is completely wrong.
None of it, however, fully identifies the worst thing about the ESG industry.
What is ESG investing?
ESG or sustainable investing involves evaluating the environmental, social, and governance performance of firms in which a fund is invested. Usually, an asset manager engages an outside research firm such as Thomson-Reuters, MSCI, or Sustainalytics to assign ESG ratings to companies being considered for its funds. The aim is for the fund (or ETF) to achieve a high average ESG rating.
Environmental performance is judged by a firm’s greenhouse gas (“carbon”) emissions or plans to reduce them, and other environmental benchmarks. Social performance is judged in part by the firm’s “inclusiveness” and racial, ethnic, and gender diversity. Governance is judged by the independence of its board, ratio of executive pay to average employee pay, and other such factors.
The sustainable investing surge
Sustainable investing has had an incredible run over the past several years. The exhibit below, from Morningstar, shows the extent of its growth.
Assets in funds holding themselves out to be sustainable or ESG investments have increased by a factor of four in the last decade. Inflows into ESG funds in 2020 were more than double the previous year, and 10 times those in 2018.
What is causing this sudden trend?
The rush toward ESG investing is a result of the confluence of three factors:
- Investment management firms have faced a sharp drop in fees over the last two or three decades. Average mutual fund expense ratios have more than halved due mainly to the increased popularity of low-cost index funds. ESG investing provides a reason – one might say, an excuse – to charge higher fees. It is an “active” strategy; it requires research on companies that are candidates for an investment portfolio. For that reason, advertising for wealth management services has been plastered recently with the word “sustainability,” successfully fanning the craze.
- Investors have strongly awakened in the last few years to the problems of climate change, injustice and inequity, particularly racial injustice, but also wealth and gender inequality.
- With regard to environmental issues especially, but also as regards ethnic and gender bias, individuals have been encouraged to take responsibility for their own actions. They have been strongly encouraged to calculate their carbon footprint, recycle, use less resources, shun plastic bags, and eat less meat. A bestselling book, Drawdown, lists ways to mitigate climate change, mostly involving things that individuals can do. Some have argued that this shift to place the responsibility on individuals is not in fact environment-friendly; yet it helps to salve people’s consciences. Unfortunately, it often makes them feel guilt-ridden when they fail in their efforts to follow the recommendations.
Put all these things together and you have ESG. A way for investment management to increase its fees; for investors to feel that they are doing something to mitigate climate change and injustice; and for them not to feel personally guilty when they fail to follow the recommendations.
The ultimate recognition: a new CFA certificate in ESG investing
Recently, the Chartered Financial Analysts’ certificate-awarding institution, the CFA Institute, has launched a new Certificate in ESG Investing. This serves as recognition that ESG is firmly part of the investing mainstream.
From the CFA Institute website, one can download the syllabus for the course in ESG investing. After taking the course one can apply for the ESG investing certification.
In that syllabus, under section 2.1, The ESG Market, is the following course element, Section 2.1.3:
2.1.3 Explain key market drivers in favor of ESG integration:
- investor demand/intergenerational wealth transfer;
- regulation and ‘soft law’;
- public awareness;
- data sourcing and processing improvements.
Notice the absence of my first factor explaining the surge in ESG investing: the desire of investment management firms to re-establish their economics of the past through higher fees for active management.
This push to offer sustainability funds with higher fees, and the plethora of advertising for these funds, peppered so prominently with the word “sustainability,” is a factor in the rise of ESG investing. And yet it is not mentioned as a market driver in the CFA Institute’s ESG course syllabus.
There has been a drive recently to cleanse corporations, particularly in the finance industry, of the profit motive – the motive to maximize shareholder value and thus profits. This drive is surely well-intentioned, on the part of many CEOs who have enunciated the shift toward “stakeholder value” as opposed to mere “shareholder value.” But it has not canceled the profit motive. The profit motive is part of the push on the part of investment management firms for ESG. The CFA Institute module on market drivers ought to say so.
Several high-level ESG managers have recently formed the vanguard of a backlash against ESG investing.
Tariq Fancy, the former chief investment officer for sustainable investing at BlackRock, the world’s largest asset manager and chief exponent of ESG investing, wrote a three-part essay on Medium to explain “how my thinking evolved from evangelizing ‘sustainable investing’ for the world’s largest investment firm to decrying it as a dangerous placebo that harms the public interest.” Desiree Fixler, former head of sustainability at Deutsche Bank’s asset management subsidiary DWS, was fired after criticizing the firm’s green investment program. “The company,” she says, “has massively overinflated its public image and presented itself as far ‘greener’ than was appropriate for its investment policy.”
Much of this backlash is justified, though a key criticism often made of ESG is fallacious. And nothing that I’ve seen identifies the worst things about the rise of ESG.
Misguided objections to sustainable investing
The main objection to sustainable investing has always been the objection raised more than 50 years ago by Milton Friedman to corporate social responsibility. It has been regularly repeated ever since by most institutional investors and many economists until relatively recently. That objection is that the objective of investment should be solely the maximization of shareholder return, nothing else. Any other objective would be a violation of the fiduciary duty of an institutional investor, who invests on behalf of its investor-clients.
But this objection never made any sense, at least in the context of asset management. Any active equity investment manager has, and always has had, a methodology for picking companies to invest in. That methodology involved screening stocks according to some set of criteria. To claim that a methodology that involves screening companies according to their “sustainability” is somehow inferior to all those other methods for screening stocks, and therefore does not seek to maximize investment return and does not meet the standard of fiduciary duty, is utterly absurd and always has been. And yet that objection has been repeated over and over.
Recently, we have seen that objection start to fade away, especially since ESG investment strategies emphasize that seeking to maximize investment return is in fact their objective. Yet it is still frequently repeated.
But will it really accomplish anything?
Getting over the objection I just mentioned is an important and beneficial development. But the problem remains that ESG investing has become a fad and a distraction that could ultimately be damaging and not beneficial, and I will tell you why.
A huge industry is growing around ESG investing, an industry that includes the participation not only of institutional investors and the ESG rating firms they engage, but also of numerous organizations of institutional investors, international bodies like the United Nations, major stock exchanges, and so on. The purpose of all those organizations is to set standards and, particularly, requirements for disclosures of information by corporations, for example about carbon emissions or the diversity of their work force.
Since carbon emissions are still high worldwide, in fact as high as they have ever been and growing, the average corporation will of necessity disclose high carbon emissions in its global activities and supply chain. Hence, ESG ratings are based not only on current emissions but on plans to reduce them in the future, as expressed in targets and goals. ESG-vetted portfolios are therefore rated in good part on the composite of targets and goals set by the companies in the portfolios – that is, on how well they expect to do, or say they aim to do, on their ESG targets.
Unfortunately, this sounds too much like the main activity that institutional investors have engaged in for years; namely, to set goals and expectations for their investment returns that they almost invariably fail to meet. To cover for this failure, they make a variety of excuses and set so-called “custom benchmarks” that are easier to beat than more appropriate benchmarks like market indexes.
ESG investing in the hands of institutional investors could go a similar route. Expectations will be set by targets and goals, but like investment return targets, those targets and goals will not be met.
To try to ensure a greater likelihood of meeting targets and goals, they are stated in vague terms. Here is an example. One of the major global stock exchanges requires its listed companies to prepare ESG reports. It gives the following as what it actually calls a good example of a disclosure of a smart target from a multinational retailer:
Our goal is to become a zero-waste business....By 2025, the 50 key raw materials used for our products will come from sources verified as respecting the integrity of ecosystems, the welfare of animals and the wellbeing of people and communities. This will cover over 80% of raw material usage by volume... (Emphases in original.)
First of all, the goal of “zero-waste” is meaningless by itself without further clarification and elaboration and doesn’t agree with the rest of the stated target, which cites the number 80%, not 100%. The goal of “respecting the integrity of ecosystems” is too vague for its achievement to be meaningfully verified. In fact, all these goals are vague to the point of meaninglessness. So-called “verifiers” will be hired to assess progress toward these targets. But since they are vague, the verifiers, who are paid by the company, can produce sagacious-sounding reports on cue saying that the company is making progress toward its vague goals, but needs to tweak its process in one way or another.
There are three serious problems with ESG investing:
- it won’t really accomplish its claimed objectives;
- it will give the pursuit of those objectives a bad name by undermining the seriousness of their pursuit;
- and most importantly, it creates an industry of well-compensated but Mickey Mouse jobs1 paid for by increased fees for investment management, drawing people away from much more important work in which they should be engaged.
There is an effort afoot to solve problems such as that ESG ratings by different ESG evaluation firms are completely different, by merging all the evaluation methods into a single universally accepted set of standards – and some people naively believe this will resolve the issues. But mark my words, this effort will result in an even more vaguely stated set of ESG standards, adherence to which will be virtually impossible to verify but will be even more merely performative than it is now.
My biggest concern is not that ultimately none of this will be taken seriously and will be regarded as a set of Mickey Mouse tasks performed by a legion of ESG evaluators and box-tickers. It is that all of this activity employing ESG investment managers and consultants and verifiers and raters takes essential personnel away from the activity they need to be engaged in to solve the problem of climate change; namely, innovating, researching, and developing new and improved technologies.
We need many more people trained in and engaged in science and technology R&D, not more people trained in and engaged in paperwork oversight by a whole industry of ESG evaluators.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, managing partner and special advisor at M1K LLC, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.