For some years now, environmental, social and governance investing has stormed the asset management industry with explosive growth. Tighter and increased oversight may finally bring it back down to earth.
Consider these recent headlines:
These three news stories highlight the continuing debates and unresolved policy questions around ESG investing. They also illustrate what spurred the SEC into action recently with a set of new rule proposals on ESG disclosures.
Even though the term ESG is nearly two decades old and investing within an ESG framework is now the fastest-growing segment of the asset management industry, it remains difficult to ascertain exactly what ESG means. It means different things to different people – which makes it particularly challenging to identify when an ESG investment strategy should be properly labeled as such. And, given the higher fees typically charged on ESG products, asset managers naturally have an incentive to label any product as being “ESG” if they can. As a consequence, you may see all sorts of approaches to investment, from negative screening (excluding sectors such as tobacco or defense) to positive screening (picking sectors such as clean energy) to any strategy that promises to support your favorite social or environmental cause lumped under the label “ESG.”
This is a problem. But, the issue is really two-pronged. First, there is the matter of ESG ratings confusion. As the demand for sustainable investing increased, more and more investors have had to rely on ESG ratings to obtain a third-party assessment of the ESG performance of companies, funds or portfolios. The trouble is that ESG ratings from different providers disagree substantially. Recent research1 published in the Review of Finance, an academic journal, shows that even among the six most prominent ESG rating agencies, the correlations between their ratings is pitifully low, ranging from 0.38 at the low end to 0.71 at best. For comparison, the correlation between credit ratings also issued by various rating agencies is typically 0.99. The problem is that while it is much easier to assess creditworthiness – essentially, the probability of default – the definition of ESG performance can be murky.
The study digs deeper to describe how ESG ratings differ in scope, measurement and weighting. For example, on scope, one rating agency might include toxic spills, while another may not take them into account. Even when two ratings agencies agree on scope and account for similar categories, they may measure things differently, one evaluating labor practices based on employee turnover, for example, and another based on employee injuries. Finally, they may use entirely different weighting schemes, placing more emphasis on labor practices over toxic spills or vice versa. Given all that can differ in the construction of the ratings with no harmonized definitions and methodologies in place, no wonder ESG ratings are all over the place.
Then there is the issue of greenwashing, the term that has been loosely defined as making unrealistic or misleading claims about ESG credentials. The news of the asset manager DWS being raided in an ESG investigation brought these criticisms into sharper focus, especially within the asset management industry. Greenwashing is a concern on both sides of the Atlantic, but the European Union is ahead of the game. Its rigorous rulebook on ESG disclosures, the Sustainable Finance Disclosure Regulation, went into effect in March 2021 and has its own problems, but the EU has already led several big asset managers to downgrade their funds from Article 9, the gold standard in EU sustainability disclosures, to Article 8 – think a lighter shade of green. Given how few funds actually meet the SFDR’s Article 9 bar according to Morningstar’s review, it is safe to expect a lot more will follow suit.
The problem is more acute on this side of the Atlantic. One way investment firms can publicly signal their commitment to ESG investment principles is by signing pledges such as the United Nations-sponsored Principles for Responsible Investment. A natural question that follows is whether these “responsible” investors indeed “walk the talk” once they pledge by integrating ESG into their equity portfolio holdings. A Review of Finance paper2 finds that, compared with their non-PRI counterparts, PRI signatories do in fact invest more responsibly and have better ESG scores – but that is true only for those institutions outside the U.S. Comparing portfolios of U.S. investment institutions that have made the pledge with their nonsignatory peers, the study finds no evidence of any improved ESG scores. In stark contrast to those outside the U.S., American money managers who signed on actually had worse ESG scores. Not only does greenwashing appear to be more pervasive in the U.S., but the study suggests ESG labels may be sometimes used to make up for poor performance: Poorly performing U.S. funds, the authors find, are more likely to join the PRI than their high-performing peers.
None of this bodes well for the credibility of ESG, the protection of investors or the integrity of financial markets. There are already federal securities laws against misstatements of any kind; investment companies are required to disclose accurate information about how client assets are invested. The SEC is rightly catching up and getting more aggressive in its crackdown against allegations of greenwashing. That is the focal point for the special ESG enforcement task force set up last year.
In addition, the SEC has proposed new regulations that would set a common benchmark for how ESG products would be labeled, marketed and reported. One proposed SEC rule seeks to enforce consistency of ESG disclosures by requiring investment firms to give investors more information about how they are carrying out any ESG strategy. Another measure aims at restrictions on when asset managers can accurately add ESG and other green terms to their fund names. For example, to merit an ESG-label, funds would need to invest at least 80 percent of their assets in ways that are consistent with that strategy.
These proposals come on top of the SEC’s earlier unprecedented proposal targeting corporate issuers to require climate disclosures. These rules would bring the SEC closer in line with its other regulator peers around the world but present significant challenges, especially the climate risk disclosure ruling. Under the proposal, publicly traded companies would be required to disclose greenhouse gas emissions – in some cases, those from even suppliers and customers, which are known as Scope 3 emissions. They would also need to report any climate costs that are more than 1% or more of each line item in their financial statements. Given the pushback it has received from industry groups, companies and even investors – on top of the political climate – the final version of the SEC rules is expected to be much less aggressive than what was proposed.
Whatever the final SEC rulings look like, the reality is, more than anywhere else in the world, in the US, ESG investing has turned into a hot political issue that is likely to get worse into 2024. An anti-ESG backlash led by conservative Republican politicians that started brewing early last year has picked up steam and is now being promoted as part of a larger so-called anti-woke war. Large financial firms such as BlackRock and State Street among others are being accused of trying to force companies to follow a liberal agenda. A number of Republican states have already cut off official business ties with financial companies over ESG policies, and Republicans in the Congress are promising hearings and probes of the largest financial groups over their climate policies. Just a few days ago, the Senate voted to overturn a new Biden administration regulation that would allow retirement plan managers to consider climate and other ESG factors when making investment decisions. The political pressure campaign may be having an impact beyond that, however: Asset managers are increasingly taking note, as Vanguard’s departure from the Net Zero Asset Managers initiative shows. A number cautioned in their annual filings that the backlash against ESG is now a material risk that could hurt financial performance.
We are now at a place where regulatory scrutiny is hitting all parts of the ESG investing value chain, from issuers to data and ratings providers to asset managers to asset owners such as pension funds and insurance companies. From Europe to Asia, regulators are setting stricter rules for transparency and the robustness of sustainability claims. There is increasing pressure even on central banks to better protect the financial system from climate shocks, raising questions on whether banks should incorporate climate-related financial risks in stress tests and set greater bank capital requirements for the most polluting asset. It is not difficult to imagine that may in fact be necessary at some point in the future as climate events take on greater urgency. What is certain is that there is more politically charged debate ahead.
Some question whether all this intense controversy around ESG and the backlash may be a sign of the end of ESG and predict it may fall out of use altogether. Quite the contrary: After a dizzying pace of growth, ESG investing is maturing and so is its regulation.
1 Berg, F., Kölbel, J. F., & Rigobon, R. (2022). Aggregate confusion: The divergence of ESG ratings. Review of Finance, 26(6), 1315-1344. https://doi.org/10.1093/rof/rfac033
2 Gibson B.R., Glossner, S., Krueger, P., Matos, P., & Steffen, T. (2022). Do responsible investors invest responsibly? Review of Finance, 26(6), 1389-1432. https://doi.org/10.1093/rof/rfac064
ESG Investing and the Reckoning to Come