The Truth About ESG Investing

ESG (environmental, social, and governance) assets under management are expected to grow from $18.4tn in 2021 to $33.9tn in 2026, representing approximately ⅕ of global AUM. These “sustainable” funds are touted to investors as opportunities to align investments with sustainability goals. However, the lofty statements made regarding ESG investing ignore their inability to address the environmental and social issues of today.

Profit vs. Planet

There is a misconception regarding the object of socially responsible investing. Rhetoric and marketing material may misguide many that such sustainable investing aims to deliver positive planetary and social impact. However, the intention is to compile a portfolio that will succeed in a decarbonized society and assure shareholder profits. The ESG ratings, which underlie fund selection, measure the effects of a changing world on company P&L, not vice versa. The distinction between private profit and the planet is by design and societal change and changes in incentives are required to align these interests.

Poor Environmental Results

This current relationship between profit and social welfare is one of a few characteristics and variables that are responsible for ESG investing’s inability to effectively address environmental issues. Samuel M. Hartzmark and Kelly Shue, professors at Boston College and Yale University respectively, argue in their research (which was featured in a Freakonomics Radio episode recently with host Stephen J. Dubner, co-author of the popular Freakonomics book series) that the sustainability investing movement does not meaningfully reduce environmental stress. This is due to the popular strategy to divest from “brown” firms and invest in “green” firms; however, “Increasing financing costs for brown firms lead to large negative changes in firm impact.” The research suggests we should offer the carrot rather than the stick to large polluters, for whom a 0.1% change in emissions is greater than a 100% change for “green” firms in absolute terms. 

Companies in sustainable portfolios and funds have also been shown to have worse compliance with environmental and labor laws according to researchers at the London School of Economics and Columbia University. As Stanford professor emeritus Paul Brest and the Hewitt Foundation’s Kelly Born affirm, “…it is virtually impossible for a socially motivated investor to increase the beneficial outputs of a publicly traded corporation by purchasing its stock.”

Plain Financial Performance

Unfortunately, these ESG portfolios also fail to provide improved financial returns. Numerous academics have conducted studies to demonstrate the relationship between high ESG companies and returns and ⅔ of them discovered at least a non-negative relationship between the two variables. Unfortunately, there has not been a conclusive study that indicated such companies offer higher returns, and the aforementioned research conducted by academics at LSE and Columbia questions the link between ESG and outperformance. This sentiment is echoed by a Journal of Finance paper, detailing the work of UChicago researchers, which found that funds rated highly on sustainability by Morningstar did not outperform those that were ranked worse. Furthermore, such funds tend to have higher fees and costs associated with them, and according to Morningstar investors paid nearly a 40% “greenium” for such funds as opposed to their conventional counterparts in 2021.

Proliferating Confusion

Another factor that is confusing regarding sustainable investing is the lack of standardization. ESG ratings, on which trillion-dollar funds have been built and selected, are comparative rankings to industry peers rather than concrete, universal standards. Hypothetically, this may allow a fossil fuel company to possess a better rating than that of a manufacturer or transport company. Nearly 70% of North American investors in a Capital Group study in 2022 agreed that standardization of such data is required and 46% thought the lack of robust data on ESG was a major adoption hurdle. Without this step of action, ESG investing continues to mislead investors and this significant source of concern will be unresolved.

Steps Forward

While ESG investing may possess significant flaws, there is a subcategory of the practice that Kelly Shue, Professor of Finance at Yale School of Management, mentions in the Freakonomics Radio episode, impact investing, that shows more promise. Regardless, we must not be disillusioned by the assets invested in ESG funds to believe that market voluntary action can replace public reform and regulation. The fight towards an environmentally and socially equitable is an uphill one that the mainstream sustainable investment movement cannot lead.