Efforts to incorporate environmental, social and governance (ESG) investing principles have grown in recent years, as investors seek to deploy capital toward positive societal outcomes. Propelled by surging consumer demand for sustainable business practices, banks and money managers have adopted various ESG mandates in their investment protocols. Despite this growth, 2022 was a challenging year for ESG investing, with policymakers and investors expressing frustration about the lack of standardization in the sector.
Estimates about the size and growth rate of the ESG sector vary wildly, mostly because we can’t agree on a unified definition of what ESG actually entails. According to PricewaterhouseCoopers (PwC), ESG-focused institutional investment will make up 21.5% of assets under management by 2026 – that’s $33.9 trillion in actual dollar figures. Meanwhile, Bloomberg Intelligence says the ESG sector is on track to eclipse $53 trillion by 2025, or roughly a third of global assets under management.
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What Makes an Investment “Sustainable”?
On the surface, carving out a consistent standard for ESG investing seems straightforward. For example, an intuitive ESG strategy may exclude industries such as fossil fuels and defense and prioritize green energy and electric vehicles. However, an ESG ranking provided by nonprofit research firm JUST Capital found that America’s top 100 ESG firms were largely comprised of big tech, Wall Street banks, traditional automakers, defense contractors and even fossil fuel companies like Exxon Mobil. Strangely absent from the list was Tesla, which was arguably the first company to commercialize electric vehicles successfully.
The point isn’t to single out specific companies or strategies but to demonstrate the lack of standardization in ESG investing principles. The lack of consistency in ESG assessments was further demonstrated in a May 2022 academic paper by researchers at MIT and the University of Zurich. The paper, which appeared in Review of Finance , the official journal of the European Finance Association, found very little consistency in corporate ESG assessments among the top six rating agencies — a list that includes Moody’s ESG, S&P Global and MSCI. The broad divergence in scores and rating criteria “makes it difficult to evaluate the ESG performance of companies, funds, and portfolios, which is the primary purpose of ESG ratings,” the researchers said.
ESG mandates have evolved beyond just decarbonization and green energy. In 2020, Morgan Stanley Investment Management’s fixed income team identified five sustainability themes – decarbonization and climate action, circular economy and waste reduction, diverse and inclusive business, decent work and resilient jobs, and corporate governance. These broad categories make it even more difficult to properly standardize ESG investment principles and evaluate their impact.
Stronger Oversight May Be Coming
ESG funds are facing heightened scrutiny from federal regulators due to misleading claims about their practices. The U.S. Securities and Exchange Commission (SEC) has identified greenwashing – the practice of using marketing tactics to exaggerate ESG efforts – as a prevalent issue in the sector.
On May 25, 2022, the SEC proposed new rules to bolster disclosure requirements for ESG funds. SEC Commissioner Hester Peirce came out against a specific rule for greenwashing and instead argued that the regulator already has laws that prevent advisers from misleading investors. Nevertheless, regulators were on the same page with respect to ESG disclosure issues, and even slapped multi-million-dollar fines on Goldman Sachs and BNY Mellon for failing to meet SEC guidelines on specific ESG offerings.
In the European Union, new rules for ESG investing were finalized in August, offering asset managers more clarity on how to classify sustainable fund offerings. Meanwhile, the United Kingdom is also moving forward with new ESG guidelines in 2023, as part of its updated Green Finance Strategy.
While demand for ESG investing shows no signs of slowing, the number of ESG products could decrease as asset managers and financial institutions reevaluate fund labels in light of new regulatory scrutiny. In practice, this means the days of ESG as a catch-all could be coming to an end.
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The Bottom Line
ESG investing became highly politicized in 2022, with lawmakers accusing fund managers of neglecting their fiduciary duties to pursue a broader political agenda. Despite political headwinds, new frameworks for ESG investing are coming. Investors should be prepared to ask tough questions on how ESG mandates can be properly evaluated.
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