The ESG Backlash and the Trial of Public Opinion (That Did Not Happen)

The use of environmental, social and governance factors (or “ESG”) in investment decision-making has been in the news a lot lately, for all the wrong reasons. It is facing a crescendo of criticism and multi-layered backlash, which only seems to be gaining momentum. This is why, while attending the Global Impact Investing Network Investor Forum in the Hague last month, I was looking forward to attending a panel discussion provocatively entitled, “The Trial of Public Opinion for ESG and the Implication for Impact Investing.” With such a title, I was expecting a lively debate on the criticisms and merits of ESG that might draw a clearer distinction between it and impact investing. Would the court of public opinion find ESG guilty of misleading investors and failing to deliver impact?

Unfortunately, while the panelists did make some interesting observations, the discussion generally steered clear of any provocative, meaningful debate. There are always limits to what a moderated panel discussion can achieve in one hour, but I could not help feeling disappointed. Despite all the hype and investment capital that ESG funds have attracted in recent years, it has always been my opinion that once investors realized how little ESG has to do with impact, it would face a backlash. With that backlash now in full swing, a public debate, especially at a major impact investing conference, was badly needed. So, what are the critics saying, how significant is the current backlash, and what did the panelists have to say about it?

What Are the Criticisms?

The criticisms lobbed at ESG investing, none of which are new, center around three main themes. First, the way in which company ESG performance is evaluated is inconsistent and confusing. Rating agencies that calculate ESG scores use subjective rating methodologies that are neither transparent nor standardized, resulting in non-comparable and often wildly divergent scores for the same companies. This might explain why, until recently, Russian oil companies were more widely held by ESG funds than Canadian ones, or why ESG-themed investment funds might include (counterintuitively) a company like Exxon, but not Tesla.

Second, there is a disconnect between how most ESG portfolios are constructed and how investors perceive them. Asset managers mainly use ESG factors as inputs for managing risk, while most investors (often due to misleading marketing) perceive them as judgements on the positive or negative impacts (or outputs) a company has on the planet and society. A recent Bloomberg article exposed this disconnect by highlighting how one rating agency, MSCI, used “water stress” to evaluate companies. Rather than rewarding companies for reducing the amount of stress they placed on local water supplies, rating upgrades were given based on whether the local community had sufficient water to supply the company. Such topsy-turvy criteria might explain why some 90 percent of the companies in the S&P 500 index can be found in funds built with MSCI’s ESG ratings. What does sustainable mean, the article asks, if it applies to almost every company in a representative sample of the U.S. economy?

The third main criticism has to do with the cost-benefit of ESG investing. Since fund managers charge more for integrating ESG factors, do these higher fees translate into better financial results? Academic research on this question is inconclusive. Some studies suggest ESG factors do generate better financial returns while other studies debunk this. Regardless, investors may be willing to pay more for ESG investment products if they feel they enable them to align their investments with their values. But is there evidence that ESG investing has a positive impact on the environment or society? Excluding poorly rated companies from an ESG themed portfolio might make investors feel better about how their money is managed, but there is little evidence to suggest it changes corporate behavior for the better. Boycotting the stock of a company is not the same thing as boycotting its products and services. While fund managers could use their proxy voting powers to push companies for positive change, such engagement is not a standard feature of most ESG funds.

How Extensive Is the Backlash?

Similar to the criticisms, the growing backlash against ESG is coming from three main directions. The first is from industry insiders, such as Tariq Fancy the former head of sustainable investing at Blackrock, and Desiree Fixler, the former chief sustainability officer of DWS asset management, both of whom publicly criticized their former employers for exaggerating the social and environmental impact claims that their ESG investments were making. Fancy in particular published a scathing three-part essay in August 2021, the “Secret Diary of a ‘Sustainable’ Investor” in which he said ESG gives investors a false impression that their money is being invested to save the planet. If we want to achieve a greener, more sustainable world he argues, it would be more effective to alter corporate behavior through regulation, such as a carbon tax.

The second source of backlash, in fact, is coming from regulators who have responded to allegations of “impact washing” by levying fines against some asset managers while placing others under investigation. In order to improve transparency, new regulations, such as the European Sustainable Finance Disclosure Regulation, have recently come into effect requiring standardized disclosures on the environmental and social characteristics and sustainability practices of financial products. The SEC is similarly proposing new rules that will bring greater clarity to how ESG funds are constructed and require standard disclosures on things like proxy voting and shareholder engagement.

The third source of backlash is coming from politicians in the United States. Republican-led states have passed laws and other restrictive measures punishing asset managers with ESG credentials for (in their view) “boycotting” fossil fuel companies and firearm manufactures. While this ire is somewhat ironic and misplaced given that some of the same companies being targeted remain among the largest investors in the fossil fuel industry, politicians are equating ESG investing to a form of “woke” capitalism. ESG investing has become part of the American cultural wars.

What Did the Panelists Say?

Unfortunately, the panelists mostly adhered to a somewhat scripted description of the current state of affairs rather than engaging in a lively debate with the audience. The most notable quote came from Ian Simm, Founder and Chief Executive of Impax Asset Management, who said, “the issue with ESG is it is confusing everybody, and the situation is only getting worse and more serious as regulators pile in. We run the risk of derailment.” He suggested that the reason why ESG is in such a mess today is that, conceptually, it was not designed as a fundamental guiding principle of capitalism, but rather a term coined back in 2004 by “clever consultants” who mixed together two different ideas: how to improve governance in mainstream investing, and how to shape the boundaries of investing using moral and ethical principles. Despite this muddled mixture of ideas, he said, we should not throw the ESG baby out with the bathwater. ESG factors best serve asset managers as a “metaphor” for how to do a better job of implementing their fiduciary duties. In essence, he recommends making the most of ESG without getting tripped up by it.

Tania Carnegie, partner at KPMG, quoted a few interesting statistics from their latest Global Survey of 1,300 CEOs. According to the survey, 45% of CEOs feel that ESG improves corporate financial performance and is central for long term business success. At the same time there are significant perceived downsides if ESG expectations are not met. When asked by the moderator whether regulatory pressures or consumer demand was driving executives to care about ESG performance, she said pressures were coming from “all directions,” but with these pressures come opportunities. CEOs apparently want to know how to tell their ESG story better to demonstrate how they are living up to their public pronouncements. Do they have the right approach in terms of processes, controls, feedback loops and data to satisfy stakeholder demands? All of this sounds good on the surface, suggesting that CEOs are taking ESG obligations seriously. At the same time a cynic might see this as a public relations exercise, with CEOs emphasizing the need for better “storytelling” rather than implementing changes in company business models that might achieve positive environmental or social impact.

Finally, Jeremy Keele, a partner at Sorenson Impact Group and Catalyst Opportunity Funds, gave the audience a taste of the political backlash taking place against ESG in the United States. He described as “shocking” the speed and extent to which ESG has permeated the cultural and political divide in America in the last six months. As an example, he cited a recent speech former Vice President Mike Pence gave in Mr. Keele’s home state of Utah. Speaking to an audience that was apparently not financially sophisticated, the bulk of his messaging, which was designed to rile up conservative voters, was around ESG. The rhetoric gave the impression that a liberal elite, in the form of New York asset managers that control global capital markets, is using ESG to impose their morality on the mainstream via the backdoor. When asked whether this political blowback was hurting the broader impact investing community, Mr. Keele said the best way to deal with the rhetoric was to ignore it. We should treat it like a “low grade fever that needs to burn itself out” by not giving it too much airtime. Perhaps he is correct, that the anti-ESG rhetoric is a function of the recent mid-term elections in the United States rather than part of a broader trend. At the same time, speaking about it at an impact investing conference (and me writing about it in this blog) is giving it more airtime rather than less.

So, are the shortcomings of ESG sowing doubts in the minds of investors? Have we reached a definitive turning point where investors revert to traditional investing based purely on financial returns? After years of record-breaking capital inflows, ESG funds started to see outflows for the first time this year. Such outflows may have more to do with recent market downturns, or some ESG funds underperforming their benchmarks, than with growing ESG disillusionment. However, a mean reversion of sorts has come about with the advent of Strive Asset Management, whose founder is taking an anti-ESG, anti-stakeholder capitalism approach to investing. He wants companies to disregard ESG considerations and focus exclusively on maximizing returns. In Strive’s view, mixing business with politics is bad for profits. Assets under their management will provide (through proxy voting) a counterbalance to ESG driven shareholder initiatives. Some are calling Strive’s approach “anti-woke.” Other investment managers may follow suit.

A recent special report by the Economist called ESG a “broken system” in need of urgent repair. By trying to satisfy many stakeholders, the information it provides, “often bears little relevance to what a company actually does,” and it is too imprecise to serve as shadow tax on the negative externalities a company generates. It argues in favor of reforming ESG, because carbon taxes are politically fraught, but this is precisely why Tariq Fancy argues ESG is so dangerous. It offers the illusion of a voluntary, market-based mechanism that has no influence on corporate behavior and provides policymakers an excuse not to enact tougher regulations.

It is hard to imagine putting the genie back in the bottle now that politicians have sowed doubts in the minds of conservative voters about some hidden agenda behind ESG investing. Better regulations leading to greater transparency might help correct course and lead to a new improved “ESG 2.0” that causes more capital to flow to fund managers that evaluate the environmental and social impact of companies as outputs rather than inputs. I am skeptical. The lack of any real debate at an impact investing conference, despite best intentions, suggests we will continue to hope the negative ESG rhetoric will just burn itself out while CEOs focus on better storytelling. In the meantime, we should be concerned that as ESG’s reputation is further tarnished, it will hurt impact investing by association.