Everything you need to know about ESG investing and the response to it

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In a sense, defining “ESG” is simple: it is an investment and financing approach aimed at understanding risks from environmental factors, social and corporate governance issues. Figuring out the differences between ESG and similar, sometimes overlapping approaches is more difficult, in part because ESG has come to mean different things to different people. That vagueness has contributed to its rapid growth in recent years — growth that also comes from increased oversight by regulators cracking down on banks and investment firms that make exaggerated claims. Meanwhile, ESG in the US is facing backlash, both from prominent Republicans deriding it as “awake capitalism” and criticized by some early leaders of the field who say it doesn’t create the kind of real-world effects it seemed to promise. Here’s a guide to the basics.

1. What’s the big idea?

The broadest umbrella term for the strategy that ESG is part of is sustainable investing. Proponents say the goals of sustainable investing are to achieve social impact, align with personal values ​​or manage risk. And earn money along the way, of course.

2. Where does ESG come from?

The concept was developed at the beginning of this century by United Nations officials who collaborated with the financial sector. They argued that using ESG factors in financial analysis was compatible with investors’ fiduciary responsibilities — that using ESG data would help protect investments from material financial risks from things like climate change, labor disputes, human rights issues in supply chains, and poor corporate governance. governance and the resulting lawsuits.

As time went on, the label was slapped on investments ranging from predictable things like owning renewable energy stocks to things you wouldn’t expect, like funds tracking benchmark indices that include oil companies or assets in autocratic countries like Russia. , or coal, steel and beverage companies in China, where ESG funds are growing rapidly.

Estimates vary depending on what people count as ESG. According to Bloomberg Intelligence, global assets will rise to $50 trillion by 2025, from about $35 trillion today. That’s over $30.7 trillion in 2018 and $22.8 trillion in 2016, according to the Global Sustainable Investment Association.

In the US, Republican state officials have become sharp critics of Wall Street’s ESG policies. They mock it as “awake” and change a term progressives coined to convey awareness of the role of racism in society into an insult akin to “politically correct.” Florida Governor Ron DeSantis, a potential presidential candidate in 2024, banned state pension funds from screening for ESG risks. Texas is trying to isolate financial companies it says are hostile to the fossil fuel industry. A group of attorneys general from mostly GOP-led states sent a letter to BlackRock Inc. stating that the world’s largest asset manager is pursuing an ESG investment policy to the detriment of their state pension funds. Missouri recently launched an investigation into Morningstar Inc. and its subsidiary Sustainalytics Inc. following the company’s review of ESG issues. And conservative activists have stepped up their efforts to submit proxy ballots with proposals to curb ESG policies — a page from the playbook of their liberal counterparts.

6. What criticism comes from ESG supporters?

Some think that the term has become so broad that it has lost much of its meaning. Many point to the prevalence of greenwashing, which happens when companies exaggerate the environmental benefits of their actions. Even the man who coined the acronym has said the financial industry has sprinkled “ESG fairy dust” on products that don’t deserve the label. Other criticism focuses on how fund managers rely on ESG ratings that rank companies based on how they perform on ESG factors. There is a lot of inconsistency in those scores – in some cases companies are ranked based on the risks ESG factors pose to them rather than, say, the risks they pose to the environment and society. (Looking at both sides of the equation, an approach known as dual materiality has been adopted by the European Union, but not elsewhere.) Some sustainable investing proponents say it’s time to ditch the “ESG” label altogether. throw it overboard because it has lost its meaning . One academic has said the industry should simply refer to a more colloquial term, “material risk factors.”

7. What do regulators do?

With the ESG label being widely used by money managers and bankers selling everything from mutual funds to complex derivatives, European and US regulators are focusing on companies that they believe are exaggerating their ESG bona fides.

• In May, German authorities raided the offices of the fund unit of Deutsche Bank AG over allegations that it overestimated the role of ESG analysis in investment decisions.

• The following month it emerged that US regulators were investigating whether ESG funds sold by the Goldman Sachs Group Inc. asset management group. conflict with any claims set forth in marketing materials.

• The US Securities and Exchange Commission proposed a series of new restrictions in May to ensure that ESG funds accurately describe their investments, and may require some money managers to disclose the greenhouse gas emissions of companies in which they invest.

• These proposed rules stem from new laws in Europe, the Sustainable Finance Disclosure Regulations, where investments must be labeled in categories commonly referred to as ‘light green’ and ‘dark green’, according to the priority given to sustainability.

• New European Union rules came into effect in August requiring investment managers to understand and act on the ‘sustainability preferences’ of retail clients.

8. Where does ESG fit in the sustainability spectrum?

The popularity of ESG depends in part on the belief that it will play a positive role in making the world a better place. But critics say such a warm and fuzzy feeling helps asset managers blur an important distinction: that ESG is primarily about using data to identify risks that could undermine investment performance, or to find opportunities to make money. . That in contrast to some other branches of sustainable investing that sometimes go further:

• Ethical and Values-Based Investing: These are broad strategies that allow investors to avoid or invest in companies, depending on whether they reflect their political, religious or philosophical beliefs and values. The earliest practitioners were religious groups such as Quakers who shun investment in things like alcohol, guns and gambling. Church-affiliated groups in Sweden started the first ethics-based mutual fund in 1965. The Pax World Fund was founded in the US in 1971 by two pastors who did not want their churches’ investments to support the arms industry.

• Socially responsible investing: Boosted by protests against the Vietnam War, including consumer boycotts of companies that made napalm, and by efforts to end apartheid in South Africa, a group of investors tried in the 1980s and 1990s do good by not only avoiding companies that harm society, but investing in those that improve their business practices. They may also target companies engaged in clean technology efforts.

• Impact investing: while socially responsible investing usually focuses on publicly traded companies, impact investing focuses on private projects. It is a niche strategy where investors focus on specific outcomes that can be measured, such as promoting sustainable agriculture or businesses that provide affordable housing.

• System-level investing: An emerging strategy that has yet to take off, but whose adherents hope to go beyond what they see as the limited impact of ESG. System-level investing involves making decisions that consider the whole of one’s portfolio and how the elements intersect in all assets over the long term. An example of this is climate change: a systems-level approach would examine how it affects entire portfolios, from stocks in energy and insurance companies to government bonds and foreign exchange. System-level investors will then work together with other investors to jointly drive companies to improve their business practices by creating industry standards, sharing data with other investors, and pushing for changes in government policy.

9. Does ESG really make a difference?

Some investors and academics complain that the impact of ESG is much smaller than its proponents suggested. Of course, sustainable investors have taken a number of steps, such as urging companies to reduce their plastic use, addressing workers’ rights and conducting so-called civil rights audits. They have also succeeded in appointing directors to the board of directors of Exxon Mobil Corp. to help the oil giant position itself towards cleaner fuels. Other proponents have said that if investors in Britain’s Deliveroo Plc had taken ESG issues into account, they could have avoided losses after the company faced a backlash last year over the exploitation of the gig economy and employee compensation. Still, opponents argue that the idea that ESG investments alone are enough to tackle complex problems is incorrect and that more government intervention is needed to address societal problems, such as minimum living wages and greenhouse gas emissions.

10. What do returns look like?

In three categories – Europe-focused, US-focused and global – ESG large-cap equity funds have outperformed their non-ESG counterparts on average this year. While they have lost money – in line with the broad sell-off in the market – those losses are smaller. Globally, ESG funds are down 11.7% this year through June 10, compared to the MSCI World Index’s 14.8% drop. But there are some early signs that investors are sour about ESG. In May, for example, they took a record $2 billion net from U.S. publicly traded funds, ending three years of inflows, according to Bloomberg Intelligence.

• Bloomberg QuickTakes on sustainable investing, ethical debt, ESG ratings, the ‘S’ in ESG, biodiversity and ESG stewardship.

• A Bloomberg story about how ESG is ubiquitous in capital markets.

• A Businessweek story on ESG ETF investing.

• The Freshfields report that started the ESG strategy

• A Bloomberg survey of the ESG rating industry.

• A History of ESG Investing by Morningstar.

More stories like this are available on bloomberg.com

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