ESG (Environment, Social, Governance) investing has taken center stage in an increasing number of media reports. The debate has become increasingly complex and multilayered. Part political, part legal, part administrative, and part accusations of Wall Street corruption, the disputes have rapidly changed perceptions of what not too long ago was considered a great progressive step. Many media discussions have tried to shoehorn ESG disputes into the usual left-right political divide. Those efforts have only confused matters still more than the already confusing reality. Matters have now reached a point where those who have lined up against ESG investing go well beyond familiar right-leaning perspectives to include others, who care deeply about progressive issues –social justice, fair labor practices, and climate change.
This discussion has no intention of taking sides on the climate issues or the urgent need to remedy social injustice. (The author is neither that brave nor that stupid.) What it will do instead is lay out the issues surrounding ESG investing to show how this once growing area has probably passed its peak of popularity.
As with most such movements, it is hard to pinpoint the precise origins of ESG investing. Most who have followed its rise date the moment to a 2004 United Nations (UN) report entitled “Who Cares Wins.” That paper argued that over the long run, the best investments lie with corporations that pay close attention to labor conditions, social justice, and climate. The Paper offered no evidence to back up its investment assertions, but its arguments resonated nonetheless and in time Wall Street and the investing public embraced its reasoning, especially state pension funds from jurisdictions where progressive politics prevail.
From nothing at the time of the report, by 2012 ESG investing had gathered some $4 trillion in assets. In the years that followed, it increased its size by $1 trillion or more each year so that by 2021, ESG investing claimed an asset base of $18.4 trillion. Commentary at the time forecast a coming growth in assets to $34 trillion by 2026. Investment managers chased this growing popularity, creating new funds and repackaging at least 65 existing funds for ESG between 2019 and 2022. Exemplary was BlackRock’s 2021 U.S. Carbon Readiness Transition fund. It claimed to pursue “broad exposure to large and mid-capitalization U.S. companies, tilting toward those that BlackRock believes are better positioned to benefit from the transition to a low-carbon economy.” It gathered $1.25 billion in assets in a single day, a record.
By early 2022, the trend toward ESG investing seemed irresistible, but as the year progressed, things began to fall apart, and today’s great disputes emerged. Impartial analysis questioned the assertion of the original UN report, noting that eight of the top ten actively managed ESG funds underperformed the standard market benchmark, the S&P 500 Stock Index. What was especially troubling given the long-term fundamentals stressed in the UN report, these funds had their worst relative performance in 2022, when the S&P 500 suffered a drop of some 20 percent. Perhaps even more concerning than relative performance was the news on the composition of these funds. They held many of the same stocks that dominate the broad stock indices as well as the holdings of funds that made no ESG claims. Even as BlackRock touted itself as an ESG leader, and its CEO, Larry Fink, made headlines with letters to other CEOs threatening to cut off investment flows to their firms if they failed to follow ESG precepts, the analysis showed that BlackRock was the world’s largest investor in fossil fuels and other industries not usually associated with ESG.
Some tried to explain away such seeming contradictions by referencing the lack of a settled definition of ESG. That might excuse investment differences or similarities between individual funds, but the definitional ambiguity itself raised questions. Services that scored companies for ESG compliance not only have vastly different criteria, but often have less than transparent methods. A stress on decarbonization is common, but many scorers also give equal or greater weight to how many women or racial or gender minorities sit on a company’s board. Investors in ESG funds had a hard time knowing what they were buying beyond the popular designation.
A study done jointly by Columbia University in New York and the London School of Economics found that 147 American companies that were part of ESG funds had worse compliance records in labor and environmental rules than did companies in 2,428 non-ESG portfolios. In some schemes, fossil fuel companies commanded better ESG scores than companies that manufacture electric vehicles. A study by the non-profit think tank, Influence Map, concluded that $16.4 trillion of equity funds with ESG labels held nearly three times as much in fossil fuel companies as in green investments — $880 billion compared to $309 billion. It used these findings to downgrade BlackRock ESG funds from B to C, Fidelity ESG funds from D to E+, Vanguard from C to D+, and State Street from B- to C+. The investment research and advisory firm, Morningstar, responded by removing the ESG designation from over 1,200 funds managing over $1 trillion in assets.
Along with these revelations, a consideration of fees has led to accusations of fraud. Typically, ESG funds charge 40 percent higher fees than do traditional investment funds. On this basis alone, it is easy to understand Wall Street’s enthusiasm, especially since investment managers have otherwise suffered a severe compression of fees. Investors appear to have paid up for ESG efforts that either do little of what they claim to do not and show no significant difference from cheaper products. Vanguard’s ESG fund, for example, showed an almost perfect correlation (.9974) with the broad S&P 500 Stock Index. Similar comparisons among the funds of other ESG leaders make remarks by Larry Fink sound hollow when at the 2023 World Economic Forum he described those opposed to his efforts as “ugly” and trying to “demonize the issues.”
As these facts began to raise doubts about Wall Street’s version of ESG, individual critics became bolder. Tariq Fancy, who BlackRock had recruited from the non-profit sector to oversee its ESG investing, described the venture after his departure from BlackRock as a “complete fraud” and “green paint on the existing system.” William Barr, Donald Trump’s last attorney general, described ESG investment efforts as “a form of extortion,” referring to Larry Fink’s threat to cut off investing for companies that failed to live up to his ESG demands. Carson Block of the San Francisco-based research firm, Muddy Waters, stated that “ESG investing, from fund managers to the managements of the companies themselves, is almost entirely a giant grift.” Aswoth Damodaran, finance professor at NYU’s Stern School of Business, described matters in especially colorful terms. “ESG,” he wrote, “is a scam, an idea that was born in sanctimony, nurtured in hypocrisy, and sold with sophistry.”
Leading progressives have joined in the criticisms from their own, very different perspectives. Some describe ESG investing as a distraction from the real needs of the moment. Kelley Born of the progressive Hewlett Foundation and Stanford law professor Paul Brest produced a paper decrying ESG investing as a distraction from the vitally important work of advancing social justice and efforts to mitigate climate change. Others have argued that the trillions in ESG investing does little practical good beyond giving people the illusion that the practice is generating the trillions otherwise needed to support climate initiatives and other progressive causes. Progressives have also criticized Wall Street efforts as more concerned with how firms are protecting themselves from social and environmental damage when what is important is remedying the social and environmental damage.
Investment firms and corporations might argue that they never promised to remedy social and environmental problems, that they have only aimed to direct investment dollars to those who were trying to remedy these problems. They have a point, but in the grand scheme of things, such a defense would make little difference. In the final analysis, debating points mean less than how these concerns have created yet another adversary to the ESG investing trend. And while all these criticisms have percolated, ESG investing has found new legal enemies.
The most general opposition from this quarter points out that according to law an investment manager has a fiduciary obligation to protect the assets of the fund’s beneficiaries. Perhaps climate risks fall under such responsibilities but not all the other things that go into ESG scores and ESG investing. Those who redirect investing according to all the admittedly vague criteria of ESG scoring could then open themselves up to lawsuits and even prosecution. With such considerations in mind, 19 state attorneys general have threatened Larry Fink and other investment advisor CEOs who tout ESG investing. Some states, most notably Florida, have taken state pension funds away from investment funds advocating ESG investing. States that depend heavily on the fossil fuel industry, such as Texas, have threatened to remove such funds from ESG investing because the practice is damaging the livelihood of the beneficiaries.
These attorneys general have yet to take action. In no small part that is because the definition of ESG is so vague that they have no basis to show how the practice has done investors harm, even as some of the funds have underperformed. This legal problem carries a certain irony in that the vagueness of criteria that is protecting funds from legal action has at the same time facilitated what many describe as fraud. In time, recent efforts by the Securities and Exchange Commission (SEC) may clarify. It and the European Union’s equivalent have sought measurement criteria on what they describe as non-financial factors, including carbon emissions. The SEC has come under criticism from those who say such efforts implicitly encourage ESG investing. This is a red herring. All the SEC and its European friends are trying to do is make criteria definite so that prosecutions can proceed if necessary but mostly so that an investing public that wants ESG investing can avoid fraud and know what it is buying.
Against such an array of actual and potential attacks, it seems all but assured that money flow into ESG investing will slow and that the area might well lose assets. Already, BlackRock and Vanguard have moderated their once strident rhetoric. Indeed, the former has made clear that it has no intention of abandoning its investments in fossil fuel companies and the latter has left the Net Zero Asset Managers initiative. Preliminary figures on assets under management suggest that the area saw a 20 percent drop in 2022, some due to market action but outflows of funds were tracked in the first and third quarters, the most recent for which data are available. It looks as though Wall Street will have to find a new way to bolster its fees.