Esg Investing: Does It Create Real Impact?

Environmental, Social, and Governance (ESG) investing is a form of sustainable investing that evaluates a company's or investment's sustainability. It is a way to build a more ethical portfolio by considering environmental, social, and governance factors to judge an investment's financial returns and its overall impact. However, despite its good intentions, there is a debate about whether ESG investing actually makes a difference. While some argue that it offers higher returns and helps fight climate change and social injustice, others claim that it might not be effective in improving companies' ESG performance and may even direct capital into poor business performers. With the growing popularity of ESG investing, it is essential to examine its potential impact and ensure that it aligns with investors' values and goals.

ESG investing may direct capital into poor-performing businesses

ESG investing may direct capital into poorly performing businesses. As of December 2021, assets under management at global exchange-traded "sustainable" funds with public environmental, social, and governance (ESG) investment objectives amounted to over $2.7 trillion, with 81% in European-based funds and 13% in US-based funds. In the fourth quarter of 2021 alone, $143 billion in new capital flowed into these ESG funds. However, despite the surge in popularity, ESG investing may not be making a significant difference in companies' actual ESG performance.

ESG investing is based on "single materiality", focusing on the impact of the changing world on a company's profit and loss rather than the other way around. This means that ESG ratings reward companies that are likely to profit from the climate crisis, not those doing the most to fight it. As a result, ESG funds may be directing capital towards businesses that are not effectively addressing environmental and social sustainability.

Furthermore, ESG funds often carry higher management fees, and there is a misconception that investors need to be willing to give up returns to invest responsibly. Higher interest rates can also make investments in alternative energy less attractive, impacting the finances of companies in the sector.

However, it is important to note that some studies have found that ESG investments can outperform conventional ones. For example, JUST Capital's index of the top 50% of companies in the Russell 1000 based on factors like fair wages and environmental protection returned 15.94% annually compared to the Russell 1000's 14.76%. Additionally, ESG funds have been found to consistently show lower downside risks than traditional funds, especially during turbulent markets.

ESG ratings reward companies likely to profit from the climate crisis

Despite the surge in popularity of ESG (environmental, social, and governance) investing, it may not be making a positive impact on the planet. As of December 2021, assets under management at global exchange-traded "sustainable" funds with ESG investment objectives were valued at over $2.7 trillion. However, it is suggested that ESG ratings, which underpin fund selection, reward companies likely to profit from the climate crisis, not those doing the most to combat it.

The ratings are based on "single materiality", which considers the impact of global changes on a company's profit and loss, rather than the other way around. This misunderstanding has been allowed to persist by asset management firms, as ESG funds are highly lucrative and carry higher management fees.

The issue with ESG investing is that it may give the impression that market forces alone can solve significant societal issues, such as climate change. However, only government intervention can effectively address the climate crisis. For instance, the European Green Deal, a package of initiatives to reduce greenhouse gas emissions and direct investment towards sustainability, was adopted in 2021. This is an example of concrete government action to address climate concerns.

Furthermore, investments in alternative energy have become less attractive due to rising interest rates, which affect the finances of these companies. As a result, alternative energy stocks have underperformed relative to traditional energy stocks in recent years, despite favourable trends in policy, adoption, and pricing. This highlights that ESG investing, as it stands, may not be sufficient to drive the necessary changes to combat the climate crisis.

ESG funds have higher management fees

The market for ESG funds is relatively young, with a constant stream of new mutual funds and ETFs being launched. According to research by Fitz Partners, ESG funds remain cheaper than non-ESG products. However, funds that include "ESG" in their names often charge higher fees than their peers. The average asset-weighted expense ratio for US equity funds marketed as ESG funds was 34 basis points at the end of August 2022, compared to an asset-weighted average of 12 basis points for all US equity funds. The higher fees for ESG-labelled funds are partly due to them being more likely to be actively managed than non-ESG products, which include many large index funds.

In 2023, fees from ESG funds jumped by almost 400%, providing a much-needed boost to asset managers after a challenging 2022. The number of ESG-labelled fund products in Europe grew by 89% in 2023, while the gap between ESG and non-ESG management fee averages has narrowed to 2 basis points. On average, ESG-labelled equity fund management fees stand at 0.78%, compared to 0.80% for non-ESG funds. For bond funds, clean management fees for ESG funds average 0.50%, while non-ESG costs are slightly higher at 0.53%.

The higher fees charged by ESG-labelled funds do not always translate to bigger returns, better ESG scores, or higher sales. In fact, in an environment where energy holdings have been driving positive returns, sustainable funds, particularly those excluding oil and gas, have underperformed their peers. However, it is worth noting that ESG considerations have benefited portfolios. For example, in sample portfolios with 80% equity funds and 20% fixed-income funds, replacing all non-ESG products with the highest-rated ESG ones resulted in 3.8 percentage points higher returns over 12 months.

ESG investing may not be suitable for certain values

ESG investing is a way to build a more ethical portfolio, but it may not be suitable for certain values. While ESG investing considers environmental, social, and governance factors, it does not necessarily align with all investors' values.

For example, ESG ratings reward companies that are likely to profit from climate change, rather than those doing the most to combat it. This means that ESG investing may not be suitable for investors who prioritize climate action above all else. Additionally, ESG investing may not effectively address major societal challenges, as it relies on market forces rather than government intervention.

Furthermore, ESG investing may not always lead to positive planetary impact. The trillions of dollars invested in ESG assets are dedicated to assuring returns for shareholders, rather than delivering positive environmental and social outcomes. This misalignment between investor values and the reality of ESG investing can be problematic.

Another concern is that ESG investing may direct capital into poor-performing businesses. Close analysis suggests that ESG investing is not significantly improving companies' actual ESG performance and may even be channeling investment away from more sustainable businesses.

Finally, interest rates can impact the performance of ESG stocks. For instance, higher interest rates can affect the finances of alternative energy companies, making them less attractive to investors.

In summary, while ESG investing aims to align investment choices with personal values, it may not be suitable for investors with specific values, particularly those focused on climate action and societal impact.

ESG investing may not be suitable for certain sectors

Secondly, ESG investing is not designed to save the planet. Despite the historic surge in popularity, ESG investing will not tackle urgent environmental and social challenges. For example, it is estimated that to fight climate change, $3.5 trillion will need to be invested annually over the next 30 years. However, the trillions currently invested in ESG assets are dedicated to assuring returns for shareholders, not delivering positive planetary impact.

Thirdly, ESG investing is not making a difference to companies' actual ESG performance and may even be directing capital into poor business performers. As of December 2021, assets under management at global exchange-traded "sustainable" funds with ESG investment objectives amounted to over $2.7 trillion. However, this has not translated into significant improvements in ESG performance.

Finally, ESG investing may not be suitable for sectors that are not aligned with the values and principles of ESG. For example, the tobacco and alcohol industries may not be suitable for ESG investing due to their negative impact on health and well-being.

While ESG investing has gained traction as a way to build a more ethical portfolio, it may not be suitable or effective for certain sectors.

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