The Unsustainable Sustainable Investing Boom
LONDON – Whether in airports, hotels, or glossy magazines, advertisements for sustainability-themed financial products are everywhere these days, bombarding investors with some variant of the message, “Make money while doing good.” And who could object to that?
But a movement that aims to pioneer a more high-minded, socially beneficial form of financial capitalism is starting to exhibit some familiar flaws: rapid growth driven by slick marketing, lack of standards and regulation, and confusing products that investors often misunderstand.
Sustainable investing is growing at breakneck speed. According to the Global Sustainable Investment Alliance, over $30.7 trillion of assets globally in 2018 were invested using environmental, social, or governance (ESG) criteria, a 34% increase from 2016. In Europe, sustainable investing accounts for around half of all managed assets; in the United States, the proportion is now over 25%. The world’s largest asset managers are falling over themselves to appeal to millennial investors, who increasingly want their money to be invested in accordance with a social or green theme.
ESG funds are often trying to help remedy very real problems, such as climate change, exploitation of child labor, and threats to privacy resulting from the misuse of technology. Mobilizing trillions of dollars to help mitigate these challenges holds great promise.
But the recent surge in growth in ESG investing has highlighted some long-unresolved issues that had been less visible when it was still a niche sector. Two broad challenges stand out.
One is the difficulty of defining and achieving good ESG outcomes. Because what constitutes good ESG performance is intrinsically subjective, the promise of always “doing good” with such investments is likely to be overplayed. Is it better to invest in a company that creates lots of good jobs in a poor region but inflicts some environmental damage, or in one that keeps its local environment pristine but is automating many jobs out of existence?
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The ESG methodologies used by asset managers vary hugely. Some are thoughtful and sophisticated, while others are more about posturing or “virtue signaling.” All embed a set of particular value judgments, the subjectivity of which is rarely flagged to investors.
Moreover, the data that ESG-focused asset managers use in making their investment decisions is often flawed. Many fund managers rely on specialist data providers for off-the-shelf assessments of thousands of companies’ ESG performance. These assessments are often produced quickly, mainly from public-source information such as news stories and firms’ own sustainability reports. But the information such sources provide is often highly imperfect, and sometimes downright misleading. Some firms may manage to hide shortcomings from public view, while others may receive poor ESG ratings on the basis of unfair criticism.
Unsurprisingly, ESG investors have notably failed to identify or remedy some major corporate scandals. Some of them favorably assessed Volkswagen’s ESG performance before the carmaker’s emissions scandal broke in 2015. And in the run-up to the global financial crisis of 2007-2008, ESG investors were more focused on banks’ human-rights records and their other broader impacts than on the internal ethical breaches and conflicts of interest that ultimately brought many of them to their knees.
Finally, some “ethical” investor-backed campaigns may have perverse consequences. For example, blacklisting suppliers in poor countries for using child labor has in some cases led to children being shifted into worse jobs in more opaque sectors. Child labor is undoubtedly a global scourge, but unless the underlying problem of pervasive household poverty is also tackled, it often simply tends to move elsewhere.
The second broad challenge is the slipperiness of the link between ESG investing and financial performance.
The sustainable investment movement has been right to challenge many investors’ instinctive assumption that doing good will inevitably weaken their returns. Good ESG performance can reinforce trust between a company and governments, customers, and employees. Likewise, disastrous ESG events can cause a firm’s share price to plunge – as happened to Volkswagen in 2015, to BP following the catastrophic spill from its Deepwater Horizon oil rig in 2010, and to Brazilian mining company Vale after the deadly collapse of one of its waste facilities in January. Recent studies indicate that ESG-themed funds have generally (though not always) performed at least as well as unconstrained investment vehicles.
But some ESG-focused fund managers – seeking to attract investment and secure the management fees that result – now risk overstating their case. Even with decent ESG data, it would require a rare degree of technical insight and predictive brilliance to pinpoint consistently where value may be created and destroyed due to ESG issues. Who foresaw either the Deepwater Horizon disaster, for example, or the fierceness of the US political response to BP?
At best, good corporate ESG performance may be a useful proxy for sound management of other aspects of a firm’s business, even though many thriving, well-run companies will be excluded from an ESG investor’s portfolio. For example, shares in tobacco firms have been a superb investment for much of the past 30 years, far outperforming those of other sectors, even as these companies helped to destroy the health of millions of consumers.
The many thoughtful ESG analysts and investors understand these challenges and are seeking to remedy them. Various industry efforts are underway to standardize ESG methodologies and data, and to introduce new ESG-related professional qualifications.
But as financial institutions rush to profit from the ESG trend, there is a clear danger that they will oversell the ethical and commercial benefits of such investments. And as investors see gaps between what is being promised and delivered, they may start to become disillusioned. It would be a shame if a movement with genuine potential to change the world were stopped in its tracks by old-fashioned misselling.