Is ESG investing as good as it sounds? 5 problems ESG needs to overcome

In the last couple of years there’s been a big shift in the number of people wanting to align their investments with their ethics.

So-called “ESG investing” – where issues such as a company’s environmental impact or corporate governance are considered – has taken off, to the point where a PwC survey of more than 1,000 investment professionals revealed that 77% of institutional investors plan to stop buying non-ESG products by 2022.

According to Morningstar data published in FTAdviser, inflows into sustainable funds in the UK rose from nearly £4 billion in the second quarter of 2020 to more than £6 billion in the same quarter in 2021.

On the face of it, investing more sustainably seems like a good idea. However, there are a range of dissenting voices that see ESG as a “fad” or claim that it fails to consider some inherent problems with the approach.

In a moment, read about five of the potential issues ESG investing might need to overcome. Firstly, though, here’s a refresher on the factors that ESG investing considers.

Encouraging companies to hold high ethical standards

“ESG” stands for Environmental, Social, and Governance. Essentially, this is a set of ethical standards that investors can hold corporations to, with the aim of fighting negligent business practices.

ESG investments consider these criteria, on top of the financial prospects of an asset, when building a portfolio.

• Environmental – deals with conservation and pollution, aiming to ensure that the company is not harming the environment. It considers issues such as a company’s carbon footprint and energy efficiency.
• Social – covers the relationship between the business and the community in which it operates. It focuses on human rights, working conditions for employees, and customer satisfaction.
• Governance – this category aims to assess the standards by which a company is run. Factors to consider include issues such as the pay of executives, gender equality in senior management, and the fair election of board members.

While many asset managers and investment companies now offer ESG options, some critics of the approach say that it fails to consider a range of problems.

1. There’s no accepted measure of what “good” is

How can you measure the inherent “good” a company does?

As of the end of 2021, there is little to no consensus on how to measure “goodness” and no internationally approved set of standards for ESG investing.

Goodness is in the eyes of the investor, and what you think might be a grievous corporate sin may not even register on someone else’s radar of issues.

2. Greenwashing

Greenwashing is the practice of trying to make people believe that a company is doing more to become sustainable than it really is.

For example, many ESG funds include Shell as an investment they hold. The Guardian reports that Shell invests in “lower-carbon biofuels and hydrogen, electric vehicle charging, solar and wind power”.

However, in 2020 Shell earmarked between USD 2 billion and USD 3 billion a year for low-carbon businesses, compared to USD 17 billion on fossil fuels operations.

Many investors might assume that Shell was part of the problem, not the solution. So, finding it included in the ESG fund they invest in might not align with their moral stance.

It’s a problem that doesn’t seem to be going away. Indeed, the International Monetary Fund’s recent Global Financial Stability report warned that policymakers should ensure regulatory oversight is in place to prevent greenwashing.

The report found that, while 77 of the fund names used the words “green”, “climate”, “clean” or “sustainable”, only a tiny proportion (four) had a positive impact across any of the environment-related sustainable development goals.

3. “Good” companies might not be more profitable

Aswath Damodaran, professor of finance at the Stern School of Business at NYU, is a vocal critic of ESG investing. One of his arguments is that it’s hard to find a causal link between profitability and being a “good” company.

He argues that almost every study that purports to find positive correlation between profitability and ESG scores trips up on the causality question. That is: are “good” companies more profitable, or are companies that are more profitable able to take the actions that make them look good?

He concludes: “While one can make a reasonable case that companies should work at ‘not being bad,’ there is very little evidence that there is a payoff to spending more money to be ‘good’.”

4. The value in “good” companies may already be reflected in their share price

ESG investing follows the logic that sustainability translates into higher value. However, the argument that incorporating ESG into your investing is going to increase your returns can fail a simple investment test.

That is, to generate “excess” or “better” returns, you must consider whether the value of being sustainable has been priced in already. Investing in a well-managed, sustainable company does not translate into excess returns if the market is already pricing in the good management and growth.

If the market has fully priced in the ESG effect on value (either positive or negative), investing in “good” businesses or avoiding “bad” ones will have no effect on excess returns.

Indeed, if the market is over-enthused with sustainability, investing in “good” companies could actually result in lower returns if the ESG element of the share price is over-egged.

5. It’s a distraction from bigger issues

Climate change requires global, structural change – driven by governments. So, it could be argued that switching your pension fund or investments to ESG funds is just a token gesture.

Writing in the FT, Robert Armstrong says: “Giving people the dumb idea that shifting their savings from one investment fund to another is going to help materially with, say, climate change creates a dangerous distraction from solutions that fit the scale of the problem, all of which involve changing the rules of capitalism through regulation.”

Get in touch

There’s one other issue with ESG investing that you should consider. Namely, any investments you make should be appropriate for your needs, in line with your tolerance for risk, and aligned with your long-term goals.

You shouldn’t just select an investment “because it is ESG”. It may not offer the level of diversification you need, have the wrong risk profile, or simply be unsuitable for your needs.

As experienced financial planners, we can work with you to align your investments with both your goals and your ethics. To find out how, email enquiries@rosebridgeltd.com or call 01204 300010.

Please note

The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.