Environmental, social and governance (ESG) aligned funds were, until recently, a one-way bet for the investment industry. The future looks less assured.
ESG has turned into a highly sensitised issue, LSEG Global Head of Research Robert Jenkins noted in a recent article. “The term ESG has become near toxic and arguably weaponized in the U.S.”
US Republicans have launched assaults on financial firms for being hostile to fossil fuels and “too woke,” with legislators in multiple states introducing bills to restrict use of ESG factors in investment decisions for state retirement systems (and, in New Hampshire’s case, seek to make state investment in funds that consider ESG factors a felony offence). And while E&S issues attracted a growing number of shareholder proposals, support for these measures slumped in 2023, especially for environmental proposals, which fell from 42% in 2021 to 22% in 2023. Just two received majority support, compared to nine in each of 2021 and 2022.
Whether ESG, which lumps together often disparate considerations and values, even makes sense as a label is a topic of growing debate – spurring Morgan Stanley banker-turned- London Business School finance professor Alex Edmans to propose the term “rational sustainability” instead.
ESG performance falls to earth
Relative underperformance is also weighing on investor sentiment. A buoyant energy sector, fuelled by the war in Ukraine, has hurt ESG funds, with only 35% of sustainable funds outperforming the Russell 1000 Index in 2022, against nearly 60% of their conventional peers.
Performance improved in 2023. But while Morningstar research showed the median sustainable large-blend equity fund gained 20.8% in 2023, that’s below the 23.9% achieved by the overall category (encompassing both sustainable and conventional funds).
Morningstar reported that investors pulled $5 billion from US sustainable funds in Q4, the “fifth consecutive quarter where investor appetite for U.S. sustainable funds was weaker than for their conventional counterparts.” Morningstar Direct data showed just six funds citing ESG factors launched in the second half of 2023, compared with 55 in the first half, and an annual average of almost 100 between 2020 and 2022. Climate-focused funds attracted $37.8 billion of new investor money in 2023, a 75% drop on the record $151 billion inflow in 2021.
Sustainable interest beyond the negative headlines
Yet despite the negative headlines around ESG, interest remains robust.
Hedge fund managers are reported to be increasingly incorporating environmental and social metrics into investment strategies to generate insights, according to research by analysts at UBS Group. And with interest rate cuts on the table for 2024, a recovery in green assets is expected to follow, which should in turn “increase confidence for business investment in areas tied to sustainability.”
In the wealth space, Capgemini reported that over half (56%) of high-net worth individuals in North America, 49% in Latin America, 47% in Asia Pacific (excluding Japan) and 31% in Europe consider ESG impact an important objective for managing their wealth. And more than two-thirds of wealth managers are launching ESG-related products and offerings.
The greenwashing clean up
Trust will be critical to the next phase of growth.
In part that will depend on clamping down on greenwashing. The European Union has introduced a ban outlawing generic environmental claims and other misleading product information. Only sustainability labels based on official certification schemes or established by public authorities will be allowed.
In the US, the Securities and Exchange Commission’s updated Names Rule, adopted in September 2023, aims to ensure at least 80% of investment funds’ assets match the name of the fund and that they use clear terminology.
Important as these steps are, the bigger problem is that ESG still suffers from a lack of common definitions, clear standards, and appropriate data to measure performance and assess compliance.
Initiatives are underway to instil more standardisation and rigour. The International Sustainability Standards Board (ISSB), a standard-setting body established under the IFRS Foundation, issued its inaugural IFRS Sustainability Disclosure Standards in June 2023. Based on recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), IFRS S1 requires companies to communicate the sustainability-risks and opportunities they face in the short, medium and long term to inform investors’ decision-making. IFRS S2 sets out specific climate-related disclosures and is designed to be used with IFRS S1.
According to MSCI, Hong Kong was expected to introduce the world’s first ISSB-specific rules in January 2024, but postponed to January 2025. The UK is set to launch its ISSB-aligned disclosure standards for registered companies by the summer of 2024. Companies in the EU will be required to report in line with the ISSB-interoperable European Sustainability
Reporting Standards, introduced as part of the Corporate Sustainability Reporting Directive (CSRD), with the first reports due in 2025. The US and China though have yet to announce formal plans to introduce ISSB-aligned reporting frameworks.
Better ESG data remains the priority
Along with the need for global take-up, the value of more transparent disclosures ultimately rests on the quality and relevance of the underlying data being reported on. Yet the available data is often criticised for being insufficient, inaccurate, outdated, subjective, hard to verify and/or inconsistent – making robust comparisons between companies, and the funds that invest in them, difficult to nigh-on impossible.
Trustworthy ratings that measure companies’ ESG risk exposures and performance will be instrumental in facilitating investment decisions. Today though there are more than 50 ESG data and ratings providers. And as a 2023 Irish Funds Industry Association article noted, diverse definitions of sustainable and divergent measurement practices complicate investment reporting.
The article pointed to a study of six ESG rating agencies that found the agencies applied 709 different metrics across 64 categories. Only 10 of those categories were used in common across the agencies, and many did not include the basics such as greenhouse-gas emissions.
“The subjectivity and thus inconsistency across ESG rating agencies has resulted in misleading products which have been deemed harmful to consumer transparency and raises the apprehensions of the regulator,” the article said.
In June 2023, the European Commission released a proposal for a regulation of ESG rating activities designed to “enhance the integrity, transparency, responsibility, good governance, and independence of ESG rating activities” and smooth functioning of the internal market.
Going forward, such efforts to instil clear, standardised definitions and harmonised measurement practices will be crucial to data integrity and industry trust. As the Irish Funds article concluded: “If ESG is to be successful for consumers, the environment, society, and the markets, everyone must be on board. ESG must continue to progress, learning from the lessons of the past.”
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