In 2019, McKinsey stated that 90 percent of America’s 500 largest companies now produce an ESG report—reams of paper to prove that businesses are saving society and the planet.
Consultants and analysts also spend a lot of time arguing that ESG was a more profitable way to invest. In a series of articles, McKinsey argued that companies with racially diverse leadership teams performed better financially.
“You can’t try to sell someone a concept to save the planet if you don’t have positive performance,” says Pierre-Yves Gauthier, founder of AlphaValue.
Yet there was a problem: performance didn’t always live up to promises.
For years, UK ethical funds have produced returns that have been below the simple FTSE 100 tracker fund. By 2022, the gap will widen to 10 percentage points, according to LSEG Lipper.
This meant that £1,000 invested in an ESG fund would earn £103.50 less than a tracking fund.
The underperformance reflects the way ESG fund managers invest: ethical funds are diverse but generally avoid “sin stocks” such as fossil fuels, defense and tobacco.
This means these funds have no exposure to oil and gas companies such as BP and Shell and arms manufacturers such as BAE Systems.
These companies are among the largest in the world and pay large dividends, which means owning them can add value to a portfolio.
The impact of ignoring these sectors was somewhat limited until 2022, when the war in Ukraine broke out. A surge in the price of oil drove up shares in companies such as BP and Shell, while the war boosted defense stocks.
The war has also raised questions about whether defense companies are now ethical – were companies helping to arm Ukraine and fight Russian aggression really bad for society?
“Investors still remember 2022, which was a bad year,” says Hortense Bioy, head of research at Morningstar. “There is more skepticism about what ESG funds offer, both in terms of ESG credentials and performance.”
Scholars have also begun to question the validity of claims that ESG helps financial performance.
A recent article in the academic journal Econ Journal Watch stated that, for example, the results of McKinsey’s claim about different management teams cannot be replicated. The authors said that this claim could not be “relied on”.
Alex Edmans, a former Morgan Stanley investment banker and now professor of finance at the London Business School, says there is “mixed” evidence that ESG improves financial performance.
“ESG is not ‘wake up, go broke,’ but the nonsense idea that ESG will make you a lot of money is not true,” he said.
Concerns about ticking
Investors are also weary of a series of ESG-related scandals. A constant barrage of news articles has exposed the fact that many ESG funds are not as ethical as they claim.
US regulators last year fined DWS fund manager Deutsche Bank $19 million for “greenwashing” after it made “materially misleading” statements about how much it cared about ESG.
In another egregious example, following press reports of poor working conditions in factories on which Boohoo relied, it emerged that many ESG funds had backed the fast fashion retailer. An independent report subsequently found “endemic” problems.
Cases like this have given rise to the feeling that ESG is little more than ticking boxes and rubber stamps.
Part of the problem has been that ESG has always been a hairy concept. It combined three different concepts together and often simplified it by assigning companies a single number or letter.
Edmans says ESG is so broad it’s meaningless, using the metaphor of food.
“You wouldn’t say food is good for you. Some foods are good for you, broccoli is good for you and ice cream is bad for you. So this blanket phrase ‘ESG’ is not particularly helpful.”
ESG flourished because people wanted to believe in the idea that they could make money and improve the world, which he describes as “confirmation bias.”
The impact on society and the planet is a question. Take coal mining for example. Coal is bad for the environment, so it would hurt your ESG score. But instead of closing these mines, many companies simply sold the assets to other operators who didn’t care as much. Coal was constantly being dug out of the ground and burned for fuel.
“A customer boycott can have a big effect because if I boycott McDonald’s, the hamburgers stay on the shelf and nobody buys them,” says Edmans. “Investor boycotts don’t necessarily do that because I can only sell when someone else is buying. You can have a limited effect with an ESG fund.”
Republican resistance
Attempts by finance to influence society and the climate through the back door have also drawn criticism from politicians and activists.
A US television campaign by Consumers’ Research accused BlackRock of putting political goals above the needs of its customers. Fink and BlackRock have been accused of “awakened capitalism”.
In 2022, former Republican presidential candidate and Florida governor Ron DeSantis also announced that he would pull $2 billion in state investments from BlackRock.
Observers say the backlash is largely “political theater” that probably didn’t cause the ESG trailer to derail.
“If I had to guess, it would have to do less with Republican opposition and probably more [down] on performance issues and fees,” says Oxford’s Eccles.
Amidst the showdown, the Wall Street titans who pioneered ESG began to change their tune.