Environmental, social, and governance investing (ESG) has become not just a catchphrase amongst bankers but a serious selling point for an increasing number of financial services. While so-called socially responsible mutual funds have been around for decades, and a divestiture of tobacco companies roared through investment banks and funds in the 1990s, the vast majority of the financial world simply didn’t take ESG seriously until very recently—and in some corners it is still not a central focus.
That is changing, as more and more end-investors are demanding an ESG focus and are willing to sacrifice performance in the short and medium term for it. Some high-profile changes, such as the retail and pro-oriented broker Interactive Brokers’ change of its interface to include an at-a-glance view of a company’s social impact when researching a stock, have shown that the idea is trickling down from the long-term talking points seen at the largest fund managers. Even the stereotypically cutthroat and amoral hedge fund universe has taken ESG on as a serious consideration as their largest clients, the pension funds, demand it more and more—and are willing to sacrifice performance if need be.
But there is an argument, which is becoming increasingly popular, that ESG investing will offer higher overall returns in the long run. The idea is pretty simple: if you invest in environment destroying fossil fuels as part of your broader portfolio of other companies, your returns might look higher in the long term if fossil fuel companies boom, but in the long term the damage from climate change will hurt the profits of your other holdings, thus depressing performance as a whole. So ESG investing is, from a long-term perspective, going to boost returns, even if it isn’t noticeable on a months- or couple-year holding period.
The growth of ESG has resulted in more resources and standard practices designed to define, qualify, and analyze what makes an ESG investing thesis and what does not. The prolific CFA Institute has published a guide on the issue, which explains how ESG issues can be incorporated into an analysis of an investment. This is becoming increasingly standard practice amongst professionals at every step of the financial industry.
ESG investing, of course, has critics—and not the kind you would expect. Blackrock has been a champion of ESG investing for longer than almost any other institution, yet its former chief of sustainability investing Tariq Fancy has written at length about how ESG investing is a “placebo that harms the public interest.” Among the arguments he makes is the idea that ESG investing is based on subjective criteria that can easily be manipulated (at worst) or simply lead to unexpected neutral or bad results (at best), pointing to green bonds as an example: these funding vehicles are a darling of ESG investing, but there’s little evidence that they have had much positive environmental impact at all.
One response to Fancy’s criticisms is that ESG investing is very complicated because, unlike much quantitative financial analysis, it involves qualitative issues in addition to quantitative variables that are unknown and unknowable. For instance, if a green bond is issued to produce 100,000 wind turbines, how much will that reduce carbon output? The answer might sound simple, but perverse incentives and unintended consequences of the wind farm might change that calculation radically. And since ESG analysis involves much more than the bread and butter of financial analysis—including knowledge of environmental science, physics, human psychology, geopolitics, and so much more—some have made the case that ESG investing is prima facie impossible.
As a result, the concept of ESG investing will continue to develop and change and, ideally, actually result in positive environmental, social, and governance change. But the rise of ESG investing demonstrates that the old idea of finance as an amoral and ethically neutral service is quickly going the way of the dodo bird.
