McKinsey stated in 2019 that 90% of America’s 500 largest companies are now preparing an ESG report – reams of paper meant to prove that the companies are saving society and the planet.
Consultants and analysts also spend a lot of time arguing that ESG is 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 deliver positive performance,” says Pierre-Yves Gauthier, founder of AlphaValue.
Yet there was a problem: performance did not always match the promise.
For years, British ethical funds delivered returns that were lower than those of a simple tracker fund from the FTSE 100. In 2022, that difference widened to 10 percentage points, according to LSEG Lipper.
That meant that £1,000 invested in an ESG fund would return £103.50 less than a tracker fund.
Underperformance reflects the way ESG fund managers invest: ethical funds are varied, but generally avoid ‘sin stocks’ such as fossil fuels, defense and tobacco.
This means that 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, meaning owning them can increase the value of a portfolio.
The impact of ignoring these sectors was somewhat limited until 2022, when war broke out in Ukraine. A rise in oil prices drove up the shares of companies like BP and Shell, while the war boosted defense stocks.
The war also raised questions about whether defense companies were ethical: were the companies that helped arm Ukraine and fight Russian aggression really bad for society?
“Investors remember 2022, which was a bad year,” said Hortense Bioy, Morningstar’s head of research. “There is more skepticism about what ESG funds offer, both in terms of ESG credentials and performance.”
Researchers are also beginning to question the validity of claims that ESG drives financial performance.
For example, a recently published article in the academic journal Econ Journal Watch argues that the results of McKinsey’s claims about diverse management teams cannot be replicated. The authors said the claim could not be relied upon.
Alex Edmans, a former investment banker at Morgan Stanley and now professor of finance at London Business School, says there is “mixed” evidence that ESG improves financial performance.
“ESG is not ‘go woke, go broke’, but the blunderbuss idea that ESG will make you a lot of money is not the case,” he said.
Finching fears
Investors have also grown bored with a series of ESG-related scandals. A steady stream of news stories have shown that many ESG funds are not as ethical as they claim.
US regulators last year fined Deutsche Bank’s fund management unit DWS $19 million for greenwashing after making “materially misleading” statements about its concern for ESG.
In another egregious example, following press reports of poor working conditions in factories that Boohoo relied on, it emerged that many ESG funds had backed the fast fashion retailer. An independent report subsequently found ‘endemic’ problems.
Such cases gave rise to the feeling that ESG was little more than checking boxes and rubber stamps.
Part of the problem was that ESG was always a vague concept. It combined three different concepts, often oversimplifying it by giving companies a single number or letter rating.
Edmans says ESG is so broad as to be 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 term ‘ESG’ is not particularly useful.”
ESG took off because people wanted to believe in the idea that they can make money and improve the world, which he describes as “confirmation bias.”
The impact on society and the planet is open to questions. Take coal mining, for example. Coal is bad for the environment and would therefore harm your ESG score. But instead of closing these mines, many companies simply sold the assets to other operators who didn’t really care. The coal was always dug out of the ground and burned as fuel.
“Customer boycotts can have a major effect, because if I boycott McDonald’s, the burgers will remain on the shelves and no one will buy them,” says Edmans. “Investor boycotts don’t necessarily do that, because I can only sell if someone else buys. The effect you can have with an ESG fund is limited.”
Republican response
Attempts by the financial sector to influence society and the climate through the back door have also drawn criticism from politicians and campaigners.
A high-profile US TV campaign by Consumers’ Research accused BlackRock of putting political goals above the needs of its customers. Fink and BlackRock were accused of ‘woke capitalism’.
In 2022, former Republican presidential candidate and Florida Governor Ron DeSantis also announced he would pull $2 billion in state investments from BlackRock.
Observers say the response is largely “political theater,” which is unlikely to have derailed the ESG gravy train.
“If I had to guess, it would have less to do with Republican responses and probably more [down] to performance issues and compensation issues,” says Oxford’s Eccles.
Amid the reckoning, the Wall Street titans who pioneered ESG have started to change their tune.