The Hottest Trend in Investing Is Mostly a Sham (2024)

Republicans portray ESG as the epitome of “woke capital.” The truth is closer to the opposite.

By James Surowiecki

In March, 19 Republican governors issued a statement warning of “a direct threat to the American economy, individual economic freedom, and our way of life.” The threat in question was not one of the classic objects of conservative anxiety, like high taxes, government regulation, or socialized medicine. Instead, it was a bugbear of a more recent vintage: ESG investing.

ESG, which stands for “environmental, social, and governance,” purports to allow investors to put their money into companies that care about not just their bottom line, but their impact on the world. ESG has been one of the hottest trends in investing over the past five years. There are now numerous ESG indexes and hundreds of ESG funds, including from the biggest institutional investors, that collectively have garnered trillions of dollars in assets.

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Given that nobody is forcing anyone to invest in these funds, you might see this as the free market at work. But for Republicans, this boom has been nothing short of a disaster, turning corporate executives into softhearted simps who put diversity and environmentalism ahead of the bottom line. The Wall Street Journal opinion page publishes nonstop critical coverage of it. Florida, ground zero for the effort to use state power to punish corporations for being too “woke,” passed a law earlier this month banning state and local officials from considering ESG goals when investing.

Conservative rhetoric about ESG investing may be politically expedient, but it is profoundly out of touch with reality. ESG ratings generally do not, it turns out, measure what most people think they measure. The most scandalous thing about ESG is not that it leads corporations to pursue progressive environmental and social goals. It’s that it pretends to, while in fact doing little of the sort.

The roots of ESG investing go back to the rise, in the 1960s, of what was then called “socially responsible investing.” That approach mainly relied on what’s known as “negative screening”: not investing in companies involved in products or practices deemed harmful or immoral, such as tobacco, nuclear weapons, and support for apartheid.

In the 1990s, some small investment firms began pioneering the idea that one could reap higher returns by identifying and investing in companies with excellent social or environmental performance. The theory was that these types of corporations use resources more efficiently, have lower risk profiles, and are better-positioned to deal with future regulations. Initially, this kind of positive screening catered to a niche market. It was a labor-intensive undertaking that required intensive research and direct communication with corporate executives. But by the mid-2000s, there was wider interest in investing in companies that seemed to be doing good, particularly with regard to climate change, and more hostility to the idea that companies should prioritize shareholder returns above all else. Demand for what we now call ESG investing emerged, and, as happens in a capitalist market, supply sprang up to meet that demand.

In the past few years, a host of what you might call ESG-ratings agencies have formed, many of them as new divisions within existing companies, each promising to rate corporations’ ESG performance in much the same way that credit-rating agencies assess the creditworthiness of corporate bonds. Today you can pick from ratings by Moody’s, MSCI, S&P, Refinitiv, and more. Along with the ratings came stock indexes and exchange-traded funds. Socially conscious retail investors now have an extensive menu of ready-made ESG funds to choose from—no research required. The sales pitch remains the same as it was in the 1990s: ESG investing won’t just assuage your conscience; it will let you outperform the market. You can do better by doing good.

This is, it must be said, a great pitch. The only problem is that it’s mostly smoke and mirrors.

Start with those ratings. An ordinary investor would reasonably assume that if a company has a high ESG rating, it must be doing a lot to curb carbon emissions and pollution or improve diversity in its workforce or, ideally, both. That is, after all, how the ratings are marketed. MSCI, one of the most influential ESG-rating firms, describes itself as “enabling the investment community to make better decisions for a better world” and declares, “We are powered by the belief that [return on investment] also means return on community, sustainability and the future that we all share.”

Read: The world is finally cracking down on ‘greenwashing’

In fact, an ESG rating from MSCI does not measure how much a company is doing to combat climate change. Instead, as an in-depth 2021 Bloomberg investigation showed, the “environmental” portion of the rating measures how much climate change is going to affect a company’s business and how much the company is doing to mitigate that risk. So, if MSCI thinks climate change is not a big danger to a particular corporation, it doesn’t consider carbon emissions in determining that firm’s environmental rating—even if that corporation is a big emitter. So a company like McDonald’s can have its ESG score upgraded even if its total carbon emissions have risen.

Beyond that, the ESG framework smushes together a wide range of variables into a single rating, including one category—corporate governance—that has nothing at all in common with environmental and social values. A company might score well on governance because it limits the CEO’s power, has an independent board of directors, and is transparent and open with shareholders. All of that is economically valuable, but there’s nothing inherently good for the world about it. A sinister but well-governed corporation will simply accomplish its sinister goals more effectively. Yet governance constitutes a key ingredient in a company’s score, and in the Bloomberg study was responsible for the highest percentage of upgrades. One consequence of this is that a company that has high carbon emissions and an ordinary record on diversity, but excellent corporate governance, can end up with a very high overall ESG score.

Some of these problems could be addressed by building ratings that actually focus on reducing emissions, or by building ES indexes rather than ESG ones. But another issue would remain: Different agencies provide widely divergent ratings. A 2019 study by the economists Florian Berg, Julian Kölbel, and Roberto Rigobon, for instance, found that the ratings of the six biggest agencies correlated poorly with one another, and the biggest source of disagreement had to do with how different agencies measure the same criteria. One agency might say a company is a leader in the field, while another might see it as an ordinary performer at best.

On top of all of this, ESG indexes and funds don’t always do much screening to begin with. When you invest in an ESG fund, you may think you’re buying into a highly curated selection of positive-outlier companies. In reality, it will often look similar to an ordinary market-wide index fund. The 10 biggest holdings in the S&P 500 ESG index include Big Tech companies such as Apple, Microsoft, and Alphabet; big banks such as JPMorgan Chase; and, incredibly, ExxonMobil. This has two consequences: First, ESG investors aren’t always directing their money toward companies that are doing an exceptional job on the environmental or diversity fronts; second, to the extent that an ESG fund performs well, it’s often just because the market as a whole is doing well—yet ESG funds typically have higher costs than index funds.

ESG investors, then, aren’t always, or even usually, getting what they think they’re paying for, which in turn means that the conservative claim that companies are contorting themselves to satisfy ESG criteria is hugely overblown. The ESG boom has probably encouraged companies to improve their disclosure about such issues as emissions and gotten them to think more concretely about the risk that climate change poses to their operations. But a vehicle for woke capitalism it’s not.

Indeed, if the ESG boom has had any systemic effect, it may have been to weaken the demand for government action by fostering the illusion that corporations can solve, and indeed are solving, the world’s problems on their own. In 2021, for instance, Larry Fink, the CEO of the investing behemoth BlackRock and the anti-ESG crowd’s favorite villain, argued against mandating climate-risk disclosures. Thanks to self-regulation, he said, “We’re not going to need, really, governmental change or regulatory change.” That’s a message that Republicans would normally find quite appealing. Instead of trying to bury ESG capitalism, free-market conservatives should really be praising it.

Support for this project was provided by the William and Flora Hewlett Foundation.

James Surowiecki is a contributing writer for The Atlantic and the author of The Wisdom of Crowds.

The Hottest Trend in Investing Is Mostly a Sham (2024)

FAQs

Is ESG investing real? ›

ESG investing focuses on companies that follow positive environmental, social, and governance principles. Investors are increasingly eager to align their portfolios with ESG-related companies and fund providers, making it an area of growth with positive effects on society and the environment. S&P Global.

Is it worth investing in ESG funds? ›

Sustainable investments may offer competitive returns

Yet, that may not be the case. In fact, research reported by FTAdviser compared six exchange-traded funds (ETFs) – five with an ESG overlay and one without. It found that there was no discernible difference in the returns between ESG and non-ESG funds.

Is ESG just a trend? ›

ABN Amro Investment Solutions CEO, Francois Xavier Gennetais, said the firm provides access to open architecture investing and is passionate about the ESG requirement, which he said is more than just a trend. Gennetais said the firm sees ESG as essential. He told FT Adviser: “We can see what clients want to see.

What is ESG investing and why is it under fire? ›

ESG was developed about two decades ago by United Nations officials working with the finance industry. They argued that weighing key ESG risks, such as climate change, worker disputes and litigation stemming from poor corporate governance, helps protect investments.

Who is behind ESG? ›

It refers to a set of metrics used to measure an organization's environmental and social impact and has become increasingly important in investment decision-making over the years. But while the term ESG was first coined in 2004 by the United Nations Global Compact, the concept has been around for much longer.

Why is ESG criticized? ›

One of the biggest criticisms of ESG is that it perpetuates what it was partly designed to stop – greenwashing.

What companies are pulling out of ESG? ›

Firms including Vanguard, J.P. Morgan, State Street, Pimco, and Invesco have left organizations such as the Net Zero Asset Managers Initiative or Climate Action 100+.

What will replace ESG? ›

What's next: Going forward, usage of the term ESG will likely continue to wane, says Jenkins. Instead, specific terms such as climate, transition and transparency will begin being used more often.

Is ESG risky? ›

Types of ESG Risks

Examples include causing water contamination, air pollution, or improper waste disposal. Social risks. These risks are associated with how an organization or government treats its employees, stakeholders, and the communities they serve.

What is the downside of ESG investing? ›

However, there are also some cons to ESG investing. First, ESG funds may carry higher-than-average expense ratios. This is because ESG investing requires more research and due diligence, which can be costly. Second, ESG investing can be subjective.

Is ESG greenwashing? ›

Greenwashing is when firms disclose large quantities of ESG data but have poor ESG performance. Greenwashing is a barrier to integrating ESG factors into investment decisions.

Why is everyone investing in ESG? ›

Investors increasingly believe companies that perform well on ESG are less risky, better positioned for the long term and better prepared for uncertainty. Companies that realign to the stakeholder capitalism agenda may have a competitive advantage over those that try to return to business as usual.

How risky is ESG investing? ›

ESG risks, when poorly managed, can have a significant impact on a company's reputation, finances and long-term viability. The effect of these risks can range from fines and legal penalties to loss of customer, employee and investor confidence.

Do companies really care about ESG? ›

Many companies and shareholders often overlook the full implications of not adhering to Environmental, Social, and Governance (ESG) standards. Even if you might not place much value on ESG, those who support your business do—and they won't hesitate to make their feelings known.

Is certificate in ESG investing worth it? ›

Conclusion. Pursuing the CFA ESG certification can be a wise investment for finance professionals looking to stay ahead in the evolving landscape of sustainable finance.

What are the downsides of ESG? ›

Lack of Standardization

ESG criteria is not standardized. This makes it difficult for investors to compare companies and make informed investment decisions. Without a unified system of metrics and reporting, investors lack the ability to easily and accurately assess companies' performance on key ESG issues.

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