22 Nov 2022
The ESG [Environmental, Social, and Governance] backlash in the US is more of a political issue.
However, some claims underlying the current ESG backlash have good substance, while others do not.
For example, anti-ESG groups claim that ESG investing has produced an opaque financial system that does not serve the best interest of the clients or shareholders. This is true to a large extent.
Most ESG funds are based on some ESG ratings/scores provided by major ESG rating agencies such as MSCI, ISS ESG, Refinitiv, and others.
But, a significant level of opacity revolves around the ESG rating. For example, ESG rating agencies use their proprietary rating methods that are rarely subject to any regulatory or public scrutiny, meaning it is very difficult to know what is going on under the ESG rating to build ESG funds.
Also, ESG ratings are done primarily based on self-reported, publicly available company data. Large companies can easily manipulate ESG ratings in their favour by producing extensive public disclosures.
Most ironically, ESG ratings often do not measure what they should actually measure – how the company contributes to a better society and environment.
For example, MSCI’s ESG rating (the largest provider of ESG ratings worldwide) primarily measures how environmental, social, and governance issues could pose a significant risk to a company’s bottom line.
Here, the ESG rating is more about assessing how ESG issues could financially affect the company rather than how the company’s operations could affect society and the planet. Due to all these factors, a significant lack of transparency, uncertainty, and accountability persists in ESG investing.
Also, many ESG-related labels (e.g., low-carbon, ESG Aware) are attached to different funds. These funds rarely clarify what these labels exactly mean. Perhaps the current ESG backlash could help tighten the regulatory environment around ESG investing (e.g., enacting laws to increase transparency and accountability of ESG rating agencies and ESG funds), thus mitigating the risk of ESG-washing.
However, anti-ESG groups claim that ESG investing does not maximize financial returns for pensioners.
This claim does not have much substance. Many ESG funds (albeit based on apparently flawed ESG ratings) outperform traditional peer funds, thus providing superior financial returns to investors.
Gradually divesting from “sin stocks” (eg: weapon companies) and high-emitted stocks (eg: oil companies) and investing more in “true” ESG companies would be a good way forward for a better world. However, the current politicized ESG backlash could harm the broader investing movement for a more sustainable world.
For financial advisers, the current ESG backlash means that they should not blindly rely on different labels that so-called ESG funds use. Instead, they should do their own due diligence about the ESG ratings used to build the ESG funds and the metrics and data used to monitor ESG performance.
Being more transparent and rigorous about their ESG fund selection processes might help financial advisors gain and maintain their clients’ trust that they are actually investing in “true” ESG companies whose business operations contribute to a better society and environment.
Also, instead of primarily relying on ESG funds based on traditional (flawed) ESG ratings, financial advisers could do their own research to develop a better ESG portfolio.
However, this could increase the investment cost for investors.
As an alternative to ESG funds, financial advisers could also refer their clients to impact funds. A wide range of impact funds are available in the market, which offers a different mix of financial and impact returns to their investors.
However, financial advisers should be careful that some traditional funds may simply label themselves as impact funds without providing evidence of their social/environmental impact creation, measurement, and monitoring processes.
This article was first published by Good Returns