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ESG Investing Or Misplaced Priorities?

Date

August 8, 2024

Author

Kirill Patyrykin, Pavel Chernyavskiy, Pavel Vasilenko, Vasilii Allenov

ESG investing: Are Our Priorities Misplaced?

In modern investment, ESG (Environmental, Social, Governance) criteria have seemingly become the new gold standard over the past decade. This burgeoning enthusiasm has led businesses and investors to channel unprecedented resources into environmental sustainability, often overshadowing other critical global challenges. Under the guise of social responsibility, investors frequently rely on the prevailing zeitgeist when making decisions, rather than on traditional risk assessments.

Recent research suggests that ESG scores often serve more as marketing tools than genuine indicators of sustainability. Investors, eager to align with the perceived ethos of ESG, respond enthusiastically to these scores and labels, using them to gauge the sustainability of their investments. While the intent behind ESG investing — to mitigate climate change and uphold social justice — is noble, the singular focus on CO2 reduction raises critical questions about our prioritisation of global challenges.

Are we addressing the most pressing issues effectively, or are we indulging in a costly exercise of environmental idealism? This essay seeks to understand the complexities of ESG investing, examining whether our strategies truly align with common sense and economic benefits, or if they risk becoming a misguided endeavour driven by ideological fervour.

Understanding ESG: Environmental, Social, and Governance Criteria

ESG stands for Environmental, Social, and Governance, and represents an investment approach that focuses on these three key areas. Investing with ESG factors in mind is often called responsible investing or impact investing. It evaluates companies on their environmental protection efforts, social responsibility, and governance practices for potential investments. Environmental criteria assess how companies manage emissions, resource use, and sustainability initiatives. Social criteria examine relationships with employees, suppliers, customers, and communities, including labour practices and product safety. Governance criteria focus on leadership, executive pay, audits, internal controls, and shareholder rights. Increasingly, investors incorporate ESG into their decisions, making it vital for securing capital (Deloitte, 2022).

Recent research supports the idea that ESG scores often serve as marketing tools. Investors are particularly responsive to these scores and sustainability labels, which are thought to simplify the evaluation of their investments' sustainability (Assaf et al. 2024; Ceccarelli et al., 2021).

Some companies use high ESG scores as a way to enhance their public image, attract investors, and differentiate themselves from competitors. The appeal of these scores lies in their promise to provide a quantifiable measure of a company's sustainability efforts. The increasing prominence of ESG investing has driven demand for these scores, as investors seek to align their portfolios with sustainability goals and ethical standards. The belief that ESG scores can provide a reliable gauge of a company's sustainability is appealing, particularly given the complexity and variety of environmental and social issues involved (Routray, 2024).

However, the reliance on ESG scores as a primary factor in investment decisions can be problematic, as these scores are not always reflective of a company's true environmental or social impact. Instead, these scores can be influenced by a company's ability to effectively market itself as a responsible and ethical entity, rather than its actual performance on ESG metrics. This discrepancy raises concerns about the real value of ESG scores in guiding investment decisions (Assaf et al. 2024; Ceccarelli et al., 2021).

The Hype and Reality of ESG Investing

Although ESG criteria have good intentions, they combine very different concepts, making ESG investing struggle with a clear definition. Some evidence suggests the main issue is overinclusion, with many assets now claiming to meet ESG criteria. This broad expansion has led to ongoing criticism and confusion about what ESG truly means and aims to achieve (Trahan and Jantz, 2023; Routray, 2024).

This uncertainty poses several risks, including the possibility of a sudden withdrawal of capital, which could have significant environmental impacts if investor interest wanes. The mix of unclear definitions and significant market influence also brings with it a range of emerging risks. Regulatory risk is a key example, even though it varies by region. For instance, the Securities and Exchange Commission (SEC) has yet to establish an official definition of ESG (Trahan and Jantz, 2023).

Political risk is also increasingly affecting ESG investments, with varying impacts. In Europe, there is steady movement towards implementing the proposed Corporate Sustainability Directive. Meanwhile, in the United States, 19 state attorneys general recently criticised BlackRock, a major asset manager, over its ESG-driven energy investment strategies. The lack of clear definitions and principles in ESG investing can lead to more claims and political criticism. This scrutiny isn’t limited to major asset managers but also affects service providers. Recently, a group of US Senators reached out to 51 large law firms, suggesting that ESG activities might unfairly restrict carbon-producing industries and could potentially breach US antitrust laws (Trahan and Jantz, 2023).

ESG Investment Trends and Attitudes

Over the past 15 years, institutional investors have increasingly committed to responsible investing. The UN Principles for Responsible Investment (UN PRI) has seen a significant rise in support, growing from 63 signatories and 32 asset owners with USD 6.5 trillion in assets under management (AUM) in 2006 to 3,826 signatories and 609 asset owners with USD 121.3 trillion in AUM by 2021. This shift highlights the growing focus on ESG investments, which can influence investment values due to changing investor preferences and risk assessments (Kräussl et al., 2024).

A recent survey by Capital Group found that the proportion of investment professionals using ESG criteria rose to 90%, although this increase was not observed across all countries. The institutional investors place greater emphasis on the Environmental pillar (44%) compared to the Social pillar (25%) and the Governance pillar (31%) when making their ESG investment decisions (Capital Group, 2023).

ESG investing still uses traditional financial metrics, aiming for financial returns while considering environmental risks and opportunities. Socially Responsible Investing (SRI) prioritises ethical concerns over financial returns, and avoiding investments in harmful companies. Impact investing seeks tangible social benefits, such as funding renewable energy projects. These strategies have led to the rise of ESG funds, highlighting ESG's growing stock market importance. Consequently, companies need robust ESG strategies and expertise in ESG disclosure (Jonker and Krantz, 2024).

The issue with ESG is that it’s an umbrella term, and individuals’ attitudes towards each of the three pillars can be subjective and open to speculation. Investors might express concern regarding the profitability of ESG investment, leading to a negative attitude toward it. ESG scores may not suit investors with specific sustainability interests. This means that some investors might not be interested in high ESG score investments. Investing in these products could support sustainability areas they don't care about and might also lead to financial losses due to higher costs and fees (Assaf et al. 2024).

ESG Investment Performance, Risks, and Concerns

One of the characteristics of ESG investments is that they may not necessarily result in higher returns but may generate a positive social impact. Therefore, investors may claim their investment choices are guided by considerations for sustainability, but their portfolios might not reflect these claims (Heeb et al., 2023). Therefore, investing based on ESG criteria carries inherent risks due to uncertainties about whether assets are genuinely green as indicated by their ESG scores. This uncertainty can undermine the negative return predictability of an asset's ESG score, as the increased risk associated with ESG uncertainty necessitates a higher risk premium (Avramov, Cheng et al. 2021).

ESG scores have not significantly influenced investor returns in the Eurozone recently. Companies with lower ESG ratings may offer better protection for investors than high ESG scoring stocks. This result could be due to the increased demand for ESG stocks leading to their overpricing, while lower-rated ESG stocks might be underpriced (Asteriou et al., 2023).

Climate change and sustainability are indeed crucial issues for our society, and financial economists have increasingly focused on understanding how investor capital can drive the transition to a sustainable economy. Socially responsible investors often have varied preferences across different aspects of sustainability, such as environmental, governance, or social factors. A key concern is whether ESG investors are misinformed and acting on incorrect expectations rather than genuine sustainability interests. Investors might claim their choices are driven by sustainability, but their portfolios might not reflect this. Although they prefer sustainability and are willing to sacrifice returns for societal impact, the problem of greenwashing hampers their ability to effectively shift capital from non-green to genuinely green investments (Kräussl et al., 2024).

Investors are drawn to socially responsible stocks for both ethical reasons and the hope of better returns. However, the evidence on this is mixed. Some theories suggest ESG investing leads to higher profits, but the data from international markets doesn't support this. There are no consistent or reliable extra returns from long-short ESG portfolios globally. If there are any abnormal returns, they are usually negative. Turns out, investors shouldn't expect higher returns from ESG stocks. There's also no strong link between the economy's state and the performance of socially responsible companies, with any such connection being weak or specific to certain countries or signals (Long et al., 2024).

Diverging Views on ESG

ESG investing has recently faced scrutiny and debate. While some celebrate the rise in ESG-focused funds, others criticise it, especially in the US where political divisions have intensified. This year, $40 billion has left ESG funds, reflecting a trend that mirrors other market fads that eventually face reality checks (Financial Times, 2024).

Performance issues have contributed to these outflows, as many ESG funds struggled in 2022 and 2023, particularly amid surging oil prices. Additionally, ESG investing has faced criticism for its contradictions and perceived greenwashing, with funds sometimes appearing more like traditional indices than initially promised (Financial Times, 2024).

But despite prominent anti-ESG campaigns in the USA, a recent survey found that US investors are more likely to have sustainable investment policies compared to their global counterparts. Specifically, 83% of professional U.S. investors now report having ESG policies, a significant increase from just 27% five years ago (Segal, 2024).

Interest in sustainability remains strong in Europe and the UK, where regulatory improvements have reduced greenwashing. And even in the US the underlying principles of ESG, such as reaching net zero and better governance, continue to be valued, partly due to supportive policies like the US Inflation Reduction Act. Ultimately, the future of ESG will be significantly influenced by policy decisions and political developments, particularly in the USA (Financial Times, 2024).

Greenwashing for Profit: Challenges and Criticisms of ESG

Views on ESG investments vary within the financial industry. Some experts believe ESG investments lead to better performance, while others think they prioritise social impact at the expense of financial returns. There are also concerns that ESG investing could be a way to attract funds through misleading practices like greenwashing (Kräussl et al., 2024; Routray, 2024).

Greenwashing is a practice where an organisation makes vague, misleading, or outright false claims about the environmental benefits of its products or operations. Essentially, it involves presenting a company’s actions or products as more environmentally friendly than they are. A company might market a product as “eco-friendly” or “sustainable” without providing specific information about its environmental impact or the actual practices behind the product’s production. This could involve highlighting a single green aspect of a product while ignoring other, less sustainable practices (de Freitas Netto et al., 2020).

Greenwashing is problematic because it misleads consumers and investors who are trying to make informed choices. It also undermines genuine efforts towards sustainability by creating a false sense of progress. As a result, real environmental issues may persist, and effective solutions may be hindered by these deceptive practices (Routray, 2024).

EV adoption: Fighting climate change or market manipulation?

The case of electric vehicles (EVs) and the legislation concerning their manufacturing and use highlights the collision between the environmental, social, and governance aspects of ESG investing. Although EVs do not emit tailpipe pollution, their production and battery manufacturing contribute significantly to carbon emissions (Euronews, 2023). This raises a fundamental question: is it greenwashing, real efforts to fight climate change, or just appealing to investors?

Car manufacturers are investing heavily in electric vehicles (EVs) intending to have over 30 million battery electric vehicles (BEVs) on European roads by 2030. Although EVs do not emit tailpipe pollution, their production and battery manufacturing contribute significantly to carbon emissions. Comparing BEVs to traditional internal combustion engine (ICE) cars involves looking at life cycle emissions, which include production, use, and disposal. The production of lithium-ion batteries is highly energy-intensive, leading to higher emissions during the manufacturing phase of BEVs compared to ICE cars (Euronews, 2023).

Major carmakers like Mercedes-Benz and General Motors (GM) have set ambitious targets to become carbon-neutral, but there have been setbacks. Mercedes-Benz, for instance, later revised its carbon-neutral goals. In contrast, Swedish company Polestar aims to produce a net-zero car by 2030, focusing on reducing carbon emissions throughout the entire life cycle of the vehicle (Euronews, 2023). Despite these challenges, BEVs generally result in fewer carbon emissions over their lifetime compared to ICE cars. Advances in battery technology and manufacturing are expected to further enhance the environmental benefits of EVs.

However, the rapid adoption of EVs has fuelled a race to secure supplies of critical minerals. A comprehensive review of the sustainability impacts of the extraction of these minerals at a global level, however, is lacking. Mining for these minerals often concerns indigenous rights, access to material and immaterial resources, social benefits, and conflicts. In particular, the extraction of copper, aluminium, cobalt, and manganese received relatively high coverage on most social impacts, whereas cobalt and graphite received the most intensive media attention (Augusdinata and Liu, 2023).

While the adoption of EVs represents a significant step towards reducing carbon emissions, it also presents a complex set of challenges that touch on various aspects of ESG investing. The push for EVs underscores the need for a nuanced approach that balances environmental goals with social and governance considerations. As the demand for critical minerals grows, so too does the importance of ensuring that mining practices are sustainable and equitable. The future of ESG investing will depend on our ability to navigate these complexities and develop strategies that genuinely address the most pressing global challenges, rather than simply projecting an image of sustainability and fighting climate change.

Climate Change: What We Know and What We Don’t

Climate change is undoubtedly real, but our understanding of it is still incomplete. This uncertainty complicates investment choices, given the large number of influencing factors, with CO2 being just one parameter among many.

What we know is that even if greenhouse gas emissions were halted, the climate would not revert to pre-industrial conditions. Due to the heat already trapped from past emissions, Earth's surface temperature would take thousands of years to cool back to pre-industrial levels. Atmospheric CO2 would also take millennia to decrease to pre-industrial levels because of the slow processes of CO2 transfer to the deep ocean and burial in ocean sediments (Royal Society, 2020).

Surface temperatures would remain elevated for at least a thousand years, showing a long-term commitment to a warmer climate caused by past and present emissions. Sea levels would continue to rise for centuries, even if temperatures stabilised, because reversing glacier and ice sheet melting, such as in Greenland, would require significant cooling (Royal Society, 2020).

The warming induced by current CO2 levels seems to be irreversible on human timescales. Future warming will depend entirely on additional CO2 emissions. Therefore, returning to pre-industrial climate conditions is not feasible within human lifetimes due to the long-term warming commitment and slow natural CO2 removal processes. Significant efforts in reducing emissions and deploying negative emissions technologies are necessary to mitigate long-term impacts (Royal Society, 2020).

But with all this talk about going back to pre-industrial climate conditions, we still don’t know if the amount of CO2 in the atmosphere was the determinative factor in climate change in the past.

During much of the Palaeozoic era (543–248 million years ago), atmospheric carbon dioxide levels were several times higher than today. However, these levels decreased during the Carboniferous period to values like present-day concentrations. Despite CO2 being a greenhouse gas, it was previously thought that this led to much higher surface temperatures in the early Palaeozoic. Yet, reconstructions of tropical sea surface temperatures from carbonate fossils show minimal temperature fluctuations during this time, suggesting that global climate changes may not have been significantly influenced by CO2 levels (Came et al., 2007)

There may be only a weak negative relationship between CO2 levels and temperature changes and a small, positive correlation with temperature, explaining only a tiny portion of temperature changes. The CO2 levels and temperatures have fluctuated over time, with CO2 cycles often out of sync with temperature cycles. A notable 15-million-year CO2 cycle coincides with past mass extinctions, suggesting a need for more research on CO2, extinction, and related carbon policies. Overall, ancient CO2 changes did not directly cause temperature shifts (Davis, 2017).

Making informed investment choices in the face of incomplete climate data is challenging. The focus on CO2 emissions, while important, might overshadow other critical factors. Investors must consider a broader range of parameters, recognising the complexity and multifaceted nature of climate change. Balancing the urgency of climate action with a nuanced understanding of historical and current data is crucial for sustainable and effective investment strategies.

Urgent Global Challenges Beyond CO2

While the push for ESG investing primarily focuses on environmental sustainability, particularly CO2 reduction, we need to recognise and address other urgent global issues that demand immediate attention and resources. Pandemic preparedness, access to clean water, food security, and human rights are just a few examples of critical challenges that must be prioritised alongside environmental concerns (Altman and Rabbitt, 2023).

The COVID-19 pandemic starkly highlighted the necessity of robust health systems and global cooperation to manage public health crises. Similarly, ensuring access to clean water and securing food supplies are foundational to human survival and well-being, yet these areas often receive less attention in the current ESG-driven investment climate.

Pandemic preparedness requires substantial investment in healthcare infrastructure, research, and international collaboration to prevent and mitigate future outbreaks. The pandemic's devastating impact has shown that reactive measures are insufficient, underscoring the need for proactive strategies to safeguard global health. Access to clean water, a basic human right, remains elusive for millions around the world. Investments in water infrastructure and sustainable management practices are essential to address this pressing issue. Food security is another critical area, as climate change, population growth, and geopolitical tensions threaten the stability of food systems. Ensuring that all people have reliable access to sufficient, safe, and nutritious food requires a comprehensive approach that integrates environmental sustainability with economic and social policies (Altman and Rabbitt, 2023).

Antimicrobial resistance (AMR) is another critical global health challenge and one of the top public health threats facing humanity. The causes of antimicrobial resistance (AMR) are complex, but it's clear that excessive use of antibiotics has played a major role. From 2000 to 2015, global antibiotic use rose by 65%. Urgent and coordinated efforts are needed from both national and international organizations to prevent the reality of a post-antibiotic era, which could become a serious concern rather than just a dystopian fantasy for the 21st century (Salam et al., 2023).

This looming crisis underscores the need for a comprehensive strategy to combat AMR, which includes prudent antibiotic use, enhanced infection prevention measures, and significant investment in the development of new antibiotics and alternative treatments.

The critical importance of addressing AMR highlights the necessity of allocating resources to a range of urgent global challenges, rather than concentrating predominantly on CO2 reduction. While reducing carbon emissions is undeniably important for mitigating climate change, other issues such as antimicrobial resistance, food security, and public health require immediate and substantial investment. For example, improving global food security involves not only enhancing agricultural productivity but also addressing social and economic factors that contribute to hunger and malnutrition. Similarly, tackling AMR requires a multifaceted approach that includes regulatory reforms, public awareness campaigns, and international collaboration to ensure the sustainable use of antibiotics.

While ESG investing has brought significant attention and resources to environmental sustainability, it is crucial to adopt a more balanced approach that also addresses other pressing global challenges. Issues such as pandemic preparedness, access to clean water, food security, and antimicrobial resistance are equally critical to global well-being and require immediate and coordinated efforts.

Ideology vs Practicality in Investment Decisions

Following ideological imperatives in investment decisions can be both beneficial and challenging. Investments guided by ethical principles, such as those encompassed in ESG criteria, aim to promote sustainable and responsible business practices. These investments reflect a commitment to addressing critical global issues like climate change, social inequality, and corporate governance failures. However, prioritising ideology over practical financial considerations can lead to suboptimal economic outcomes. Investments solely driven by ideology might ignore fundamental economic metrics, potentially leading to financial underperformance.

Common sense and economic benefits are crucial when making investment decisions. Investors typically seek long-term gains, focusing on the financial health and growth prospects of their investments. Considering economic benefits, and prioritising risk assessment and management over psychological and emotional factors ensures that investments are sustainable and profitable over the long term, which is essential for the stability of financial markets and the economy (Almansour et al., 2023).

Balancing ethical considerations with financial viability can help avoid the pitfalls of overpricing or misallocating resources to less effective initiatives. A focus on economic benefits helps in making informed decisions that consider both short-term returns and long-term sustainability.

A balanced approach that integrates both ideological values and practical economic outcomes is essential for effective investment decision-making. This approach recognises the importance of ethical considerations while not losing sight of financial performance. By evaluating investments through the lens of ESG criteria and traditional financial metrics, investors can identify opportunities that align with their values and provide solid returns. This dual focus can help mitigate risks associated with both purely ideological investments and purely financial ones. A balanced, non-ideological strategy ultimately fosters a more sustainable and resilient investment portfolio, promoting long-term value creation and societal benefits.

Applying Enterprise Risk Management (ERM) to ESG

Enterprise Risk Management (ERM) is a comprehensive approach used by organisations to identify, assess, and manage risks. ERM involves systematically ranking and prioritising risks based on their potential impact and likelihood. This methodology ensures that organisations focus their resources on the most significant threats to their objectives. Key components of effective ERM include governance, strategy, performance assessment, communication, and information sharing. ERM helps create a structured framework for risk management, promoting proactive strategies to mitigate and manage risks effectively. By prioritising risks, organisations can allocate their resources more efficiently and enhance their resilience to adverse events (Olaniyi et al., 2023).

Applying ERM principles to global challenges involves identifying, ranking, and prioritising risks that threaten global stability and sustainability. This approach can help policymakers and international organisations focus on the most pressing issues, be it climate change, antimicrobial resistance, or social inequalities. By systematically evaluating these challenges, ERM provides a clear framework for action, enabling more effective allocation of resources and efforts. By managing ESG like ERM, investors, organisations and policymakers could systematically tackle different priorities, fostering a more sustainable and equitable world.

Conclusion

ESG investing, while rooted in noble intentions to promote environmental management, social responsibility, and sound governance, faces significant challenges due to its ambiguous definition. This lack of clarity contributes to increasing political and regulatory risks, as evidenced by the varying regional approaches and criticisms from political entities. The overinclusion of assets under the ESG label often results in accusations of greenwashing, undermining the credibility of ESG investments and complicating the investment landscape for both companies and investors.

One of the critical issues with current ESG practices is the disproportionate amount of capital directed towards combating CO2 emissions, often at the expense of other pressing global challenges like healthcare and disease prevention. The emphasis on reducing carbon emissions, while crucial, sometimes overlooks the historical variability of temperature cycles and the broader context of environmental sustainability. This imbalance raises questions about the price-profitability goals of such investments, suggesting a need for a more nuanced and balanced approach.

The debate between ideology and practical economic benefits in investment decisions highlights the necessity for a balanced approach that integrates ethical considerations with financial performance. The application of Enterprise Risk Management (ERM) principles to ESG can help prioritise global challenges more effectively, ensuring that efforts and resources are directed towards the most critical issues.

Despite the increasing adoption of ESG criteria, evidenced by the rising number of investors incorporating these factors into their decisions, the field remains fraught with challenges. Political and regulatory scrutiny continues to grow, especially in regions like the United States where ESG-driven strategies have faced significant opposition.

Ultimately, the future of ESG investing depends on addressing these definitional ambiguities and striking a balance between ideological goals and practical economic outcomes. By refining the criteria and focusing on genuinely impactful initiatives, ESG can evolve to better meet the demands of both investors and society. This evolution will require coordinated efforts from policymakers, investors, and companies to ensure that ESG investments truly contribute to a sustainable and equitable future.