ESG investing: risks and pitfalls

It's no secret that the accelerating rate of climate change is one of the most pressing issues facing our society today. With increasing frequencies of extreme weather events across the globe and reports by the United Nations that the world will exceed 2 degrees of global warming by the end of the century, societies are scrambling to find a way to live sustainably while preserving prosperity. This push for sustainability has not only affected people’s everyday routines and the practices of large corporations but has also bled into the investing world with the rise of environmental, social, and governance investing (ESG). ESG investing refers to the practice of explicitly incorporating ethical considerations into the security selection process for a fund or portfolio. While a company’s environmental footprint is an important consideration, as the name suggests, social and governance factors, including employee diversity and the transparency of a company’s management team are also highly relevant. Large rating agencies score companies on an ESG scale, and asset management firms use those ratings to construct ESG funds comprising companies that score well.

The basic argument in favour of ESG investing is that as investors show a preference for more ethical companies, the stock prices for those firms will rise. As these companies see increases in stock price, it makes it easier for them to raise money to finance profitable projects. In this way, ESG investing makes the world a better place by increasing the likelihood of success for sustainable companies. Proponents also argue that the investment strategy is profitable because it lowers the risk of a portfolio: ethical companies have less downside risk since they have a lower chance of facing regulatory issues and are safer in the long run because their business models are more compatible with the societal push for sustainable economies.

ESG investing has taken off in recent years. According to JP Morgan, in 2021, over 500 billion dollars flowed into ESG-integrated funds contributing to a 55% growth in assets under management held in said funds According to research by Bloomberg, global ESG assets are on track to exceed 53 trillion dollars in 2025. Institutional investors are starting to make ESG a priority. Blackrock, the largest asset-management firm in the world, has pledged support for transitioning to a net-zero economy by 2050 or sooner. The firm anticipates that by 2030, 75% of its assets managed on behalf of clients will be invested in companies that have “science-based targets” for reducing emissions. As of April 2021, the second largest asset-management firm Vanguard reported that 17% of its $1.7 trillion in actively managed assets under management were invested in a manner that aligns with achieving net-zero by 2050. While arguments in favour of the trend have some merit, it's important for investors to remember that no investment strategy is a panacea and that ESG investing comes with its own unique risks. 

ESG funds might be riskier than regular funds due to a lack of diversification. When designing an ESG fund or portfolio, certain industries tend to be excluded because they are seen as less ethical. For example, companies that operate in the gambling industry, the adult entertainment industry, and firearm manufacturing are often excluded from sustainable funds due to moral concerns about these industries. Conversely, companies in clean energy are more likely to be highly represented in these funds because of their sustainable nature. As a result, ESG investing can lead to portfolios being largely composed of certain industries, increasing investors’ exposure to the unique risks of those industries. One example of this phenomenon is the significant exposure of US-based ESG funds to technology stocks. According to The New York Times, tech stocks account for about one quarter of the assets of large-cap ESG funds, compared to around one fifth for traditional large-cap funds. In September, The Financial Times reported that US-based ESG funds are on average 29% composed of technology stocks compared to 23% for traditional funds. This exposure has hurt many sustainable funds this year as tech stocks have tumbled in response to rising interest rates and growing fears of a recession.

Another issue that makes effective ESG investing difficult for the average person is the lack of regulation surrounding ESG reporting by firms. Due to increased interest in sustainable investing, greenwashing has been on the rise recently. Greenwashing refers to a marketing tactic used by companies that involves providing investors with misleading information about the environmental footprint of a firm to improve the company image. There have been several high-profile greenwashing cases as of late, including a lawsuit filed in July against fast-fashion giant H&M. The lawsuit accuses H&M of lying on its new environmental scorecards about the amount of water that is needed to make products. In October, the UK banned an advertisement by HSBC which promoted its contributions towards meeting net-zero emissions for making “unqualified claims about its environmentally friendly work.” This past May, German police raided the offices of The DWS Group, an asset management firm, for misleading investors about the amount of ESG assets it held. Although the firm denied these claims, a German consumer group filed a lawsuit against them in September for overstating their green credentials. This kind of misinformation being spread by large companies makes it difficult to have trust in ESG scores.

The significant divergence in rating methodology that exists between major ESG rating agencies also casts substantial doubt on the validity of ESG rankings. A paper recently published by MIT and The University of Zurich examined the ESG ratings of Moody’s, S&P Global, MSCI, Refinitiv, KLD, and Sustainalytics. The paper found that the correlation of ratings between these agencies ranged from 0.38 to 0.71. For reference, the same study found that credit agency ratings have a correlation of around 0.92. This issue largely stems from the fact that ESG is a broad, subjective term, with no agreed upon method for determining what aspects of a company’s operations should be graded and how those operations should be graded. Overall, until there is stronger regulation establishing formal rules for ESG scoring and reporting, a lot of the onus is placed on individual investors to determine how sustainable a company really is.

Thankfully, there has been more talk about establishing robust disclosure requirements lately, with regulatory bodies creating proposals for how to address the issue of false information. In March of 2022, the Securities and Exchange Commission proposed rule changes that would require companies to include information about their environmental impact in their periodic reports. Specifically, companies would be required to report on their direct greenhouse gas emissions, indirect emissions from purchased electricity, and emissions from upstream and downstream activities in their supply chains. The SEC followed up with another rule proposal in May, which would require ESG funds to disclose more specific information about the ESG strategies they pursue and the sustainability-related impacts they achieve through annual reports and investor prospectuses. Neither of these proposals have been implemented yet but could represent serious progress on the regulatory front if finalized. In June, the Council of the European Union and European Parliament reached a provisional agreement on the scope and timeline for adoption of the Corporate Sustainability Reporting Directive (CSRD). The CSRD requires comprehensive disclosures about how sustainability issues affect a company's business as well as how a company affects the environment and is expected to take effect in 2024. So, while regulation in the ESG space has been historically poor, if regulators are successful in implementing their planned policies, they could make notable progress in solving the issues of inconsistency and false information.

While the issues with ESG investing paint a somewhat bleak picture for people looking to invest their money both sustainably and profitably, this article is not meant to discourage ESG investing. Rather, you shouldn’t take claims made by companies and asset management firms about sustainability at face value. If you’re considering investing in an ESG fund, take a careful look at the holdings to make sure that you’re comfortable with the level of diversification. While lack of diversification certainly can be an issue, it’s possible to have both a well-diversified and sustainable portfolio if you make a conscious effort to include companies from different industries. It can also be helpful to treat having a high ESG score as just an additional benefit to an investment rather than a strict requirement for investing. When you see an ESG score for a company, try to cross-check that rating against other major rating agencies, and do further research on the company to see if the rating makes sense to you. Always research before investing your money.