The ESG balloon gets a puncture

For anyone who has missed, deliberately or otherwise, the arrival and growth of ESG investing, here’s a brief primer. ESG stands for environmental, social, and (corporate) governance. Broadly speaking, ‘Environment’ includes a company’s carbon footprint, its greenhouse gas emissions and climate change policies. The ‘Social’ component includes company culture and issues that impact employees, customers, suppliers, and the wider society. ‘Governance’ covers the way that the company is managed. A company with good corporate governance and a strong board of directors should relate well to different stakeholders, run its business effectively, and align the management team's incentives with the company's success. This will also include diversity of the board of directors and management team, along with transparency in communication with shareholders.

Doing good

Consequently, those investors who choose to focus on ESG-compliant companies are understood to prioritize responsibility and sustainability while ensuring an overall positive environmental impact on the planet. The feeling is that these companies can benefit by going the extra mile to keep their workers and customers happy, putting the health of the planet at the forefront of everything they do, while ensuring that management is transparent and fair in all their dealings. Studies have shown that these companies profit from such measures. This is summarised in the phrase: “Doing well by doing good”.

Objective and subjective

The world of ESG is complicated. Some companies score well in certain areas and do badly in others. Does that mean they should be shunned by investors? Also, some things can be measured and certified while others can’t. Hard evidence can be difficult to track down, but it’s possible to find data prepared using respected sustainability standards, such as those established by the Global Reporting Initiative (GRI) and the United Nations Principles for Responsible Investment (PRI). Nevertheless, not only is there a subjective aspect to ESG investing, but it is also increasingly clear that previous cast iron definitions have become more fluid. For instance, Russia’s invasion of Ukraine has changed the notion of ‘defence’ stocks. It now appears acceptable to own stocks of arms manufacturers providing munitions to Ukraine. But what if these same manufacturers provide weapons to totalitarian regimes as well? According to analysts from Citigroup: “Defence is likely to be increasingly seen as a necessity that facilitates ESG as an enterprise as well as maintaining peace stability and other social goods.” The message here: if defence maintains peace, it can’t cause social harm.

Regulators step up

The success and popularity of ESG investing over the last four years or so has brought with it greater scrutiny. Allegations of ‘greenwashing’ have been widespread. Back in May, Deutsche Bank, and its fund arm DWS were raided by police in Germany following allegations made by the firm’s former sustainability officer that it had overstated the degree to which its funds integrated ESG. The US Securities and Exchange Commission (SEC) is also investigating. This follows on from claims by BNY Mellon that five funds run by a subadvisor, Newton, factored in ESG criteria when selecting all securities. BNY Mellon was fined $1.5 million when it became apparent it only applied ESG standards for some stocks. According to the Wall Street Journal, the SEC is currently investigating two ESG funds run by Goldman Sachs Asset Management. The SEC have also proposed that ESG funds must adhere to a standardized set of disclosures about what kind of ESG fund they are and give more information to prove they match up to their billing. So, the regulators are taking notice. The question is whether the punishment is big enough to deter future greenwashing. But there are other issues which are affecting ESG investing, and the main one is a significant push-back against the whole idea itself. Last month, HSBC Global Asset Management’s head of responsible investing declared that climate change risks are overblown and ‘hyperbolic’. Stuart Kirk made the comment, and others in a similar vein, during a speech at a Financial Times Moral Money event. HSBC were unhappy with Mr Kirk expressing his opinion, and subsequently suspended him.

Claims countered

Changes are also afoot for individual companies. For instance, as we know, Tesla produces electric vehicles, and constantly burnishes its environmental credentials. The company requires lithium, nickel, and cobalt, to manufacture the batteries within those vehicles. These are mined in some of the most dangerous parts of the world where there is little in the way of social and environmental protections. Yet it wasn’t this that saw Tesla ejected from the S&P Dow Jones ESG Index. Instead, it followed the news that 4,000 current and former Tesla employees have filed the largest racial discrimination lawsuit of its kind. So, for years now, ESG investors have blithely ignored the working conditions of Tesla’s staff, and downplayed tricky environmental issues while lauding others. Perhaps it’s instructive to note that the top seven holdings in Vanguard’s US ESG ETF were Alphabet, Amazon, Apple, Meta Platforms, Microsoft, and Tesla. In other words, the same companies that head up the NASDAQ and S&P 500.

The bottom line

A lot of investors got caught up in the world of ESG. That was fine as the intentions were noble, and the outcomes were generally profitable, until the beginning of this year. Since then, it is only oil and gas that has made significant gains. This is consistent with higher energy costs. But energy companies were rallying off a relatively low base. Over the last few years, ESG had seen many funds divesting themselves of the ‘bad’ stuff and buying up anything ‘green’. The stock price of the former went down, while the latter went up. In the light of this year’s broad-based equity sell-off, and thanks to a certain reassessment of ESG, it looks as if a rethink is taking place. This should mean that there is always a place for ESG investing, if it is regulated, and the proponents are honest. At the same time, there should be an understanding that we still need companies to provide the old technologies in order to develop the new ones. Consequently, the most successful investors will be those with open minds and an understanding of true value.