An article by Ian Kilbride.
Environmental, Social and Governmental (ESG) funds are big business, but do they really do what they say on the tin?
By 2025, $25 trillion is expected to be invested in some form of ESG fund globally. In the US, for example, ESG investment amounts to $1 of every $8 in all assets under professional management. Forbes magazine notes that the number of fund managers reporting at least one ESG fund in their portfolio rising by 300% since 2016. Although ESG investing is particularly popular with generations X and Y and with millennials more broadly, the fundamental principles underpinning ESG investing is hard to argue against. Few would not wish to invest in companies with exemplary environmental standards, who practice social responsibility as a core ethos and who apply best practice governance in the interests of all stakeholders.
But with their growth, so too has grown the scepticism and criticism of ESG funds, with some validity.
ESG funds and investment decisions stand accused of placing ‘political’ considerations above those of investment returns, investors and beneficiaries. For example, in response to the politicisation of ESG funds, the US Senate recently overturned a ruling that allowed retirement plans to consider ESG factors when making investment decisions. Whereas only the most sceptical would deny the reality and future impact of climate change, a difficult question confronting legislators, fund managers and individual investors is whether some form ESG investment ought to be prescribed and whether any short-term sacrifice of returns through ESG investing can be justified for the longer-term gain of sustainability. This is a generational question of course in which millennials have a vested interest in inheriting a greener planet, but they also have a longer-term investment horizon in which to realise their ESG investments in low carbon technology and green energy alternatives.
The dilemma facing ESG funds and investors is also highly material. Any fund manager’s primary responsibility and objective is to ensure no permanent loss of capital and to ensure long-term sustainable returns for clients. Fund managers are of course required to act legally at all times as well as ethically. But it is this latter point of ethics that is moot. Is it ethical to bypass an entire category of investments in order to claim ESG credentials? For example, the recent phenomenon of super profits by the oil majors produced fantastic returns and dividends for investors as well as extraordinary windfall tax collection by governments. Moreover, in purely financial terms, ESG funds and their investors simply lost out on this wave of energy company super profits. Is this ethical towards pension fund investors facing retirement in a high-inflation environment?
But even if the case for ESG investing is made on ethical and principled grounds, the entire industry has yet to deal effectively with the twin problems of greenwashing and lack of consistent criteria for ESG qualification. Broadly speaking, ‘greenwashing’ refers to companies spending more time and money on marketing their sustainability credentials than actually minimising their environmental impact. This practice is far too widespread and further incentivised by the investor premium earned by companies qualifying for ESG fund membership. Crude forms of greenwashing can simply be the adoption of ‘green’ labels and unsubstantiated sustainability claims regarding product and process. For example, ‘certified 100% organic’, is increasingly seen on food and clothing labels, but with no explanation of what 100% organic actually means, nor who provided the certification and against which objective measurement? Other forms of greenwashing are found in data or standards manipulation. The most infamous case of this was the deliberate and systematic manipulation of Volkswagen exhaust emissions to bypass US Environmental Protection Agency limits in 2015. The software deployed by Volkswagen to bypass exhaust emission restrictions was deployed in 11 million vehicles worldwide, including 500,000 in the US. The company paid an enormous price for this greenwashing, seeing its share price drop by one third in the days following the exposé, with further massive costs incurred in the retrofitting of corrective software and the reputational damage to one of the world’s leading motor manufacturers and flag bearer for German global exports.
Yet the flip side of the Volkswagen greenwashing scandal turns on the question of inconsistent, and some would argue, unfair emission standards imposed by the US EPA and the State of California in particular, which placed European manufactures such as Volkswagen at a distinct disadvantage. And this is the rub with much of ESG investing today and that is the lack of agreed frameworks, criteria and standards against which to evaluate, punish and reward companies. Currently, there are some 600 ESG standards applied globally, and it is easy to see how individual companies could pick and choose the standard that best suits them and that places them in the most favourable position.
In South Africa, we face similar challenges regarding the variability of ESG frameworks and standards, although the JSE, together with the King lV code, provide helpful company reporting guidelines. We have some great South African companies who deserve the green/sustainability accolades they have earned over the years, but before rushing in to invest the hard-earned savings of investors, asset managers have an absolute fiduciary responsibility to objectively evaluate and justify their reasons and motivations for investing their clients into ESG funds.
ESG investing should not be done for fashionable, woke or political reasons, but rather as a sober and well-reasoned investment strategy that suits both the individual investor and the skill-set of the asset manager. Amidst the headlong rush to fashionable investing, avoiding the greenwash spin is the professional and ethical responsibility of the South African asset management industry.