The Promises and Perils in the Rise of ESG Investing

Commentary: More investors consider environmental, social and corporate governance (ESG) factors important but aren't putting their money where their mouths are. This might have more to do with ESG investing's limits.

As the climate crisis grows in urgency, many investors want to use their money to make a positive change in the world. The predominant approach to sustainable investing is ESG, which uses environmental, social and corporate governance criteria for judging a firm’s behaviour. It promises to combine ethical or environmental considerations with financial reward, a win-win solution for investors. ESG investing is especially important to younger investors. According to United States finance company MSCI’s report in 2020, 89 per cent of millennials expect financial planners to consider a company's ESG credentials and impact before making recommendations. In Singapore, an HSBC survey found that 80 per cent of investors consider sustainable, environmental and ethical issues to be central to managing their investments. In reality, only a quarter of their investments consider ESG metrics. If the environmental and social outcomes of their choices mattered so much to retail investors, why aren’t they walking the talk?
Hesitation and a Lack of Knowledge HSBC suggested this gap arises from a lack of investor awareness. 66 per cent of respondents don’t want to lose out financially when they make an ESG investment, while 58 per cent don’t know how to embark on ESG investing, even though they would like to.

“Against the backdrop of growing financial obligations, higher living costs and less predictable employment prospects, a 2017 BlackRock survey found that 2 in 5 Singaporeans believe they will run out of money during retirement. To factor in positive change into their portfolios is a tall order.”

There are many doubts that hold retail investors back from trying a new financial product. They want an adequate rate of return and young working adults in particular can only bear so much risk. For many of them, they are putting their life savings on the line. Against the backdrop of growing financial obligations, higher living costs and less predictable employment prospects, a 2017 BlackRock survey found that 2 in 5 Singaporeans believe they will run out of money during retirement. To factor in positive change into their portfolios is a tall order. But advocates for ESG investing might cite funds’ robust performances to coax those on the fence. As the world was ravaged by COVID-19 in 2020, ESG stocks outperformed market benchmarks by up to 3.8 per cent. This trend extends over the long term too. Financial services company Morningstar found that six out of 10 Europe-based ESG funds yielded higher returns than traditional ones over the past decade.
Doing Good by Doing Well? The gap between investors’ ideals and actions can partly be chalked up to a lack of awareness. However, could more fundamental flaws of ESG investment be the culprit? Sustainable investing isn’t without its sceptics, who say the correlation between ESG and financial performance doesn't mean that higher returns were caused by ESG factors. Studies have shown that in most cases, they were simply the result of ESG funds’ exposure to higher quality stocks and better performing sectors. In fact, an ESG fund doesn’t guarantee market-beating returns at all. We have seen friends put their money in green investments and get burned. One invested in a US clean energy ETF (exchange traded fund) following the presidential inauguration of Joe Biden at the start of 2021. Many others worldwide did as well, expecting windfalls from an America taking climate change seriously again. But this wave of inflows in January 2021 formed a mini-bubble and the resulting correction in the following weeks wiped out a quarter of the stock price. This underscores how the workings of financial markets don’t always lead to better outcomes for the environment.

“For every investor who wants to support a transition to a green economy, there are those betting against the performance of green assets.”

As more money flows into ESG stocks, they become more expensive, reducing their relative returns. This makes “dirty”, non-ESG-compliant stocks cheaper, and therefore better value for investors. For every investor who wants to support a transition to a green economy, there are those betting against the performance of green assets. Even the most eco-conscious of investors cannot always act like activists fighting for change. They are still subject to the ebbs and flows of financial markets. Environmentalists often wonder whether investors can be regarded as allies.
Can ESG Investing Save the Planet? The more pertinent question then is whether ESG investing meets its objective of slowing down environmental destruction. On that front, the case for ESG investing is even weaker. For one, ESG scores are often highly abstracted. How much does an “AAA” ESG rating tell an individual investor about a company’s environmental actions? Is it enough for an investor to buy a stock just because they know that it has a high ESG score? This is compounded by the fact that the ESG landscape is highly fragmented, often providing divergent, contradictory ESG scores. For investors, it can be nearly impossible to come to an informed decision. The absence of consistent standards enables greenwashing over ESG. The August 2021 controversy involving German investment fund DWS, whose former chief sustainability officer alleged that it misrepresented the environmental credentials of its ESG-labelled products, is one of many. Despite these shortcomings, investors who want to make a difference don’t have to turn their back entirely on ESG funds. But they must go in with their eyes wide open. The first step would be to ask the right questions: Whether a fund was built for achieving ESG outcomes, or just a conventional fund repackaged to attain as high an ESG score as possible; what a firm’s ESG engagement capabilities and engagement history are. These go a long way in making informed choices. Regulators can also help by implementing uniform frameworks and standards. The last thing investors would want is to sink their funds in ESG products, only to realise down the road that such ESG claims were fabricated, as was the case with DWS.

“Beyond small steps such as climate risk disclosures, which are soon being implemented in Singapore, more needs to be done to penalise polluting economic behaviour.”

This will necessitate an active role played by governments. Beyond small steps such as climate risk disclosures, which are soon being implemented in Singapore, more needs to be done to penalise polluting economic behaviour. This may include measures like a rigorous, well-enforced green taxonomy, which classifies assets as clean or dirty. For example, fossil fuels, even the lowest emitting types like natural gas, must not be counted as clean. Such regulations will help sort the wheat from the chaff of ESG ratings. The issue is ultimately one of scale. As is the case with emissions, the greening of finance will be determined by the actions of governments, corporates and financial institutions, all of whom wield far more power and influence than consumers or retail investors. As interest in ESG investing grows, all this will determine whether it’s just a moneymaking fad or if it can rise up to the demands faced by a planet in peril.

This insight piece was co-authored by Bertrand Seah and Tok Xinying and first published as a commentary article titled “Why investing in green funds isn’t so simple” on CNA. Bertrand is part of the team at the Green Swan Initiative. Xinying is a co-founder of Climate Conversations and works with institutional investors on climate transition issues.