Cutting Through the Nonsense Around ESG
Block out the noise and focus on these three points.
There is a lot of noise about ESG these days, and it’s coming from different directions. Mostly from Europe comes the claim that ESG is just greenwashing by the world’s largest asset managers, distracting attention from the urgent need for comprehensive policy solutions to climate change and other global sustainable development goals. From traditionalist investors, ESG is said to be unnecessary for investment decision-making and doomed to underperform. And Republicans in the United States have recently ginned up the idea that ESG is a scheme to advance the “leftist” goals of putting the fossil fuel industry out of business and imposing diversity, equity, and inclusion on corporations that don’t want it.
Most of this is nonsense, but it muddies the waters for sustainable investors, advisors, and asset managers. If you are a sustainable investor or interested in becoming one, what should you make of all this? If you are a financial advisor, how should you advise your sustainability-minded clients? If you are an asset manager, how should you be communicating your approach to advisors and end investors? My advice is to block out the noise and focus on these three points:
1) Use “Sustainability,” Not “ESG”
This promotes better communication and understanding. It’s also a more accurate way to understand investor preferences. Few of us think of ourselves as inherently “ESG” investors. It is unfortunate that this short-hand and, to most, meaningless initialism (it’s not even an acronym!) has become so widespread. Its use obscures what investors are really interested in, confuses advisors, and makes it easier for critics to malign. Sustainability, by contrast, is a concept that is widely understood and popular. Using it meets people where they are.
Sustainability may not mean exactly the same thing to everyone, but most people have positive feelings toward the term. (That’s why critics avoid using it.) Sustainability has been defined as meeting our own needs without compromising the ability of future generations to meet their own needs. I think of it as a societal goal that broadly aims for us to coexist and prosper on planet Earth over a long time. Sustainable decision-making is not limited to what is in our own narrow self-interest, but it considers an extended sphere of stakeholders, and not only people, but the planet.
I believe that a sustainability ethos is in ascendence today, especially among younger people and those who are more likely to become decision-makers at key institutions like public companies and asset managers. At the individual level, more of us are making both everyday and life decisions with sustainability in mind—consumer decisions, career decisions, lifestyle and locational decisions, political decisions—and so it should come as no surprise that those who are fortunate enough to be investing increasingly want to make their investment decisions with sustainability in mind.
2) Know That Sustainable Investing Covers a Range of Approaches
This is central to developing an accurate understanding of the field. In fact, I have written that there are six commonly used approaches to investing that may satisfy end investors’ desire to apply a sustainability lens to their investments. Furthermore, real-world sustainable investment strategies and funds often combine more than one approach. Thus, one sustainable fund may not be much like another.
Much confusion exists between approaches that use information about material environmental, social, and governance issues to achieve a more holistic view of an investment and those that emphasize the broader societal impact of an investment. In fact, ESG best describes the metrics and ratings that are inputs to investment decisions. Most often, ESG information is used to help manage risk, but many sustainable strategies also use it to help uncover investment opportunities.
To end investors not familiar with how ESG information is being used, there is often confusion and disappointment when they see companies that they perceive to have a negative societal impact in a sustainable fund portfolio. But few sustainable funds evaluate their investments solely on the basis of broader societal impact. Impact approaches are less well-developed, and less information exists for investors to use in evaluating impact. The field may be catching up with investor preferences. For example, Morningstar Sustainalytics has focused mainly on its ESG Risk metrics and ratings for a long time but just recently began releasing impact metrics. On the one hand, there is using ESG information to evaluate issues that may affect a company’s financial performance. On the other, there is using impact metrics to assess a company’s broader societal impact. They are not necessarily mutually exclusive concepts, but they are two different approaches, and sustainable investors need to be aware of them.
3) Asset Managers: Communicate Exactly What You Are Trying to Accomplish in Your Sustainable Funds
To date, many asset managers have failed at this task. The U.S. Securities and Exchange Commission has tackled this issue in a proposed rule that is currently in the public comment period. Regulation will go a long way toward mitigating this problem, but funds need to make clear what approach or combination of approaches they are using. They need to provide more-specific reasons why they hold certain companies and how those holdings fit the fund’s sustainability focus. They need to distinguish whether they are using ESG information to help them generate better investment results and whether they are considering broader societal impact. They should clearly articulate their approach to engagement and proxy voting. Because of its growing importance to many investors, they should all have a statement about how they are addressing climate change. They should also make clear what other investment factors come into play in the execution of the strategy.
With these things in mind, it’s easier to cut through the noise.
A lot of the greenwashing claims come from those who believe that impact rather than ESG risk should be the focus of sustainable funds. Keep in mind that sustainable funds are investments first, as they should be, and that most consider ESG risks and opportunities to help them uncover good investments. That doesn’t mean these funds have no impact, even if achieving impact is not a stated priority.
Investments must satisfy their basic reason for being: to provide an appropriate level of risk-adjusted return that helps investors reach their financial goals. Using ESG information to help make better investment decisions is thus something that all sustainable investors should desire. But in so doing, every dollar that goes into a sustainable fund that uses ESG information is signaling to public companies that a growing part of their investor base is concerned about sustainability and about companies addressing their material ESG issues. No public company today wants to be an ESG laggard. Many aspire to be sustainability leaders. They recognize that other stakeholders are increasingly sustainability minded and now many of their investors are as well. Sustainable investors can have more influence through engagement and proxy voting, and I expect they will play a key role from here forward in helping public companies set and meet their net-zero commitments. That’s impactful.
There is also the assertion that sustainable investing is somehow distracting from the “real” task of passing public policies that address climate change and other externalities of global capitalism. This seems like a non sequitur to me. Literally no one is making the claim that sustainable investing is a panacea for solving the world’s problems. But at a time when policymakers have not yet proved to be up to the task, especially in the U.S. where one political party unanimously opposes any action that would address sustainability problems, investors have been playing an important role at pressuring change in corporate behaviors. These include changing the demands that corporations make of politicians. Moreover, the global policy solutions needed have thus far been beyond the reach of national policymakers. Solving a problem like climate change requires all hands on deck. The alternative, I guess, would be to just forget it and return to traditionalist investing because there’s nothing anyone can do about anything.
The traditionalist investing critique assumes that funds using any type of exclusion (tobacco, guns, coal, and so on) will lead to underperformance, ignoring the myriad ways that portfolios can be optimized to account for exclusions. This critique also assumes funds use only the summary ESG rating of a company rather than the more nuanced approach actually used by most portfolio managers, who focus on more specific metrics and use multiple ESG data. Worse, the critics assume that ESG funds use company ESG ratings as the sole basis for their investment decisions, ignoring all other investment criteria. This is simply not true. Portfolio managers using ESG information are typically consulting more information, not less, than those who don’t use ESG information.
Finally, the Republican view on ESG is political hyperbole that seeks to marginalize and vilify the ideas that companies should focus on creating value for all stakeholders, address diversity and pay equity issues affecting their workforce, and take steps to alleviate the risks of climate change to their businesses. Notably, these ideas are widely supported, as polling from Just Capital has well established.
My advice for sustainable investors is to seek out funds that use ESG information to help them identify good investments, consider the broader impacts of investments in their investment analysis and engagement, and communicate clearly about what it is they are doing. An end investor’s portfolio of sustainable funds need not consist of funds with identical approaches. Of course, investors need to consider allocation for proper diversification, but they should also consider different approaches as a way to diversify the sustainability of their portfolios.
Jon Hale (email@example.com) has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.