ESG investing facing a bumpy road (2024)

Sustainable investing has become a partisan political topic in the US and the subject of increased regulatory scrutiny in Europe. What does the future hold for ESG?

It seems like only yesterday that wealth and asset managers began boasting about the financial services industry’s key role in the transition to a ‘Net Zero’ economy. In 2020, Larry Fink, CEO of BlackRock, the world’s largest investment house, promised to reshape finance and put “sustainability at the centre of our investment approach”. He was not alone. Fellow fund giants Vanguard and State Street started developing environmental, social and governance (ESG) strategies as the green movement gathered pace.

Consensus around combating global warming continues to advance, with high-profile agreements made by world leaders attending the UN’s COP28 climate meeting in Dubai in late 2023, focusing on transition away from fossil fuels.

But despite this early momentum, the ESG investment journey has now run into some major roadblocks. BlackRock’s Mr Fink will no longer use the term “ESG”, believing it has become “weaponised”. Similarly, the firm’s annual report on priorities for the year dropped references to “global warming” included in previous iterations.

The whole issue has been become partisan and political in the US. In December, the state of Tennessee sued BlackRock for misleading consumers about the scope of its ESG activity. This followed Texas, Florida, South Carolina and other Republican states pulling assets from BlackRock, claiming the asset manager was effectively boycotting fossil fuels. BlackRock has denied this, leading to complaints from the left of the political spectrum. This politicisation of ESG is only likely to increase as November’s presidential election grows closer.

In Europe, fund firms are being reprimanded for not being green enough, with the spectre of ‘greenwashing’ of investment products hitting the headlines. In May 2022, German prosecutors raided asset manager DWS, and the headquarters of its majority owner Deutsche Bank. This followed allegations from a whistleblower claiming investors were being misled by products not as environmentally friendly as was being claimed. The prosecutors say the investigation is ongoing, and revisited the DWS offices on January 16 this year to carry out another search. In September 2023, DWS also agreed to pay a $19m fine to settle charges brought by the US Securities and Exchange Commission over misleading statements made about its ESG investment process. ESG has become an area that regulators on both sides of the pond are now taking seriously.

Stormy weather

So just how severe are the headwinds facing ESG? So far, the “backlash” has been mainly confined to the US, says Amin Rajan, CEO of the Create-Research consultancy. “That it is a part of a wider pushback against ‘woke capitalism’, which is contained mainly to the Republican states,” he says.

Republican states, says Mr Rajan, are trying to ban asset managers from engaging in ESG investing, while Democratic states are moving in the opposite direction, making greater demands when it comes to sustainable investing.

“It is like a tug of war, which in my view is going to end up in the courts. It won’t be settled easily, whether Trump wins in November or not,” cautions Mr Rajan.

This high-octane politicisation of ESG in the US — resulting from attempts to protect the fossil fuel industry — has yet to impact Europe, confirms Hortense Bioy, global director of sustainability research at Morningstar. Yet she believes the direction of travel — towards a greener, cleaner future — will not change, even if Republican Donald Trump is returned to the White House in the upcoming presidential election.

The consensus is that Joe Biden’s Inflation Reduction Act, already well under way, will not be repealed, though it could end up losing some of its intended impact. “The legislation could still be watered down, while measures more favourable for fossil fuel companies are introduced, contradicting what was agreed at COP28,” warns Ms Bioy. “But there’s still going to be lots of investment in renewable energy, in technology to mitigate climate change, in carbon capture and storage. No one will stop that.”

This landscape makes things incredibly difficult for asset managers operating in the US, especially those with operations across different states. “It is a case of damned if you do, damned if you don’t,” says CaraWilliams, global head of ESG, climate and sustainability for wealth management at the Mercer consultancy. “I’ve had a couple of asset managers ask me whether they should be hiding their ESG credentials in certain pitches,” she says. “You’ll have one state looking to transition its entire public pension to Net Zero, and in the same week another looking to prove they have no ESG integration whatsoever.”

Across the pond

Although there have been some political elements to the ESG story in Europe, including the UK government’s U-turns on oil exploration and key climate policies, the ESG trend has not been politicised to the same extent as in the US. Here the story is more about regulation and so-called ‘greenwashing’ of funds, which were not nearly as sustainable as those investing in them had believed.

In Europe, the Sustainable Finance Disclosure Regulation (SFDR)was introduced to improve transparency in the market for sustainable investment products, to prevent greenwashing and increase transparency around sustainability claims made by financial market participants. Substantive provisions of the regulation have been effective since March 2021.

Since then, many investment products have been launched, or rebranded, with an ESG theme. “There were all sorts of branding names, without really having underlying investments that were reflecting that,” says Maurizio Carulli, senior corporate research analyst, oil and gas, at think-tank Carbon Tracker. “They might have a few renewable energy stocks. But the reality was that the bulk of these funds were invested in other stocks.”

A resulting backlash from regulators has prevented products being marketed as sustainable, if their investments favour non-sustainable stocks. Similar pressures have come from investors, claiming they were not gaining exposures to sectors they thought they were buying into.

“The regulators have responded by tightening definitions,” says Mr Carulli. “They have done it well. A little too late, probably, but it certainly is a worthwhile initiative.”

Meanwhile, asset management firms have started rebranding ESG products, now positioning them as more traditional funds. This confusion about just how ‘green’ funds really are is nothing new, claims Mark Campanale, Carbon Tracker’s founder.

“We’ve been talking about this for 35 years, right from the beginning,” he says. “Back when I was at Jupiter Asset Management, 30 years ago, we wrote a paper on the assessment process for green investment, to try and explain to people what’s really going on.”

Rather than deliberately greenwashing their funds, Mercer’s Ms Williams believes most asset managers were merely jumping on the ESG bandwagon, particularly when marketing products, without recognising the impact of what they were doing.

“I think the impact of this mislabelling was really felt at the retail level,” she says. “I don’t think advisers knew what the ESG label meant and were not conveying it very well. At the institutional level, there has always been a better understanding of this.”

Abuse of the ESG story

One of the results of these pressures is that after several years of ESG being in the limelight, investors are experiencing “disappointment and fatigue” with the topic, says Didier Duret, chairman of the board at Omega Wealth Management, which oversees the assets of wealthy European families.

“Greenwashing isn’t the right word,” he says. “But we did see abuse of the ESG story. So many firms jumped on the bandwagon, but have they delivered? Several years ago, we were all greens. If you look at the annual reports, today’s tone is very different.”

Many banks have been making ESG criteria the default option for retail clients, claims Mr Duret, especially over the past two years, leading to some clients complaining, because their investments underperformed.

“ESG is basically a form of thematic investing, so it cannot encompass the full universe,” he says. “Whether it’s ruling out mining or energy stocks, it’s restricting what you can invest in and limiting diversification. Of course, there are times when it is okay, and times where it’s not okay, but with ESG, we are aggregating into concentrated ideas where the free will of individuals is left behind.”

Banks are becoming increasingly marginalised from this specialism, as family offices put their own research facilities and investment approaches in place, no longer needing major wealth managers to act as their moral guardians, adds Mr Duret. “Wealth managers and family offices remain interested in ESG, but in a very bottom-up, pragmatic way,” he says.

Pre-Covid, there was a “little bit too much noise” around ESG, admits Daniel Wild, chief sustainability officer at J. Safra Sarasin Sustainable Asset Management, with many firms claiming to do things “stricter, faster and earlier than others”.

“Maybe the pendulum went a little bit too much in that direction, from negligence to overexcitement,” suggests Mr Wild. “Perhaps it is healthy for us to take a moment and ask, ‘What does this all mean? What do we do for ethical reasons? What do we do for financial reasons? And what should we do for impact?’ Everybody can choose. And my hope is that the regulations goes only so far as to create transparency and comparable tools.”

Following an explosion in ESG product development in recent years, 2023 saw a slowdown, states Morningstar’s Ms Bioy, predicting a trend of funds setting decarbonisation targets. She also explains that while many products have been focused on the ‘E’, or environmental, it will be interesting to see what happens to the ‘S’ and ‘G’ factors, while fixed income is an area set for more activity.

“We are seeing a lot of products repurposing, evolving their ESG agendas,” says Ms Bioy. “We’re going to continue to see transformation and product launches, but this will take the form of much more moderate product development activity than in the past.”