By the end of 2021, Bloomberg Intelligence reports, worldwide ESG investments of all forms totaled $35 trillion. (ESG investments purport to consider environmental, social and governance factors alongside purely financial ones, although the term is unregulated.) Growth to $50 trillion is projected by 2025. In 2021 alone, more than $650 billion was newly invested in ESG-focused funds worldwide, according to Reuters, a nearly 130% increase compared to $285 billion in 2019. The rapid growth in popularity of ESG investing is hard to overstate.
But with such growth come questions, perhaps none more important than: what’s actually behind ESG investing? Beyond the acronym, there is no rulebook for how to properly incorporate environmental, social and governance criteria into investment decisions or management practices, no single definition that unites ESG investment managers. Instead, a host of practitioners—from large firms spending heavily on marketing to cash in late in the game, to firms like ours that were early adopters in the socially responsible investment movement of the early 1980s—must make their own definitions, and live with them.
For many ESG fund managers, ratings have become a primary research tool. ESG ratings provide an easy, even automated way to screen investments, allowing ESG portfolios to be built and marketed with minimal additional research on the environmental or social impacts of any particular company. One ratings agency in particular, MSCI, accounts for approximately 60% of all retail ESG investment, according to a recent analysis by Bloomberg.
While such concentration may sound like a welcome efficiency for ESG managers, the same Bloomberg analysis found that “almost 90% of the stocks in the S&P 500 have wound up in ESG funds built with MSCI’s ratings.” Put another way, MSCI’s ESG ratings are only ruling out about 10% of all S&P 500 stocks. Why? According to a recent New York Times Opinion article, there is little to no connection between MSCI’s ratings and a company’s environmental or social performance. In fact, MSCI ratings are not even designed to address companies’ environmental and social impact. Rather, they rate how well-prepared companies are to manage the risks that environmental and social challenges pose to their balance sheets. In other words, if you have a strong corporate strategy for protecting your bottom line from the effects of climate change, for instance, you can receive a high rating regardless of the extent to which you may be contributing to that climate change. Case in point: in 2022, fossil fuel giants Chevron, Conoco Phillips and Phillips 66 each received an “A” rating from MSCI. (Exxon Mobil, McDonald’s and Walmart all received “BBB” ratings, still earning a place in the “Average” band.) These are the ratings that form the basis of 60% of all ESG investment.
As practitioners of environmentally and socially responsible investing for more than 40 years, we have never used outside ratings as more than a data point—and a relatively minor one, given our considerable in-house ESG research. Our research instead begins with a detailed look at a company’s background, its products and services, its environmental initiatives and its ethics, to begin to assess the company’s social and environmental impact. We use this research not only to exclude companies with unduly negative impacts, but also to ensure those pursuing more positive environmental and social impacts stand out for investment consideration. While this approach may fall under the same heading as others who heavily market their ratings-based funds as “ESG,” we believe our approach allows us to build much more robust portfolios, in terms of environmental and social impact, than those that rely inordinately on outside ratings such as those produced by MSCI.
Another area where ESG investment practice can be at odds with its marketing is in proxy voting, where fund and investment managers typically cast shareholder votes on behalf of their clients. During the much-heralded 2021 proxy season, several major fund and investment managers supported climate-related resolutions for the first time (or at a higher rate than previously), as illustrated by non-profit Ceres in this graph. That support led to the approval of record numbers of climate-related resolutions last year. But in 2022, despite another record number number of climate resolutions, levels of support from large managers regressed significantly. Some large managers argued that proposals had become too proscriptive, but with public momentum for corporate climate action growing, despite conservative ESG investment backlash—and these investment managers’ own marketing continuing to tout their ESG credentials—those arguments increasingly put them in a bind.
Our own proxy voting strategy is, again, a bit different. Every holding we purchase on behalf of clients, along with a significant share of “legacy” holdings that clients typically brought with them when they came to us, undergoes a thorough proxy review (as described in our 2022 proxy season summary). Each shareholder resolution receives careful and equal consideration on its environmental, social, governance and financial merits. Because shareholder resolutions are prohibited by SEC rules from dictating how companies should run “ordinary business,” most resolutions related to environmental or social issues simply request that companies produce reports or audits, or set or align targets in accordance with their stated values. In such cases, we typically give the benefit of the doubt to shareholders—many of them working with firms like ours—rather than to companies we feel are extremely well-resourced to meet such requests. Many large managers, on the other hand, still seem to be using traditional, rubber-stamp proxy voting approaches even for investments that have been marketed under the banner of ESG.
For decades, socially responsible investment managers were forced to confront criticism that their strategies could not perform on a level with traditional investment management, or that environmental and social risk were completely divorced from financial risk. The coining of the term “ESG investment” in 2005 (by a group of large, global managers) was a welcome repudiation of these arguments. But today, overreliance on the ESG ratings industry and the blurring of the lines between traditional and ESG approaches risks diluting the hard work of the past 40+ years. Such dilution, in turn, enables further “greenwashing” by corporations, while allowing adverse environmental and social impacts to continue. To counter these risks, ESG investors can ask hard questions of their investment managers, interrogating what methods and approaches are used to justify the term “ESG.” Fortunately, if the answers are not satisfactory, many options for environmentally and socially responsible investment management still abound.