The knives are out for Environmental, Social, and Governance, or ESG, investing, notably in two recent essays.
A blog post from NYU finance professor Aswath Damodaran, which called ESG “a mistake that will cost companies and investors money, while making the world worse off, but that it create more harm than good for society.”
Not long ago, Tariq Fancy, the former chief investment officer for sustainable investing at BlackRock, argued that sustainable investing is a “placebo” that allows people to avoid grappling with difficult environmental and social challenges.
Fancy and Damodaran draw a number of correct conclusions, most notably that ESG and sustainable finance haven’t yet accomplished their full objectives. Yet they both throw the baby out with the bathwater by
- Blurring the lines between risk and impact.
- Not understanding what ESG has accomplished.
- Failing to recognize that we are in the early innings of the adoption of ESG with many innings yet to play.
Damodaran positions ESG as focused on ‘doing good,’ which may lead to financial outperformance, or not. The reality is that ESG products and research are more focused and targeted than that--with specific ratings, research, and approaches for the motivations of risk, impact, and values. ESG ratings firms are aiming to provide better, more comparable data and signals to support the analysis of factors that previously were challenging for investors to analyze. Money managers are in the risk management business. Incorporating material ESG considerations into investment decision-making is a fiduciary obligation. As such, ESG risk management may well become so normal over the next few years that the ESG label may become unnecessary.
ESG has accomplished a great deal.
I agree that there are many shortcomings when you look at where we are right now. For example, in places it is challenging for investors to manage ESG risks because data is unavailable--for example, climate risk. Capital is certainly not yet being allocated in the most sustainable way. And there is a degree of greenwashing from corporations and within some financial products. Poor disclosures from companies and a lack of necessary government action contribute to these gaps.
However, it is entirely wrongheaded to think that ESG has created no positive impact. The increasingly widespread adoption of ESG reporting, practices, and pressures have achieved incredible success in helping to bring the most important societal issues into the focus of investment and corporate strategy.
Would we ever imagine that something as significant as the European Union Action Plan on Sustainable Finance, likely upcoming Securities & Exchange Commission regulations on mandatory climate disclosures, or lawsuits against companies for greenwashing, including Royal Dutch Shell (found to be partially responsible for climate change and ordered to reduce emissions) or Deutsche Bank’s asset-management arm (accused of overstating how much sustainable investing criteria it used in managing portfolios), would have happened in the absence of the ESG movement?
Moreover, the bar for what constitutes acceptable corporate behavior has changed dramatically in the past decades in part because of ESG. Are we where we need to be? No. If ESG provides people with that illusion, that is mistaken. But ESG, broadly speaking, is pushing in the right direction.”
ESG is still maturing.
We are in the early innings when it comes to ESG. Moreover, ESG has been running uphill without a lot of the basic necessary requirements--such as robust corporate disclosures, even when it comes to material issues. The level of ESG adoption that we are seeing across regions and among different financial market participants is remarkable. But it is also possible that ESG is at times being oversold. It is therefore predictable that ESG is facing a bit of a comeuppance.
The Gartner Hype Cycle may have some similarities to how ESG may evolve within the marketplace. There is a period of rapid adoption that perhaps leads to inflated expectations, followed by a period of disillusionment and criticism, and finally a period of stable mainstreaming. ESG is not going away because the issues that are material from a financial and impact perspective are only becoming more financially impactful over time.
There is also a widespread understanding, at least among many influential market participants, that we need to find a way for the financial system to allocate capital better--so that it leads to more sustainable environmental and social outcomes.
It is also clear to us, especially within Sustainalytics, that ESG ratings, research, data, and tools are all going to improve over time--the pace of innovation is high, and the quality of information we are working with is improving.
The upshot.
While I agree that today’s approach to sustainable investing faces challenges, that doesn’t mean companies and investors should give up their efforts to deploy private capital more sustainably. Nor does it mean that investors can afford to disregard ESG Risk factors that are material.
Is Aswath Damodaran right in his criticism of ESG?: Leslie Norton, Morningstar's editorial director of sustainability, explains that while Damodaran raises some good points, he's mostly wrong on his key assumption.
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