Hriday Dhawan

Over the last several years, Environmental, Social, and Governance (ESG) investing has progressed from an oddity of an ethical preference to one of the drivers in rapid developments in the global capital markets. With governments, businesses, and investors struggling to figure out how to honestly respond to extreme pressures to deal with climate change, social inequity, and governance failures in a systematic manner at every level, ESG frameworks offer a path to allocate capital to the collection of business activities that produce a more sustainable and responsible allocation of capital. Investors are invited to do well by doing good, potentially benefitting from attractive returns and investing in sustainable outcomes at the same time.

While this promise has been an important motivator of explosive growth in ESG capital, global ESG has over $25 trillion in total assets at the end of 2023, and expected average annual growth of nearly 19% per year for the next 5 years. Other institutional large players such as BlackRock are simultaneously beginning to elevate ESG investing to a core methodology in their investment approach, suggesting ESG investing has grown to be “normal” to mainstream behavior.  However, with the growth and normalization of ESG as an investment philosophy, a lot of skepticism has begun to develop surrounding the meaning of ESG for investment portfolios. Skeptics cite multiple factors but usually are especially motivated that ESG is a lot of times simply ‘greenwashing’ in as much as it has become a more sophisticated marketing technique for companies to appear more sustainable without having to actually act in a more compliant fashion.

This article analyzes the effect of ESG investing had on company actions and financial performance to further be able to evaluate if ESG is a legitimate mechanism for sustainability, or simply a culling for greenwashing. By examining ESGs data-related challenges, market performance, and effect on corporations we see a somewhat hybrid reality where there is hope and promise notable dangerous elements. Along the way we apply financial theory and empirical evidence, to prove an accurate and balanced representation on how ESG investing is shaping the current market.

The Rise of ESG Investing: Drivers and Appeal

The sharp climb in the ESG investing space results from a unique combination of social, regulatory, and financial forces coming together. Increased awareness of climate change, movements for social justice, and corporate scandals and collapse have moved sustainability and ESG matters up nearly the very top of investor priorities when deciding where to deploy capital. This social momentum is situated alongside ongoing and growing evidence that environmentally and socially favorable practices can lead to changes in financial risk and return when investing money into ESG defined funds and investments.

Institutional investors are the largest actors in the capital/debt markets. BlackRock asset management has assets under management of roughly $10 Trillion with approximately $700 Billion in ESG funds or related investments. They openly advocate for ESG, as a focus area, as the best-for-business approach that is necessary for access to strategic long-term thinking. Similarly, regulatory guideposts like the “Sustainable Finance Disclosure Regulation” (SFDR) for the EU also require asset managers to be clear about how they disclose the sustainability risk of assets and how they measure it. This is changing how managers are embedding ESG considerations from being a personal motivation to that of one’s firm in order to influence ethics and values around investing.

These ethical and financial incentives have accelerated ESG’s appeal among millennials and Gen Z investors, who prioritize social responsibility. According to Morgan Stanley, 85% of individual investors expressed interest in sustainable investing in 2023, compared to 65% in 2019.

ESG Data: The Crux of the Matter

The practical implementation of ESG investing has a major obstacle – data quality and standardization. While financial accounting standards exist universally, ESG does not. This led to an ecosystem of rating agencies, each using different methodologies to create ratings and the environmental social governance marketplace is inherently fragmented and has incompatible methodologies. There have been several studies showing that ESG scores from different providers lack correlation, which means investors cannot rely on the scores. For example, one rating agency may put a good rating on a company for having sustainable strategies, but that same agency may find that the company has poor governance and assess it a bad rating.

This inconsistency frustrates investors who are trying to find true ESG leaders and avoid laggards. The inconsistency has to do with what ratings agencies consider in arriving at their ratings. ESG ratings contain both qualitative and quantitative variables that differ in scope, timing, and weighting. What is more, ESG data contains a lot of self-reported metrics companies provide.  With self-reported data, there are inherent problems such as selective disclosure or “cherry-picking” favorable dates, which creates a lack of auditability, and can lead to potential greenwashing if companies are using ESG to market themselves as sustainable, without appropriate operational changes being made.

ESG ratings are, by nature, backward looking, and based on historical data, which may or may not include an organization’s emerging risks and innovation, at the core of an evolving sustainability agenda.

Another level of complexity is raised by the controversies pertinent to ESG, including lawsuits, spills, and labor disputes that can potentially have significant material implications on ESG ratings. This introduces additional volatility into ESG scores and makes them less reliable and predictable than established financial metrics.

Even given all of this complexity, there are still some clear movements towards greater types of standardization, specifically efforts to establish global ESG reporting standards through the IFRS Foundation’s recently created International Sustainability Standards Board (ISSB). The purpose of these types of initiatives to establish global standards is to enhance comparability, reduce potential greenwashing, and improve investor confidence.

ESG and Corporate Behavior: Influence or Illusion?

One of the principal promises of ESG investing is the potential to influence corporate behaviour, primarily through capital allocation and shareholder behaviour. It has also been demonstrated that despite the probable lack of formal reporting, the pressure of investor scrutiny and the prospect of ESG-related capital may induce corporations to improve environmental disclosures, strengthen governance, and act socially. Many of the larger asset managers routinely either vote against directors for failure to meet their ESG standards or are far more engaged in sustainability conversations.

For example, shareholder activism campaigns have led companies like ExxonMobil to adopt emissions reduction targets, and Walmart to improve supply chain labor standards. These changes indicate that ESG investing can cause real corporate reform. On the other hand, Volkswagen’s “Dieselgate” scandal is one of the most notorious instances of ESG greenwashing, revealing the vulnerability of ESG ratings and the dangers of self-reported data.

However, this influence has limits. Some changes remain symbolic rather than transformational. Companies may engage in “ESG arbitrage”, focusing on easily measurable ESG indicators while ignoring complex or controversial issues. This behavior reflects a tension between genuine sustainability and market-driven incentives to appear compliant.

Financial Performance of ESG Investments: Evidence and Theory

From an investment/financial performance viewpoint, ESG investing seems to have successfully argued against the notion that we need to trade returns for values or ethics. Evidence indicated that ESG funds may have provided superior long-term investment returns, compared to traditional equity investment. In 2021 and again in 2023, ESG funds produced a median return of 12.6 compared to 8.6 percent return for non-ESG funds. The private-market side of ESG and impact also produce strong and competitive returns in the range of 8.4 to 26.6%.

Financial theories, such as the Modern Portfolio Theory by Harry Markowitz, recognized the issue of diversification and risk adjusted returns, as the concept of risk. The inclusion of ESG factors to the ESG investment strategy can enhance the efficiency of the portfolio by avoiding significant exposure to unidentified and unrecognized risks, such as those related to climate risk, regulation, and reputational risk.

However, these benefits are not uniform. Excluding entire sectors such as fossil fuels may reduce diversification and increase portfolio risk according to MPT principles. The trade-off between ethical exclusion and maximizing financial returns remains a challenge for ESG portfolio construction.

The Challenges and Limitations of ESG Metrics: Navigating Data Inconsistencies and Greenwashing Risks

One of the biggest problems with ESG investing is that different rating agencies have different agendas when scoring companies, causing different ESG ratings. For instance, MSCI, S&P Global, and

Sustainalytics all have their own criteria and weightings, thus there is a range of possible ESG ratings for

a company, which increases the uncertainty for investors (MSCI, 2022). This is because there is no consistent standard, leaving investors confused about which ratings are credible.

There have been new developments such as the International Sustainability Standards Board (ISSB); both the ISSB and the IFRS Foundation aim to have common and transparent reporting rules (IFRS Foundation). However, creating standardization takes time and the work on developing sustainability disclosure standards is ongoing.

These inconsistencies not only make ESG investing an easy target for greenwashing (an example of ESG investing distracting from ‘real’ impacts). For example, companies may highlight their good environmental or social behavior to create an impression of being responsible without any real or ongoing change happening behind the scenes.

Regulators to have provided us with rules that enforce clear and truthful reporting, for example, the

Sustainable Finance Disclosure Regulation (SFDR) that came into effect June 2021 introduced by the European Commission (European Commission, 2023). Nevertheless, investors should be aware that there is no government regulation with ESG ratings and scores ultimately weakly rely upon trust and integrity of the companies themselves. Investors should be vigilant and incorporate other ways into their assessment to avoid being misled, instead of solely using a number of ESG score.

The Regulatory and Technological Evolution of ESG

Understanding the data and credibility concerns with ESG, regulators are placing greater emphasis on assuring better reporting standards with ESG. The EU’s Sustainable Finance Disclosure Regulation universally mandates that disclosures about sustainability-related risks and performance must be detailed and impact-oriented. This regulation aims to improve comparability and reduce greenwashing, which is central to its rationale. Similarly, the United States Securities and Exchange Commission (SEC) is currently proposing new rules that would mandate climate-related disclosures.

Advances in technology further support and complement the regulatory landscape. AI technologies, along with powerful big data analytics, are increasingly being used to analyze satellite images, media sentiment, and social media, and produce more interactive and real-time ESG sensibility. These advances represent demonstrable change also from backward-looking data analysis into timely risk assessment, evolving towards more precise funding decisions in socially responsible ESG investing.

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Conclusion

ESG investing is at a tipping point. It is not a silver bullet to global sustainability problems nor a shallow exception from corporate greenwashing. ESG as a movement has gained incredible momentum, with over $25 trillion in ESG assets, strong performance against traditional funds, and clear indications that awareness and willingness to act is developing within the investor, regulatory, and corporate community, the transparency and engagement across ESG disclosures will ideally likely improve.

However, ESG’s potential is impeded by insufficient data clarity, ratings inconsistencies, and compliance tick-boxing. In the future the industry needs to build firm standards, regulatory barriers, and technology enhancements to maximize the “ESG” concept as a driver of true sustainable change.

At its heart, ESG investing is about balancing the financial imperatives with moral imperatives in for-profit capitalism. With sufficiently rigorous due diligence, investor activism, and responsible governance, ESG investing can be pathway to sustainability and is much more than a greenwash.

Designation – Hriday Dhawan — Grade 11 Student, Delhi Public School, Bangalore East.

References

European Commission. (2023) Sustainable Finance Disclosure Regulation (SFDR). Brussels: European Commission.

International Financial Reporting Standards Foundation. (2023) International Sustainability Standards Board (ISSB) Launch. London: IFRS Foundation.

Morningstar. (2023) Global Sustainable Fund Flows Report Q4 2023. https://www.morningstar.com/articles/1086543/global-sustainable-fund-flows-report-q4-2023

MSCI. (2022) MSCI ESG Ratings Methodology. https://www.msci.com/documents/10199/239004/MSCI+ESG+Ratings+Methodology.pdf

Morgan Stanley. (2023) Sustainable Signals: Individual Investor Interest. New York: Morgan Stanley Institute for Sustainable Investing.

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