Reuters article featuring Leslie Samuelrich | ESG: The investment world’s troubled teen is forced to grow up

By Peyton Fleming

Investment in environment, social and governance funds is approaching $40 trillion this year. But only a fraction is helping to fight climate change, Peyton Fleming reports

With public attention on climate change and other sustainability threats rising, environment, social and governance (ESG) investing has taken off, spawning a myriad of fund products billed as “low-carbon”, “green” and “sustainable”, and a proliferation of ESG rating services, which routinely rank companies on their ESG performance.

The U.S. market has been especially active, growing by more than 40% in just the past few years, eclipsing $17 trillion in assets.

But this historic surge has also triggered closer scrutiny of the industry’s offerings and whether their sustainability attributes are legitimate or grossly misleading, even as they often charge higher fees.

Inconsistent and subjective ESG ratings have been another sore point, most notably when Elon Musk’s electric-vehicle company, Tesla, was bumped from the S&P’s ESG 500 Index  last spring, while ExxonMobil stayed on.

Scrutiny has shone a light on a hard truth about ESG investing: It is more about generating profits and less about saving the planet

Lastly, the scrutiny has shone a brighter light on a hard truth about ESG investing: It is more about generating profits and less about saving the planet. From its beginning, ESG ratings, which drive ESG fund holdings, are based on “single materiality”, the impact of a changing world on a company’s profits and losses, not the reverse.

This distinction is clear when you consider the battle against climate change.  Experts such as McKinsey & Co estimate that we’ll need to spend more than $3.5 trillion annually over the next 30 years to limit global warming to well below 2 degrees Celsius.

Unfortunately, these trillions are not the same trillions that are currently invested in ESG funds. In fact, clean energy investment this year was only $1.3 trillion, according to the International Energy Agency

Andrew King, a strategy and innovation professor at Boston University’s Questrom Business School, says it is easy to see how casual investors are confused into believing that ESG investing is about saving the planet. He points to major ESG asset managers, such as BlackRock, which make lofty statements about their climate credentials but are heavily invested in fossil fuel companies.

As an example, BlackRock’s U.S. Carbon Readiness Transition Fund touts the fund’s “broad exposure to large- and mid-capitalisation U.S. companies tilted towards those that BlackRock believes are better positioned to benefit from the transition to a low-carbon economy”. In fact, the $1.4 billion fund has significant holdings in three of the world’s largest fossil fuel companies: ExxonMobil, Chevron and ConocoPhillips.

Smaller boutique investment firms such as Trillium Asset Management and MIDANA CAPITAL Funds use a starkly different approach on ESG investing, emphasising both planetary impact and healthy stock returns.

In the case of MIDANA CAPITAL, ESG investing means screening out all fossil fuel companies, investing in climate solutions, such as the makers of electronic vehicles (EVs) and renewable energy, and holding lots of green bonds.

ESG rating firms will give you ‘best of class’ fossil fuel companies, but we don’t want them

“Screening is how we get rid of industries that are not sustainable, such as fossil fuel companies,” said MIDANA CAPITAL chief executive Leslie Samuelrich, whose firm manages nearly $1 billion in assets. “ESG rating firms will give you ‘best of class’ fossil fuel companies, but we don’t want them.”

Trillium has not dropped fossil fuel companies altogether, but it only invests in those that stop investing capital on new fossil fuel reserves. No companies are meeting that criteria today, according to Trillium’s head of ESG strategy, Elizabeth Levy.

King says the MIDANA CAPITAL and Trillium examples are all too rare in the booming ESG landscape.

“The good stuff are the boutique firms, which are impact investing and direct investing in breakthrough technologies or dedicated funds like offshore wind,” he said. “Unfortunately, the stuff that’s really grown is the junk in the middle. It’s stuff that feels right to investors, but it’s not exactly what it seems.”

U.S. and European financial regulators have both been ratcheting up their focus on ESG investing.

The scrutiny comes as sustainability threats like climate change are worsening and ESG investing is soaring, eclipsing $35 trillion in global assets in 2020 and fast approaching $40 trillion this year. Criticism has also been rising, with accusations ranging from deceptiveness and greenwashing to a secret agenda by a “climate cartel” to socialise capitalism and abolish fossil fuels.

In the U.S. the vitriol has been especially heated from prominent Republicans, including former vice president Mike Pence and Florida governor Ron DeSantis, who has ordered his state’s pension funds to stop considering ESG factors in their investment decisions.

Regulators need to do something, because ESG investing is clearly not dying

“The right and the left are both attacking this,” said King, who wrote about ESG’s wide-ranging strengths and flaws in a Harvard Business Review article in August. “Regulators need to do something, because ESG investing is clearly not dying.”

The European Union adopted new ESG disclosure rules last year, the Sustainable Finance Disclosures Regulation, for fund managers, along with a new green taxonomy, a classification system defining environmentally friendly investments.

In the United States, the task falls on the Securities and Exchange Commission, which has proposed wide-ranging new rules that would force investment managers to better describe their ESG funds and how their goals and metrics are being met.

Among the specific changes is requiring ESG fund managers to disclose greenhouse gas emissions of companies they are invested in. Another proposal, the Names Rule, would require that 80% of an ESG fund’s holdings be invested in the kind of assets suggested by the fund’s name.

While the SEC has declined to say when it will finalise the ESG rules, for SEC chairman Gary Gensler, the tighter scrutiny is long overdue.

“It can be very difficult to understand what some funds mean when they say they’re an ESG fund,” Gensler said , in announcing the proposals in May. “I think investors should be able to drill down and see what’s under the hood of these funds.”

In public equity investing, if you’re not doing active shareholder engagement, I can’t see how you’re making a difference

The SEC has been investigating potential ESG misconduct since early 2021, when it launched a special task force focused on ESG and climate issues. It has since levied a $1.5 million penalty against BNY Mellon for ESG misstatements and is also investigating Goldman Sachs.

The agency’s ESG proposals have triggered hundreds of public comment letters, with opponents saying it is regulatory overreach and sustainability-oriented investors offering strong support, even if it leads to a decrease in assets claiming to be ESG worthy.

“In the short-term, these rules if adopted, may result in a decrease in total assets invested in funds that purport to be sustainable,” wrote Ceres president Mindy Lubber, whose non-profit group works with more than 200 global investors. But “ultimately, they would bolster confidence in climate and other ESG investment products”.

One area where MIDANA CAPITAL and Ceres would like to see improvement is stronger disclosure rules on how ESG funds are engaging with companies on sustainability issues. Shareholder resolutions  requesting that companies disclose their risks and strategies on climate and other sustainability threats has been an especially popular engagement tool that a growing number of investors are using.

“In public equity investing, if you’re not doing active shareholder engagement, including shareholder proxy filings, I can’t see how you’re making a difference in the world,” MIDANA CAPITAL’s Samuelrich said.

Another approach  not included in the SEC’s proposals but gaining traction among European regulators, is deploying double materiality, whereby investors evaluate companies both for their ESG risks and their impact on the world. Among the early adopters embracing this approach is Fidelity International, one of the UK’s largest money managers.

ESG-managed assets keep growing, with some experts projecting the industry will eclipse $50 trillion by 2025

No matter where the SEC’s final rules land, ESG investing is clearly not going away. Even as state attorney generals in 18 states are challenging the rules, ESG-managed assets keep growing, with some experts projecting the industry will eclipse $50 trillion by 2025.

“ESG is like the gawky teenager becoming an adult,” said Andrew Behar, chief executive of As You Sow, a shareholder advocacy group that tracks thousands of ESG funds. “With so much money flowing into these funds, new SEC rules, combined with the EU’s efforts, are a critical step to help ESG and sustainable investing reach maturity.“

 

Peyton Fleming is a freelance journalist who has written extensively about climate change, climate finance and energy issues. His articles have appeared in the Guardian, Quartz, Yale Environment 360 and National Geographic. peytonfleming22@gmail.com