Where will the ESG backlash lead?
In recent weeks, the gloves have come off in the ESG wars.
On 20th August, BlackRock’s former CIO for Sustainable Investing, Tariq Fancy, published an explosive account of his time at the world’s largest asset manager, in which he describes ESG investing as ‘a dangerous placebo that harms the public interest.’ Just days later, it was announced that DWS Group, Deutsche Bank’s asset management arm, is being investigated by regulators in both the US and Germany for overstating the ESG credentials of some of its funds.
There will, for sure, be more whistleblowers, more ESG apostates and more regulatory probes to come. So is this the end of the ESG boom? Or just a minor setback for the ESG juggernaut? Or will we look back on 2021 as the moment when the ESG industry came of age and cleaned up its act in response to justified criticism and increased scrutiny?
Here are three predictions for what to expect once the dust settles:
1. A clearer delineation between risk and impact
The most egregious example of the ESG industry’s self-serving vagueness — its ‘cloudy linguistics’ and ‘marketing gobbledegook’, in Fancy’s words — is the blurring of the distinction between risk and impact. As Fancy writes, ‘protecting an investment portfolio from the disastrous effects of climate change is not the same thing as preventing those disastrous effects from occurring in the first place.’ One salutary effect of the ESG backlash will be to make it much harder to dress up ESG risk management as being about making the world a better place.
That said, the management of ESG-related risks will continue to go mainstream fast, simply because, as Robert Armstrong of the Financial Times notes, ‘money managers are in the risk management business,’ so they are not going to ignore financially material ESG risks. If they do, they are liable to be sued for breaching their fiduciary obligations, which tends to focus the mind. In fact, ESG risk management is likely to become so normal over the next few years that the ESG label may become redundant: if everyone is doing it, it’s just risk management and it confers no bragging rights.
2. More focus on impact strategies that actually have an impact
Critics of ESG argue that buying and selling shares in companies is a fantastically ineffective way to influence their behaviour. Which is true. In theory, if enough people sell Exxon or Shell stocks, and few enough are willing to buy them, this hurts those companies by increasing their cost of capital. But in reality, the threshold for how many sellers — and how few willing buyers — you need before the companies start to feel the squeeze is so high that most attempts to influence company behaviour through divestment are meaningless. As Fancy writes:
‘Divestment, which often seems to get confused with boycotts, has no clear real-world impact since 10% of the market not buying your stock is not the same as 10% of your customers not buying your product. (The first likely makes no difference at all since others will happily own it and will bid it up to fair value in the process, whereas the second always matters, especially for a company with slim profit margins and high fixed costs.)’
But it doesn’t necessarily follow that there is no way for investors to have an intentional positive real-world impact: it’s just that the ESG industry has largely plumped for the wrong strategy. Tinkering with asset allocation in secondary markets — ie., buying and selling the shares of publicly traded companies — is a flawed approach to creating impact. As that realisation sinks in, expect to see other strategies come to the fore. Two in particular are worth watching out for.
First, strategies that focus on primary rather than secondary markets. Primary markets — which include areas like bond issuance, equity issuance, initial public offerings (IPOs), private equity and venture capital — are where companies raise new capital to invest. Therefore, unlike in secondary markets, asset allocation in primary markets can and does have a real-world impact. (See this excellent research paper by Ellen Quigley of Cambridge University for more detail on why this is.)
When a venture capitalist invests in a cleantech company, or when an energy major issues a green bond to build a new wind farm, there is a positive impact in the real world. Which is why the green bond market’s growth, for example, is likely to be more resilient in the face of the ESG backlash than some ESG-labelled equity funds that are constructed using methodologies like positive or negative screens, carbon tilts, or best-in-class stock selection.
Second, strategies that focus on stewardship and engagement. Big asset managers do wield a lot of influence — but as owners, rather than buyers or sellers. As Fancy notes, his former employer, BlackRock, owns more than 5% of nearly all of the companies in the S&P 500. That means all of those companies have to take BlackRock’s calls. And when you start aggregating the voices of multiple large asset managers through initiatives like Climate Action 100+, it becomes very difficult for companies to ignore what their owners are demanding of them.
So, if you’re looking to create impact through secondary market investments, forget divestment and focus on “forceful stewardship” instead — the kind of stewardship that doesn’t just target better disclosure, but seeks to actually change a company’s strategy.
None of this is remotely sufficient to prevent catastrophic global warming without serious action from policymakers and regulators — which is the ESG critics’ most important point — but the impulse to use finance as a tool for creating impact isn’t going away, and nor should it.
3. ESG issues will become more — not less — important for companies
Ironically, the more successful the ESG backlash is, the more important ESG issues are likely to become for companies. That’s because what Fancy and others are trying to achieve by dispelling the illusion that ESG investing will save the world is to clear the path for the science-based policy and regulatory response we need. They want to make sure the rules of the game punish those that perform badly on ESG issues and reward those that perform well.
Clearly, there are many reasons governments have yet to come up with an adequate response to issues like climate change, biodiversity loss and rising inequality. There are bigger hurdles to overcome than a misguided belief that ESG integration will magically solve everything. But, as Fancy convincingly argues, noise about investors and companies doing good things really does distract people from the reality that the rules of the game need to change.
He cites a study that found that exposure to headlines about companies or investors doing ESG-type stuff made people in the US 17% more likely to say that business, not government, will lead the way in building a more sustainable economy. The distraction effect is strongest amongst those with the strongest desire to believe in the ‘convenient fantasy’ that voluntary measures are enough:
‘Older progressives were a whopping 57% more likely to latch onto the idea that there’s no need to fix the rules… Their age is a hint why: those most invested in the status quo are the least likely to want to change it. But when they’re progressives, they also need a way to feel better about maintaining a status quo that benefits them, so any fantasy that combines business as usual with moral satisfaction flies off the shelves.’
Older progressives are also one of the most important constituencies in terms of building an electoral support base for bold policy action on environmental and social issues. So if the whistleblowers’ message does cut through, and the regulatory clampdown on “greenwashing” does reduce its volume and effectiveness, then maybe, just maybe, the ESG backlash will succeed in its ultimate goal: to speed up the arrival of the new rules we need.