The Fact and the Fantasy of ESG Investing

The Fact and the Fantasy of ESG Investing

by Colin Mequet

Environmental, social, and governance (ESG) investing is transforming finance. In an industry known for sponsoring environmental degradation and worker exploitation, investors have diverted around $20 trillion into funds aimed at delivering sustainable and social impact.  Bloomberg projects ESG to represent one third of total assets under management by 2025.

ESG funds are most commonly traded as indexes that screen and select companies based on their commitment to environmental, social, and corporate governance values. By channeling investment toward responsible and ethical firms, more capital is made available to these businesses who can, in turn, outperform their competition.  At the same time, institutional and individual investors can reduce exposure to climate risk (like government regulation and litigation).  

But as the market for ESG has exploded, its definition becomes increasingly nebulous. With little government oversight, the demarcation of what “is ESG” and what isn’t has blurred significantly.  This is creating critical transparency issues that hinder ESG’s ability to serve its full potential in the fight against climate change.

There is neither a single definition for ESG investing nor a standard methodology for quantifying ESG compliance. Its pillars include everything from diversity in the workplace to carbon emissions; but while racial and gender parity in the boardroom—the governance pillar—are straightforward to measure and compare, it is the environmental and social criteria that are extremely difficult to calculate.

Indeed, ESG rating providers have to gather data from incomplete and unaudited corporate disclosures that are often manipulated to portray the company in a positive light. These firms then extrapolate and interpolate this data, according to their own methodologies, to fill in its gaps. Finally, they rate the company’s global ESG compliance—once again, according to their own weightings and procedures.

What has stemmed from this uncontrolled system for assessing ESG compliance is a multi-billion-dollar ESG rating industry comprising companies using inconsistent, unstandardized data collection and interpretation techniques. The US Securities and Exchange Commission formally acknowledged this much, commenting, “[ESG] factors are not defined in federal securities laws and may be defined in different ways by different funds or sponsors.  There is no SEC ‘rating’ or ‘score’ of E, S, and G, and while many different private ratings based on different ESG factors exist, they often differ significantly from each other.”

The lack of standardization among ESG funds creates a major transparency issue that calls into question the very nature of sustainable investing. In a financial system where the lack of oversight creates moral hazards that can cause recessions, it is not unreasonable to fear a bubble growing in ESG investing—but this time, instead of our economy, it is the environment that is at stake. 

These fears would be well-grounded. Undoubtedly driven by a lack of transparency and accountability across multiple levels of the industry, ESG funds are not delivering on their sustainability promises. 

Climate think-tank InfluenceMap published a highly-cited report on ESG’s underwhelming sustainable performance, finding that 71% of ESG funds are misaligned with the Paris Agreement targets, with some performing worse on their sustainability metrics than the S&P 500. Explicitly climate-themed funds displayed better Paris-alignment scores than broader ESG funds, but they still tended to hold stakes in oil and gas giants—most commonly Chevron, ExxonMobil, and TotalEnergies.  

These were not isolated findings: researchers from Columbia University and London School of Economics also concluded that “on average ESG funds pick firms with worse employee treatment and environmental practices than non-ESG funds”. 

In a particularly damning analysis of ESG scoring reliability, the OECD sheds light on why ESG performs so poorly: “For some ESG rating providers, high E pillar scores positively correlate with high carbon emissions. This suggests that firms’ plans to reduce emissions play a significant (and positive) role in determining their E pillar scores, rather than their current level of emissions.”  Corporate pledges to reduce carbon emissions obviously have no legal binding: ESG compliance can mean almost anything.

And so, while mind boggling amounts of money continue to pour into ESG funds, the practice’s fundamental objective does not stand up to scrutiny. It is the Wild West of the investment world—fund managers and rating firms are fiercely competing with each other to cash in on the ESG craze, and the industry’s lack of oversight means that there’s no accountability if they misrepresent or do not deliver on their essential promises.  

But it is vital that climate advocates make an important distinction when considering where the finance industry stands in the fight against climate change. While they are quick to demonize institutional investors for supporting major polluters, it must be recognized that financiers are not inherently against the climate transition.  Investors will always speculate in high-growth industries—currently, that includes oil and gas, but if the government is serious about decarbonization, these same firms will be ready to provide the financial backing for our sustainable future.

Perhaps unsatisfyingly, this brings us back to a familiar place: the ballot box. ESG is a happy thought, but the rules of the game need to be adjusted before it can save the world on its own.



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