It’s a bird… it’s a plane… it’s ESG

More and more funds are pouring into financial instruments that purportedly meet environmental, social and governance (ESG) criteria. But just how sustainably sound is this wave of ‘ethical’ investments?

Alexander Kozul-Wright

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OVER the past decade, the amount of money flowing into ‘sustainable’ investment funds has swelled from a drip feed into a flood. More than ever, public and private entities have embraced environmental, social and governance (or ESG) criteria as financial risk benchmarks.

        Last year, ESG assets under management were reported anywhere from $3-35 trillion. The wide margin of error is indicative of the confusion hanging over the industry. However, while the absolute size of the market remains in doubt, vast sums have flowed into ethically-labelled securities in recent years.

Sustainably-labelled debt grew at a clip in 2021, with issuance exceeding $1.6 trillion, up from $760 billion in 2020.  A record $650 billion also poured into ESG-focused funds in 2021, up $100 billion from the year before. On average, two new ESG-linked funds were launched every day in 2021.

        Two key factors are underpinning this development. The first is improving ESG audit systems, galvanised by market developments from accountants, data analytics companies and law firms. The second factor reflects how political battlegrounds, responding to public pressure, are adapting to ESG-related challenges. Tens of central banks around the world now consider environmental factors in assessing systemic banking risk.

        At the very least, this is forcing company boards and portfolio managers to confront increasingly onerous ESG rules, changing the zeitgeist one cash flow statement at a time. At its best, it may also undermine corporate assets and investments linked to high carbon emissions and illegal activities.

Lay of the land

        Although the US represents the largest market for ESG, there has also been growing interest from developing countries. In September 2020, the government of Egypt issued a $750 million ‘green’ bond that was five times oversubscribed, resulting in interest savings of $19 million. ESG instruments generally benefit from competitive prices due to high demand.

        Increasing numbers of lenders – from sovereigns to SMEs – are raising ESG-linked capital, supplying debt and equity to investors, which is then repackaged and traded as fund holdings and structured products. These initiatives primarily focus on enhancing the socio-economic and green data generated by firms and projects. 

        ESG analysis is designed to adjust the traditional risk-return calculus to gauge non-financial indicators, like an entity’s carbon footprint or how it manages its labour force. For it to work well, two conditions need to be met: first, reliable information about the use of ESG proceeds is required; and second, investors have to respond to this information.

        Many ESG ‘products’ are now available; market players can purchase dividends in companies with robust ESG track records, or they can increase their exposure to mutual and exchange traded funds with clear ESG mandates. Investors, notably young retail investors, typically buy these instruments in good faith.

Market participants can also trade fixed income securities with an ESG label. Proceeds from ‘green’ bonds are exclusively earmarked for environmental activities. Meanwhile, the ‘social’ and ‘governance’ components of ESG are frequently sold as ‘sustainability’ bonds, whose proceeds are used to finance (or re-finance) projects with positive societal impacts.

        Alongside the explosion of individual securities, the use of ESG indices has grown in recent years to track the performance of multiple sustainable instruments at the same time, mainly in advanced economies. However, the market has also been extended to developing countries. In June 2021, Bloomberg launched an Emerging Market Fixed Income ESG Index.

        ESG framing and guidance services form an important, though patchy, part of the industry and include a cast of actors who help define an investment’s sustainability. Framework developers include the Sustainability Accounting Standards Board (SASB), the International Integrated Reporting Council (IIRC) and the International Capital Market Association (ICMA).

        Other bodies that develop rules and standards include market regulators, international organisations and credit rating agencies (though ESG factors are not directly used as rating criteria by Moody’s, S&P and Fitch). For the time being, however, there is no harmonised rulebook that entities must comply with in order to market their products as ESG.

Cure or anaesthetic?

        As with ethical consumption, the popular adoption of regulated sustainable finance would be a welcome development. However, a lack of commonly adopted industry standards means that ESG scorecards remain inconsistent and difficult to measure.

        A key concern is that unclear definitions, together with rising pressure to meet demand, is resulting in misleadingly packaged products. Moreover, companies typically charge higher fees for ESG-related services, creating questionable incentives linked to sustainable financing.

        Last year, The Economist conducted a study of the world’s 20 largest ESG funds and found that 17 held investments in fossil-fuel companies. A similar 2021 report by climate think-tank InfluenceMap found that 71% of ESG equity funds it assessed had portfolios that were not aligned with the Paris climate accords.

For now, sporadic industry oversight means that greenwashing remains rife. ESG rating providers use their own (typically non-transparent) sources of information, most of which rely on self-reporting by the companies they rate. Some have accused the movement of virtue-signalling. Others have gone further, accusing ESG labels of duping ethical investors to raise profits without fundamentally changing business practices.

        Last year, Tariq Fancy – Blackrock’s chief sustainable investment officer from 2018 to 2019 – warned that ESG investors continue to be ‘exceedingly focused on the short term, a time horizon for which few believe that good sportsmanship is linked with points’. The view that maximising profit is consistent with ‘responsible’ investing will remain open to criticism so long as the negative externalities created by polluting and unethical firms go untaxed.

Green gold standard

        The European Union (EU) is aiming to ratify a ‘Green Deal’ this summer, which would seek to establish a blueprint for sustainable finance, including a common green-bond standard. Underpinning the deal is a compendious taxonomy covering roughly 70 forms of economic activity, informing investors about what is, and isn’t, green.

        Despite some initial setbacks (several countries have lobbied the European Commission to ensure their favoured energy sources will be labelled as sustainable – natural gas in the case of Poland and Romania), roughly 11,000 European companies may have to disclose how their sales and capital expenditure qualify as ‘green’ later this year.

        Several market commentators have already predicted that the EU’s Green Deal will become a global standard against which all climate financing will be measured.  There’s a strong possibility that international financiers will have to adopt the Green Deal anyway, as European firms may be forced to start reporting green data in line with EU standards.

        That said, even if the bloc eventually agrees to a new classification system, half of the world’s oil and gas is produced by national oil companies (NOCs), which are not subject to shareholder interests. OPEC’s flagship NOCs preside over roughly 70% of the world’s proven oil reserves.

What’s more, growing numbers of fossil-fuel companies are selling their most polluting assets to private companies, whose assets – including oil rigs and gas pipelines – remain strictly outside of shareholder control.

        To date, it is understood that private-equity firms have purchased roughly $65 billion worth of fossil-fuel-linked assets since the start of 2020. Their appetite will likely grow as the ongoing conflict in Ukraine amplifies oil and gas prices. This retreat to private and SOE (state-owned enterprise) ownership is part of a broader global trend. More opaque institutions are taking over ‘dirty’ assets.

None of this suggests that investors shouldn’t channel their savings into ethical assets. It does mean that market participants shouldn’t think of ESG as a wealth-maximising and planet-saving strategy. In the meantime, improved ESG oversight would make it easier for investors to discern their portfolio’s carbon footprint and socio-economic contribution.            

Alexander Kozul-Wright is a London-based consultant for the Third World Network.

*Third World Resurgence No. 350, 2022, pp 36-37