Yahoo Finance How woke capitalists’ gravy train came to a juddering halt
When Mark Carney corralled 450 finance companies to tackle climate change at Cop26, it seemed like his crowning achievement.
Carney’s Glasgow Financial Alliance for Net Zero, as it was known, joined together companies that controlled $130 trillion of customers’ cash. These banks, fund managers and investment firms committed to using the money to address climate change.
But the launch three years ago now looks like the high watermark of the environmental, social and governance (ESG) craze.
ESG investment promised it could change the world for the better, while also delivering strong financial returns. Drawn in by the promise of no downside, investors around the world poured billions into these funds. Investment in UK ESG funds peaked at £11.1bn in 2021. It spawned a cottage industry of advisers, fund managers and so-called experts.
But today many are rethinking ESG. While Carney’s group is still going, investors are increasingly sceptical that finance can save the world.
Financial returns have been disappointing: ESG funds have underperformed a simple UK tracker fund every year since 2020.
Adding to the sense of disillusionment is the war in Ukraine and the energy crisis, which have made people question many of the assumptions underlying “ethical” investment.
“It’s clearly an oversimplification to say companies trying to make the world a better place are going to make a lot more money,” says Bob Eccles, a professor at Oxford University. “On the whole the way these funds were marketed [suggested] you can have your cake and eat it.”
Globally, investors have pulled around $38bn out of ESG funds since the start of the year. 2024 is set to be the first year on record when ESG-labelled funds have seen more money withdrawn than added, according to Barclays.
After years of strong-growth, the ESG gravy train is coming to a juddering halt.
Going green
While the acronym only rose to prominence in the City in the last five years, ESG has been around for far longer. The term was first coined in 2005 in a UN report called “Who Cares Wins”, which argued that companies where bosses behaved ethically would deliver better returns for shareholders.
The idea remained niche for more than a decade but increased politicisation, polarisation and concern about things like climate change saw it rise up the corporate agenda.
A key moment came in 2019 when a powerful Washington lobbying group run by JP Morgan chief Jamie Dimon, called Business Roundtable, declared that the purpose of a company was no longer just to deliver profits for investors but also to look after other “stakeholders” such as staff, suppliers and communities.
Suddenly, businesses were responsible for keeping a huge range of people happy – opening the door to politics and climate science.
A year later, BlackRock boss Larry Fink, who sits atop an investment company controlling $9 trillion, declared that “climate risk was investment risk” and said he would make protecting the planet one of his biggest priorities.
Cynically or not, the investment industry seized upon this shift in tone.
Between 2020 and 2023, almost 3,000 ESG funds were launched, according to Morningstar, promising investors the ability to save the planet by backing ethical companies that also made money.
The funds attracted $600bn of investment globally in the three years to the end of 2023, according to Barclays. In 2021 alone, net inflows were about $300bn.
Nearly £20bn of cash went into UK ESG funds between 2020 and 2022, according to data provider Calastone. It peaked in 2021 when £11.1bn of money from pension funds, retail investors and a host of other British institutions went into ESG.
The gravy train also spread outside the confines of fund management, with consultants hiring thousands of new staff to help service the growing ecosystem set up to cater to ESG demand.
McKinsey declared in 2019 that 90pc of America’s 500 biggest companies were now producing an ESG report – reams of paper meant to prove the businesses were saving society and the planet.
Consultants and analysts also spend a lot of time arguing that ESG was a more profitable way to invest. In a series of papers, McKinsey argued that companies with racially diverse leadership teams performed better financially.
“You cannot try to sell to somebody a concept to save the planet if you don’t have positive performance,” says Pierre-Yves Gauthier, founder of AlphaValue.
Yet there was a problem: performance didn’t always match the promise.
UK ethical funds for years delivered returns that were below a simple tracker fund of the FTSE 100. In 2022 that gap widened to 10 percentage points, according to LSEG Lipper.
That meant £1,000 invested in an ESG fund would earn £103.50 less than a tracker fund.
Underperformance reflects the way ESG fund managers invest: ethical funds are varied but on the whole they shun “sin stocks” like fossil fuels, defence and tobacco.
That means these funds have no exposure to oil and gas companies such as BP and Shell and weapons manufacturers such as BAE Systems.
These companies are among the largest in the world and pay large dividends, meaning owning them can boost the value of a portfolio.
The impact of ignoring these sectors was somewhat limited until 2022 when the Ukraine war broke out. A surge in the oil price drove up the shares of the likes of BP and Shell, while the war boosted defence stocks.
The war also raised questions over whether defence companies were now ethical – were the companies helping arm Ukraine and battle Russian aggression really bad for society?
“Investors still remember 2022, which was a bad year,” Hortense Bioy, Morningstar’s head of research, says. “There’s more scepticism about what ESG funds offer, both in terms of ESG credentials and performance.”
Researchers have also begun to question the validity of claims that ESG helps financial performance.
A recently published paper in academic journal Econ Journal Watch said the results of McKinsey’s claims on diverse management teams couldn’t be replicated, for instance. The authors said the claim could not be “relied on”.
Alex Edmans, a former Morgan Stanley investment banker and now finance professor at London Business School, says there is “mixed” evidence that ESG improves financial performance.
“ESG is not ‘go woke, go broke’ but the blunderbuss idea that ESG will make you loads of money is not the case,” he said.
Box-ticking fears
Investors have also become jaded by a series of ESG-linked scandals. A steady beat of news stories have exposed the fact that many ESG funds are not as ethical as they claim.
US regulators last year fined Deutsche Bank’s fund management arm DWS $19m for “greenwashing” after making “materially misleading” statements about how much it cared about ESG.
In another egregious example, following press reports about poor working conditions at factories Boohoo relied on, it emerged that many ESG funds had backed the fast fashion retailer. An independent report subsequently found “endemic” issues.
Instances such as this gave rise to a feeling that ESG was little more than box-ticking and rubber stamps.
Part of the problem was ESG was always a woolly concept. It blended three different concepts together, often oversimplifying it by giving companies a one-number or letter rating.
Edmans says ESG is so broad as to be meaningless, using the metaphor of food.
“You wouldn’t say food is good for you. Some food is good for you, broccoli is good for you, and ice cream is bad for you. So this blanket phrase ‘ESG’ is not particularly helpful.”
ESG boomed because people wanted to believe the idea they can make money and better the world, what he describes as “confirmation bias”.
The impact on society and the planet is open to question. Take, for instance, coal mining. Coal is bad for the environment so would harm your ESG score. But rather than shut these mines down, many companies simply sold off the assets to other operators who didn’t care as much. The coal kept being dug out of the ground and burned for fuel.
“Customer boycotts can have a large effect because if I boycott McDonald’s, then the burgers stay on the shelf and nobody is buying them,” says Edmans. “Investor boycotts don’t necessarily do that, because I can only sell if somebody else buys. There’s a limited effect you can have with an ESG fund.”
Republican backlash
Attempts by finance to impact society and the climate through the backdoor have also drawn criticism from politicians and campaigners.
A high profile US TV campaign by Consumers’ Research accused BlackRock of putting political goals over the needs of its customers. Fink and BlackRock were accused of “woke capitalism”.
In 2022, former Republican presidential candidate and Florida governor Ron DeSantis also announced he would pull $2bn of the state’s investments from BlackRock.
Observers say the backlash is largely “political theatre”, which is unlikely to have prompted the derailing of the ESG gravy train.
“If I had to guess, it would have to do less with Republican backlash and probably be more [down] to performance issues and fee issues,” says Oxford’s Eccles.
Amid the reckoning, the Wall Street titans who pioneered ESG have started to change their tone.
BlackRock’s Fink has said he would no longer use the term because it had become “entirely weaponised”.
“I’m not going to use the word ESG because it’s been misused by the far-Left and the far-Right,” he told the Aspen Idea Festival last June.
JP Morgan, Pimco and State Street, three of the world’s largest investors, earlier this year quit a major environmental coalition that presses companies on climate change over new rules they deemed too radical. BlackRock has also reduced its involvement with the Climate Action 100 group.
Elsewhere, there has also been a fightback from oil companies against the activism.
ExxonMobil broke rank last year by suing a Dutch climate activist group that had bought a small stake in the oil giant.
It filed a lawsuit against the group for filing a frivolous resolution at its annual shareholder meeting. Despite the group withdrawing the resolution, Exxonmobil is still pursuing the group through the courts.
Political earthquake
The backlash against ESG has not reached the same levels in Europe as it has in the US. But a different political earthquake in Europe is having repercussions.
The latest EU parliamentary elections have delivered what is likely to be the most climate-sceptic political bloc in Brussels for a generation – something that will be bad for green-focused investment funds.
Renewable energy tumbled in Germany after the Green Party was hammered in the elections. SMA Solar Technology has fallen 4pc over the last week, while rival solar panel company Nordex has fallen by 10pc.
“It’s still a question of what will happen to the green agenda with the new EU parliament,” says Morningstar’s Bioy. “That might give pause for some investors.”
However, she adds: “This is not the biggest factor: performance and greenwashing accusations are the biggest factors.”
To combat greenwashing, UK and EU regulators have launched a crackdown on how managers can label funds.
In a sign of how mislabelled ESG has become, dozens of funds worth about $140bn from the likes of BlackRock, Amundi and Pictet have been downgraded under the new EU rules.
Ethical investment has not disappeared. The world’s biggest ESG fund, the Handelsbanken Global Index Criteria, recently ballooned to about $11bn in size, and is likely to be a juggernaut for years to come.
But £2.3bn was pulled out of ethical funds last year, the highest on record and the first reversal in fortunes since 2017.
The scales have fallen from the eyes of many – you cannot have your cake and eat it too – and the easy money that ESG delivered to the City in the boom years is no longer available.
“What you’ve now had is healthy scepticism,” says Edmans. “Whenever there is a fad and there’s a lot of excitement, then you should have a push back.”
