ESG at a crossroads?

Larry Fink, CEO of Blackrock

Larry Fink, CEO of Blackrock, the world’s biggest asset management firm, recently announced he will no longer be using the term ESG (environmental, social and governance), as it had become “too political”. He is opting instead for terms like stakeholder capitalism, sustainable investing, or climate investing.

This is a far cry from a few years ago, when ESG, or environmental, social and governance, had swept the board in the wake of the pandemic when investors had funds and time, and good intentions. In fact, everyone wanted a piece of it and ESG came to be the label applied to a lot of companies and funds that might not have matched with most people’s interpretation of the term.

ESG investing followed the pandemic’s arc: net investment inflows to ESG funds peaked in the first quarter of 2021, then declined throughout 2022, according to Morningstar. An inflection point occurred in the first quarter of 2023, with a net investment outflow from ESG funds.

So, what happened?

Rebound effect

Perhaps inevitably, 2023 saw something of a conservative backlash against ESG in the USA after such a stellar few years. ESG was tied to climate objectives, which notoriously split electorates. Fink acknowledged this and tried to placate the broad political views of his investor base.

Even those in favour of a transition from fossil fuels have questioned the stated speed of transition and moving money out of funds or favouring non-ESG funds was a form of protest. The UK has seen climate targets and related targets like the adoption of electric vehicles pushed back as politicians wrestle with long-term ambitions and short-term popularity. The Ultra Low Emission Zone (ULEZ) in London is another great example of this.

The impact of conflict

Russia’s invasion of Ukraine and subsequent political moves to ostracise the Russian economy forced a spike in the performance of defence and energy stocks, which are understandably not in some ESG funds (but they are in others, which is part of the problem!). With further conflict in the world since then, it’s logical that defence stocks will continue to do well.

Reputational issues

Whatever you want to call investing with other goals in mind, not just pure profit, it has suffered from some reputational issues in recent years as the clamour to join the ESG explosion in 2020 moved too quickly for common measurements to be agreed on. Some companies that were invested in oil and gas made it onto some ESG lists – it depended where you looked, and how hard.

“Greenwashing” became the catch-all term for ESG investments that weren’t very ESG but were promoted as such. A number of ESG ratings agencies sprung up to fill the void, while unintentionally adding to the issue, as they were non-standard in their approach and presented the confused investor with more contradictory information.

Incoming standards

Politicians have recognised this, and a forthcoming change is the EU corporate sustainability reporting directive (CSRD), which mandates sustainability reporting.

To address the proliferation of ESG ratings agencies and ensure their quality and reliability, the EU has proposed a regulation that requires ESG ratings agencies to obtain authorisation and supervision from the European Securities and Markets Authority (ESMA).

The EU wants to standardise the approach and ensure quality and integrity for investors.

In the UK, the FCA has implemented the Sustainable Disclosure Requirements (SDR) which began at the end of May 2024 and are giving greater steer on categorisation of approaches.

They are also bringing in “anti-greenwashing” requirements but this is a work in progress.

Across the pond, the US federal-level climate disclosure requirements are expected to be finalised in 2024 and effective as of 2026. The Securities and Exchange Commission (SEC) will hold public companies to a higher standard of climate data transparency, likely facilitating a smoother development of the US sustainable finance market.

We haven’t seen this sort of cooperation at a global level and so deciding what was ESG and what was greenwash was down to investors and their advisers. A more reliable and stable market will give the sector a stronger basis and root out bad actors.

Have investors lost their appetite?

A report from consultancy Research in Finance showed the number of investors considering ESG when making their decisions fell from 65% in 2021 to just 53% in 2023, with all three elements – environmental, social and governance – declining in importance.

However, this might be attributable to the novelty of it having dissipated in recent years.

The numbers suggest that ESG still holds plenty of investor appeal. Despite political backlash over ESG, in 2023, BlackRock experienced a 16% increase in managed assets from $8.6 trillion to $10 trillion.

Fund managers, the ultimate investors, have certainly benefited from a rise in standards and are helped by the ESG principles when assessing companies. ESG is an “integral part” of the investment sector, Magnus Chief Investment Officer, Rory McPherson says.

He believes most clients want to make a positive contribution via ESG investing and that the ‘G’ is particularly important, as if a company has good governance, then ‘E’ and ‘S’ will likely follow.

Good governance has never been a bad thing in companies, so maybe it was always healthier for companies to operate like that and be included in funds through good governance, rather than forcing their business to fit a description of ESG in order to make certain funds.

What’s coming next?

The initial driving forces of ESG are still prevalent and will no doubt come back in importance in the coming years.
The UN reports the earth’s temperature has risen by an average of 0.14° fahrenheit (0.08° celsius) per decade since 1880, or about 2° F in total. The rate of warming since 1981 is more than twice as fast. A million plant and animal species now face extinction, while deforestation is also a major concern.

The climate crisis is not going away and in just the same way Australian and Californian forest fires brought the issue to the top of the news agenda before, we could see other natural disasters restarting the conversation about the importance of corporate responsibility towards the environment.

The #metoo and Black Lives Matter movements that drove a lot of social change in the pandemic era might have stalled with a backlash against progressive politics, but as a cycle, that could come around again. In many parts of the world, a level of oppression is the norm, either in the form of a single party state or persecution against minorities. The world is not short of opportunities for positive social change and companies can facilitate that.

Turning to the money, ING predicts some short-term stagnation. ESG bond markets for example have seen staggering growth in supply over the last seven years. A peak of €1 trillion of self-labelled ESG bonds was reached in 2021. However, with the issuance of Covid-19 mitigation bonds dying out, supply chain disruptions, inflation and higher (funding) costs, market conditions have changed significantly. We believe similar trends will emerge throughout 2024 to those seen this year, with some segments slowing down their ESG bond issuance – leading to a relatively stable market compared to 2023.

As we always say, investing is a long-term pursuit and we see ESG as experiencing some growing pains at the end of a honeymoon period.

Looking further ahead, global ESG assets surpassed $30 trillion in 2022 and are on track to surpass $40 trillion by 2030 — over 25% of projected $140 trillion assets under management (AUM) according to a latest ESG report from Bloomberg Intelligence (BI).

As the impact of the regulation imposed on the sector becomes second nature, it’s likely to facilitate further growth. Looking further ahead, the forecasted decline in the reliance of fossil fuels aligned with, hopefully, a period of geopolitical stability, would reduce the prevalence of excluded stocks in the investment market.

It seems like the direction of travel is much more certain than the journey itself.

IMPORTANT: The value of your investments can go down as well as up, so you could get back less than you invested. Past performance is not a reliable indicator of future performance.

The article is for information only and does not constitute individual financial advice.