ESG Investing: Fad Or Future? (2024)

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For quite some time, ESG (Environmental, Social, and Governance) investing has been all the rage.

Although the concept has been around since the 1960’s, institutional interest in ESG really began to accelerate at the end of the 2010’s, and net inflows into ESG and sustainable funds peaked in 2021 at USD $649 billion. At that time, ESG was heralded as the wave of the future.

But lately, many in financial and media circles are beginning to decry this investment strategy, not just for its worsening financial performance but for its perceived insincerity. People are beginning to wonder if the established ESG criteria actually mean anything.

In this article, we’ll take a look at both sides of the discussion: those who say that ESG is more than a passing trend and those who insist that ESG is just a fad.

A Background On ESG

Although the ESG acronym was coined in 2005, the notion that companies should be conscious of their impact on the environment and society has existed for well over a century. As far back as the Industrial Revolution, the public has been concerned about the effects of pollution, exploitative labor practices, and corruption within corporations.

So it’s no surprise that companies, governments, and regulators would come together to try and improve business practices - or at least create that perception in the eyes of the public. In 2004, the U.N. released a report entitled Who Cares Wins, which went on to become widely considered as the basis for ESG thinking in the modern era.

From there, more and more companies jumped on the ESG bandwagon, increasing inflows massively and putting pressure on traditionally non-ESG focused companies to begin investigating ways to participate. Ratings systems emerged, each with distinct methods of assessing the various factors of each component. Fast forward to the present and one third of global assets under management are ESG-related.

The Problems With ESG

But what is ESG, really? How can investors determine how impactful a company actually is?

This question is at the core of the controversy about ESG. Because, in spite of the myriad of ratings criteria, methodologies, weightings, data, etc., few can agree on exactly what ESG is. This has created an environment where many feel that ESG ratings are “confusing, inconsistent, and opaque,” leading to further distrust.

Additionally, it’s beginning to look like ESG factors are not as correlated with strong financial performance as was previously assumed. Writing in Harvard Business Review, professor Sanjai Baghat notes that in a University of Chicago study of various ESG and non-ESG funds, “none of the high sustainability funds outperformed any of the lowest rated funds”.

This declining performance seems to have been noticed by the investing public. Inflows into sustainable funds suffered their sharpest decline in 7 years during 2022, falling to $3.1 billion. Rising interest rates, inflation, and fears of recession certainly were contributing factors, but the fact remains that confidence in ESG funds seems to be declining. Of course, it’s worth mentioning that overall U.S. fund flows declined at a similar rate, but there’s no denying that ESG principles are being strongly called into question.

In Defense Of ESG

All that being said, it’s clear that taking these factors into account is important for the business world, especially as the effects of global warming are becoming more apparent. Moody's forecasts that tens of trillions of dollars in wealth could be destroyed by climate change before the end of the century, and it’s impossible to deny that extreme weather events are becoming more frequent and devastating year after year. At this point, it’s not about compassion or goodwill - it’s about risk management.

There’s also an undeniable financial benefit for companies that can take advantage of expanding tax credit and bond programs. Carbon bonds and credits, tax breaks for green investments, and grants for renewable energy and efficiency improvements funnel money toward sustainable sectors. And at the same time, regulators are introducing stricter frameworks for carbon emissions to ensure that companies are held accountable for their environmental, social, and governance practices.

It’s also true that the investing public has an increasingly pronounced interest in ESG factors. 62% of global consumers prefer that companies implement policies on issues such as sustainability, transparency, and fair employment practices, according to a study from Accenture. So it certainly seems that there’s a market for ESG investments and services, one that doesn’t seem like it’s going away any time soon.

Navigating The Terrain

The core criticisms from the investing community contend that ESG is just a fad and that corporate sustainability reports are a weak metric for assessing actual risks. Some ESG-centric investors argue that the sector should focus more on environmental factors and less on social and governance. There’s also valid criticism that the subjectivity of the environmental criteria increases "greenwashing." Some even say ESG factors are fundamentally at odds with making money.

Many of these criticisms are valid. As a consumer, it can feel nearly impossible to distinguish between truly sustainable products and those with greenwashed packaging. The social and governance components are unwieldy, hard to measure, and open to interpretation.

However, these critics may be missing the bigger picture. In reality, a company that values environmental stewardship, social responsibility, and good governance may be more likely to perform well in the long term, making ESG investing an intelligent choice for those who want to do well while doing good. It's also worth mentioning that companies that are able to obtain industry-standard certifications are generally more organized and efficient.

At the end of the day, it's understandable that some people would have reservations about the efficacy of ESG grading practices and the hype surrounding ESGas a concept. Nonetheless, the goals of ESG investing are critical to maintaining the stability of the global economic system. The investing public isn’t going to stop caring about the planet and its people, and the money is going to go towards companies that share those concerns. Imperfect though it may be, ESG isn’t going away, and companies will have to adapt.

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