The unsustainable hype around ESG

Three letters have demanded outsized attention from companies, consumers, and investors in recent years — E, S and G. The uptick in funds with increased scrutiny over portfolio companies’ environmental, social and governance credentials has been a cause for celebration to some, and an object of derision to others — particularly Republican lawmakers in the US. News last week that patchy outflows from ESG funds have become a firm trend, with $40bn leaving so far this year, similarly divided political opinion. 

Most hyped market trends — be it hot Japanese stocks in the 1980s, the dotcom boom of the late 1990s, or, perhaps soon, the surge in AI stocks — eventually reach a point where the fundamentals can no longer justify high valuations. That leads either to a gradual readjustment or, in serious cases, the calamitous bursting of a bubble. The same can be said of trends in asset management. When investment vehicles perform below the market, hype alone cannot sustain investor interest.

ESG outflows are in part due to performance. Many ESG funds underperformed in 2022 and 2023. Despite fund managers’ attempts to engineer clever solutions, many could not outrun a surge in oil prices prompted by Russia’s war in Ukraine.

Yet, the lustre of ESG has largely been dimmed by politicisation, especially of its own contradictions. Defence company stocks were initially left out of most funds, but support for Ukraine and a broad rally around the flag led to their inclusion by some fund managers — a shift that opened ESG to sneers from the right and criticism from the left. Persistent jibes from Republican policymakers have pushed many US companies to change their language around ESG and net zero commitments, engaging in “green hushing”.

Part of the issue here is that ESG is something of a Frankenstein’s monster of buzzwords. The grouping tells us less about the impact of a fund or a company and more about society’s muddled sense of beneficence. Environmental, social and governance standards are often vague, allowing fund managers to “greenwash” their records to lure investors. In truth, the make-up of many funds has largely mimicked typical indices, but with the exclusion of oil.

To the dismay of its critics, however, the first sustained outflows do not mark the death of ESG as a concept, though it may mark its decline as a marketing tool. Investors are still interested in sustainability, especially in Europe and the UK, where the market has been insulated from the worst of the US culture wars. More effective regulation has reduced greenwashing, and fund managers are becoming better at creating funds with fewer inconsistencies. And an outflow of $40bn is relatively small compared with the approximate $7tn of ESG assets under management.

The principles underlying the ESG boom are also becoming entrenched. Reaching net zero is seen as good business by executives. Mitigating governance issues is viewed as necessary risk management. Green investments are increasingly profitable, too, in large part due to well-crafted policies such as President Joe Biden’s Inflation Reduction Act.

Indeed, the role that the IRA has played in stimulating green investment underlines the importance of policy in creating the right incentives. The market has a role in steering financial flows — which makes it all the more regrettable that ESG has become entangled in the US culture wars. But markets can only do so much. In the US in particular, policy, and the outcome of the November elections, will have the greatest bearing on the future of the green transition.