ESG investing: blurred lines, grey areas and changing views

Until recently, environmental, social and governance (ESG) investing appeared to be a one-way street. It had the support of governments, institutional investors and regulators. Companies with weak ESG scores not only saw it reflected in their share prices, but also in their cost of capital and even in their ability to do business. However, attitudes to ESG investing are shifting and this could change what is and isn’t considered socially responsible investing.

The nascent backlash against the ESG investment movement is most evident in the US, where there have been a series of ‘anti-woke’ launches. Most have raised few assets, but a self-styled ‘anti-ESG’ ETF focused on the US energy sector launched in September and attracted £315m in less than a month. Florida recently passed a resolution barring pension fund managers from embedding ESG criteria into their investment strategies , while the Republican party withdrew $1bn from BlackRock on concerns about its ESG strategy .

Investor scepticism is not the only problem facing the sector. There has long been a problem of definition. There are multiple approaches to ESG, with some investment managers accused of using ESG labels with little or no changes to their investment processes. Even at the broadest level the labels sustainable investing, socially responsible investing and ESG investing may be used interchangeably. To date, ESG has meant whatever managers want it to mean. Regulators have started to put some parameters around it, but these will take time to bed down.

Many ESG-focused funds routinely exclude areas such as fossil fuels or armaments, but the war in Ukraine has highlighted why this might not be the best approach. Are businesses in the armaments trade taboo if they help Ukraine’s defence following its invasion by Russia? Many fossil fuel companies are also significant investors in green energy, so should they necessarily be excluded?

Some ESG groups are willing to hold areas such as fossil fuels, or defence, providing there is real evidence that companies are improving their ESG performance.

Are ‘toxic’ businesses better off in the hands of responsible shareholders who can provide capital and support to become better businesses? There is a danger that if responsible investors divest, they are taken over by less responsible investors and nothing happens to solve the problems.

Some sectors are undergoing a wholesale reappraisal. Nuclear energy has historically been excluded from many ESG portfolios or just considered ‘too difficult’. The energy crisis across Europe has prompted investors to look again at the sector. Recent research by S&P showed it is now only excluded by 37% of funds, down from 43% a year earlier. Nuclear also looks set to be included in the EU Taxonomy, which helps define which investments the EU considers sustainable, next year.

Finally, there is the issue of ostensibly ‘clean’ businesses which actually have a ‘dirty’ supply chain. There has been ongoing debate over Tesla, for example, and the environmental costs of its manufacturing processes. After this controversy, Tesla issued an impact report to reassure its investors.

New regulations, such as the UK’s Sustainability Disclosure Requirements and the EU Environmental Taxonomy and Climate-related Financial Disclosure are pushing companies to disclose more information and providing a common language to discuss ESG. Now that investment companies have committed more resources to ESG analysis, that information is interrogated more robustly at all stages of the financial planning and investment process. Inevitably, that will throw up issues which will need to be resolved.

Equally, ESG investing cannot be black and white. There will always be grey areas and one person’s values will inevitably be different to another’s. However, initiatives such as the UN’s Sustainable Development Goals have provided a framework for investors. Even if they may not chime perfectly with everyone’s moral values, at least investors increasingly understand what they are getting.

The political backlash on ESG may be more difficult to navigate. Right-wing governments across the world have sought to equate net zero with excessive red tape and an anti-business agenda. To date, the regulatory agenda hasn’t turned and plenty of capital is still being directed to green initiatives. However, there is a risk that governments with straightened finances start to change the goalposts.

In the meantime, investors will almost certainly need to accept some fluidity in the definitions and implementation of the ESG agenda. This is still new and the whole investment industry is still feeling its way but there are plenty of opportunities for investors looking to make ethical investment choices.