ESG Investment Funds Are One of the Hottest Investment Trends for Good Reason
The New York Times recently published a guest editorial by NYU professor Hans Taparian asserting that “One of the Hottest Investment Trends in the World of Investing [ESG] is a Sham.” As a long-time sustainable investment professional, I was dismayed to see this attack on sustainable investing in such a prominent forum. And, of course, I disagree: ESG investment funds are very much not a “sham”.
When done properly ESG analysis – the foundation of sustainable investing – looks closely at the impact of a company on the environment, its employees, its customers, its shareholders, and the world at large, as well as what it is doing to mitigate these impacts. The issues vary considerably from one sector of the economy to another and how a company manages its impact can vary just as considerably.
Good ESG analysis makes it clear which sectors and companies are problematic, which are not, and which are simply not investable at all. For well-managed sustainable or ESG investment funds, thorough ESG analysis of a potential investment is just as demanding as thorough financial analysis and just as important a driver of long-term performance.
In order to make the case for sustainable investing beyond simply feeling good about what your investments are financing we in the field often cite the ability of ESG analysis to reduce risk. Companies that are paying attention to the context in which they operate and to their impact on employees, customers, shareholders, the community, and the world at large are less likely to give investors unpleasant surprises than companies whose primary focus is the next quarter’s earnings.
We have seen this happen a number of times in recent years. A particularly high-profile example was BP’s massive explosion on an offshore oil rig that led to a massive oil spill in the Gulf of Mexico. BP was already considered uninvestable even by sustainable investors who did not screen out all fossil fuels because of its safety record, in particular its high rate of industrial accidents. Conventional investors were caught out by this disaster and lost a lot of money on their BP holdings. Sustainable investors – even those who invested in oil - did not hold the stock and their portfolios were unscathed.
Yes, Some Major Players in the Industry Are “Greenwashing”
Mr. Taparian points out – correctly in my view – that some leading ESG ratings agencies and ESG investment funds managers are taking the risk avoidance argument and using it as their sole ESG analytical tool. He’s a little late to this story since Bloomberg reported on it in 2021. Mr. Taparian is right that the results of this distorted ESG process are a sham.
What Bloomberg discovered – and Mr. Taparian after them – is that MSCI, one of the leading providers of ESG research and indices, is basing its analysis not on the ESG risks that a company is exposed to and what it is doing about them but on the likelihood that they will be held accountable by regulators or by the markets.
The funds that use MSCI’s ESG indices are putting this perverse analysis into practice. For example, until earlier this year, Black Rock’s MSCI ESG Aware Emerging Markets ETF held Russian giant Gazprom. In addition to being an enormous fossil fuel producer, Gazprom is practically the poster child for companies that are uninvestable on environmental, social and governance grounds due to its terrible environmental record, history of industrial accidents and abysmal treatment of shareholders other than the Russian government.
MSCI’s analysts had access to this information but – as an analyst revealed to me in a conference call in early 2021 – they did not take social and governance issues into consideration and considered Gazprom acceptable on environmental grounds because it does not mine coal or extract oil from tar sands. Furthermore – as identified by Bloomberg and Mr. Taparian – they knew that no one in Russia cared about Gazprom’s dismal performance on all three ESG factors and therefore these issues were not going to cause it any problems with regulators or local investors so its ESG risks were actually minimal.
What MSCI is doing is “Greenwashing”. Using their indices allows fund providers to slap the “ESG” or ”Sustainable” labels on their funds without actually doing the hard work of proper ESG analysis. Investors who buy these funds are being misled into believing that they are investing in companies that meet high ESG standards when in fact they are simply investing in companies that are not likely to get in trouble, regardless of their adherence to ESG standards. Not only is their money being invested in ways that do not align with their values, but they are also giving up the key long-term advantage of sustainable investing. At some point, these greenwashed companies may in fact get in trouble for their ESG failings and their share prices will suffer accordingly.
This Does Not Mean That the Entire Industry Is a “Sham”
Where Mr. Taparian is wrong is in his assertion that because a few big companies like MSCI are greenwashing, the entire ESG investment funds industry is a sham. He is focusing on the big players who are relatively new to ESG investing, having jumped on the bandwagon as it became mainstream. He ignores the fact that ESG investing has been around for decades, having begun in the opposition to the Vietnam War and to South African apartheid, as well as decades of activism by organizations dedicated to protecting the rights of shareholders.
Until recently ESG investing was mainly done by specialist financial firms for whom it is their core business. These specialist firms do their own in-depth ESG research and have developed considerable expertise in the field. They are fully committed to ESG investing and do not engage in the greenwashing that Mr. Taparian is criticizing. Some of the more recent entrants to the field are also genuinely committed to ESG investing.
Look Behind the ESG Label — ESG Investment Funds Are Real
I am not able to recommend particular ESG investment funds or fund management companies. However, it is important to understand that Mr. Taparian is wrong. There are many well-managed, genuine ESG investment funds on the market and many firms that are serious about ESG investing. The essential thing is to look behind the ESG label at what a fund that bears it actually owns. This will tell you if it is the real deal or not. Services such as www.asyousow.org or www.sustainalytics.com rate funds and companies on key ESG factors and highlight their exposures to problematic industries. As You Sow focuses on investment funds while Sustainalytics (unfairly criticized by Taparian) analyzes individual companies.
It does require some extra work and some asking of questions but it is very much possible for an average investor to build a truly sustainable investment portfolio. ESG investing is real.
Urban Larson
Principal
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