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STATE OF PLAY

A guide to ethical investing

ESG
Illustration by Matt Williams
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Table of contents

What is ESG investing? | A brief history of ESG | How to measure corporate responsibility | The debate over ESG’s effectiveness | The future of sustainable investing

Global corporations virtually never lose shareholder votes on how to govern their boards and businesses. For decades, ExxonMobil, the seventh biggest oil producer in the world, has swatted away activists who tried to force it to improve its poor environmental record. Year after year, the company’s biggest investors have rubber-stamped whatever the board wanted, just as they were expected to.

This year, that changed.

On May 26, shareholders stunned ExxonMobil, and much of the business world, by replacing two of the company’s directors with nominees backed by a small, obscure San Francisco-based hedge fund called Engine No. 1. A couple of weeks later, the firm sealed the election of its third nominee on the 12-member board. Just five months old and holding a meager 0.02% of ExxonMobil’s shares, Engine No. 1 lambasted the oil company for failing to reckon with the epochal changes carbon emissions are causing on the planet and in the global economy. The hedge fund argued that ExxonMobil had mismanaged capital by aggressively developing new sources of oil rather than shifting to renewable energy.

That criticism resonated with ExxonMobil’s most influential stockholders—BlackRock, Vanguard, State Street—who had been frustrated with the company’s poor stock performance in recent years. To pressure the company to change its climate and financial strategies, they voted for the outsiders.

“This was a breakthrough,” says Tim Mohin, a leading voice in the environmental investing movement and the chief sustainability officer at Persefoni, an Arizona firm that makes software to measure carbon emissions. “When institutional investors like these vote their shares for an activist resolution, then sustainability has moved from shaking fists at the front gate to the mainstream. Companies cannot ignore these resolutions anymore because they may lose.”

What is ESG investing?

For decades, advocates have urged public pension funds and money managers to use their financial clout and press companies to address crises ranging from arms sales to tobacco’s cancer risks to climate change. The movement is now known by a catch-all acronym: ESG. It stands for the environmental, social, and corporate governance criteria that investment firms are increasingly using to screen the stocks and bonds issued by companies. The idea is that the capital markets have the power to change corporate behavior without onerous government regulations.

Even if you’re not an avid investor and only review your 401k statements once in a while, chances are you’ve come across ESG. The market is chock-a-block with ESG-branded mutual funds and ETFs, many of which are beating the S&P 500’s performance. Almost $40 trillion is held in ESG assets worldwide, according to the Global Sustainable Investment Alliance. And Bloomberg Intelligence projects that ESG assets may top $53 trillion by 2025, accounting for a third of total global investments. An entire industry of data crunchers—Morningstar, MSCI, Bloomberg, to name a few—analyze and score companies on how well they comply with carbon emission goals, human rights and labor protections, and, especially in the wake of the Covid-19 pandemic and the Black Lives Matter movement, mental wellness and diversity practices in the workplace.

While the very notion of ESG may still raise the hackles of money managers who believe their only job is to deliver big returns, socially responsible investing has become a force that cannot be ignored.

BlackRock, the world’s biggest investment house that manages $9 trillion in assets, is betting on it. When the company finally set aside its long-held agnosticism on green investing in 2020 and declared that climate change augured a “fundamental reshaping of finance,” it put the rest of Wall Street on notice. “I believe this is the beginning of a long but rapidly accelerating transition, one that will unfold over many years and reshape asset prices of every type,” Larry Fink, BlackRock’s influential CEO, wrote in his annual letter this spring. “We know that climate risk is investment risk. But we also believe the climate transition presents a historic investment opportunity.”

A brief history of ESG

The idea of tying investments to social responsibility has been around a long time. In the 19th century, Quakers and Methodists urged business leaders to shun enterprises that supported slavery, as well as companies that profited from vices such as drinking spirits or smoking tobacco. The modern era of activism got going in the 1960s when college students protesting the Vietnam War implored university endowments to stop investing in arms manufacturers. By the 1980s, a series of environmental disasters—the Three Mile Island and Chernobyl nuclear meltdowns, numerous crude oil spills—made environmental concerns a top priority for crusading investors.

It was the struggle to end apartheid in South Africa that truly galvanized socially responsible investing into an organized force. In the late 1980s and early 1990s, many US states and municipalities started combing through their pension fund portfolios to weed out the stocks of companies that did business in the racially segregated country. Corporate boards, which tended to treat political issues as beyond their purview, got the message and hundreds ceased doing business in South Africa. The upshot was an awakening inside giant pension funds like the California Public Employees’ Retirement System, or CalPERs, that they had the power, and the responsibility, to spur changes that benefited society and not just their income statements.

In 2005, the United Nations backed an initiative led by CalPERS and 50 other institutional investors called the Principles of Responsible Investment. This document became the movement’s Magna Carta by calling for ESG issues to be incorporated into investment analysis and decision making. The term ESG stuck. (Today, the organization has more than 3,000 signatory institutions representing more than $100 trillion in assets.)

This shift coincided with mounting evidence that human activity, especially the burning of fossil fuels, was heating up the atmosphere. In 1990, the UN’s Intergovernmental Panel on Climate Change (IPCC) published its first report concluding that soaring emissions of carbon and methane would lead to the melting of polar ice caps, rising sea levels, and environmental devastation. As subsequent IPCC reports detailed the looming crisis, a political consensus formed in developed economies that a global response was needed. Soon enough, climate change became the core cause of ESG.

The movement gathered momentum with the adoption of the UN-sponsored Paris Agreement of 2015. Under the landmark accord, 196 nations committed to limiting the global temperature increase this century to no more than two degrees Celsius higher than pre-industrial levels, a measure scientists believe should mitigate the most catastrophic effects of the rapidly changing atmosphere. Money managers and company boards now had to reckon with the likelihood that new regulations on carbon emissions were inevitable.

“Companies cannot ignore these resolutions anymore because they may lose.”

Even though president Donald Trump refused to acknowledge climate change was real and withdrew the US from the Paris Agreement in 2017, ESG had already industrialized into a force affecting the flow of trillions of dollars in investment capital. Scores of firms analyzed companies and produced ratings and rankings based on ESG criteria that guided pension funds and other investors. Fund factories such as Fidelity, Vanguard, BlackRock, State Street, and Amundi rolled out dozens of ESG-branded products. ESG had truly arrived. Yet so too did questions: How could anyone measure the effectiveness of the project? And could investors trust ESG labels?

A bevy of standards bodies weighed in to try and impose some order. There was the Carbon Disclosure Project (CDP), the Climate Disclosure Standards Board (CDSB), the Global Reporting Initiative (GRI), the International Integrated Reporting Council (IIRC), and the Sustainability Accounting Standards Board (SASB). Unsurprisingly, company officers eager to improve their ESG scores found the process convoluted and uncertain. So, too, did investors who took the trouble to delve into the nitty-gritty of ESG ratings. Often they’d find a company scored quite differently by ratings firms and there was no baseline to fall back on. In a study published in 2018, Robert Eccles and Judith Stroehle of the University of Oxford highlighted the problems posed by diverging methodologies.

“As there is no generally agreed-upon set of measures to capture the fuzzy concepts which describe a firm’s non-financial performance, the construction of ESG is virtually left to the discretion of the undertaker,” the authors wrote.

In other words, everyone should get on the same page.

How to measure corporate responsibility

In practice, getting all stakeholders to evaluate ESG in the same way isn’t really feasible, or desirable, says Michael Jantzi, the CEO of Sustainalytics, an Amsterdam-based ESG ratings firm that covers 20,000 companies worldwide. There’s nothing wrong with having myriad scoring outfits and approaches for ESG, Jantzi says. That’s how bond rating agencies and equity analysts size up the other risks of companies.

Sustainalytics, which is owned by the Chicago-based market data giant Morningstar, uses home-grown software to gather and analyze data and more than 350 analysts to assess the risks companies face if their environmental, social, or governance practices aren’t up to snuff. It rates companies both within the total corporate universe and within their industry groups. The ratings range from “negligible” to “severe” risks. For example, Sustainalytics rates ExxonMobil a high risk primarily due to its carbon-heavy operations. As for companies that fall under the S-for-social segment of ESG, Sustainalytics scores Facebook a medium risk because its vast collection of user data raises privacy, security, antitrust, and reputational exposure.

In contrast, MSCI, another major ESG ratings firm, focuses on sizing up companies relative to their sectors. It uses a letter-based system similar to those employed by bond-rating outfits like Moody’s, ranging from AAA to CCC. MSCI rates ExxonMobil an average BBB, which is better than Sustainalytics’ grade. Yet MSCI branded Facebook a laggard with a B because it compares so unfavorably with the two dozen or so peers in its industry. That’s worse than Sustainalytics’ rating.

Jantzi, a 30-year veteran in ethical investing, says forcing ratings firms to homogenize their scoring methods into a single framework doesn’t make sense. What is needed, though, is a way to make companies disclose ESG-related data under a universal standard.

“We should have the same baseline for these type of data because we need to have faith that the reporting is accurate.”

Companies already report their fiscal performance in a standardized way—thanks to Generally Accepted Accounting Principles and International Financial Reporting Standards (IFRS) it’s easy to compare income statements and balance sheets. Now there’s a push to develop similar standards for disclosing greenhouse gas emissions. Remember that gaggle of standards bodies? Last September, they joined together to hammer out a unified plan for climate-related reporting standards; in March the IFRS started work on developing sustainability disclosure practices in coordination with the effort.

“We should have the same baseline for these type of data because we need to have faith that the reporting is accurate,” says Jantzi. “That’s the direction we’re headed. I think it’s a matter of when, not if.”

Meanwhile, regulators are finally introducing rules for ESG disclosure. This March, the European Commission, the executive branch of the European Union, started implementing provisions of the Sustainable Finance Disclosure Regulation. The measure requires financial firms doing business in the world’s second biggest economy to disclose how they factor environmental risks into their investment decisions. The British government is poised to make climate-related financial disclosures mandatory for listed companies; it would be the first G20 nation to take such a step. In the US, the Biden Administration, which rejoined the Paris Agreement earlier this year, is also making climate-related disclosure a priority. In June, Gary Gensler, the chair of the Securities and Exchange Commission, said the agency was reviewing potential measures to require public companies to disclose metrics around greenhouse gas emissions.

The debate over ESG’s effectiveness

Amid all the action one fundamental question remains unanswered: Will ESG truly change the practices of companies and financial institutions?

It hasn’t yet, at least not directly, according to a study published in May by the European Corporate Governance Institute. The authors found that increasing the amount of ESG investment in companies did not lead the recipients of those funds to reduce pollution, improve workplace safety, or increase the gender and racial diversity of their boards.

“Our results suggest some caution is warranted,” the report concluded. “While investors clearly value the idea of socially responsible investing, the evidence suggests it may not actually improve real-world behavior.”

Skeptics contend that ESG, for all its good intentions, is primarily marketing hype designed to make investors believe their funds aren’t contributing to a host of ills. Tariq Fancy, the former chief investment officer for sustainable investing at BlackRock, says there’s too much “greenwishing” that a sustainable form of capitalism will take root on its own, while the reality is that to truly slash greenhouse gases, governments are going to have to direct industries to bake the price of carbon into their economic models.

“Look what governments did with Covid-19,” says Fancy. “Everyone understood that states had to take extraordinary action to flatten the curve. They closed schools, shops, restricted travel, made masks mandatory. That’s what needs to happen with climate change. I mean, so ExxonMobil gets three new directors. So what? It doesn’t matter. My concern is that well-intentioned campaigners are wasting their energy on things that don’t have any impact. And we are burning valuable time.”

“…we are moving into a dynamic new era of shareholder activism that will start to hold individual directors and chairmen accountable.”

Yet activists on the front lines of ESG counter that changing the board of a company like ExxonMobil, or the policies of a firm as powerful as BlackRock, is a major leap forward no matter how you slice it. The mindset of an entire generation of investors is changing, as are their expectations and priorities, and companies will have to respond or watch their stock valuations fall. Catherine Howarth, the CEO of ShareAction, a London-based charity that advocates for ESG issues, is building alliances with global investment firms rather than hectoring them from the sidelines. And the organization’s tactics are yielding results. Just this May, ShareAction allied with two major European investment firms and persuaded the global lending giant HSBC to phase out financing for coal producers.

“Tariq has a point—I completely concur that tough government action, including financial regulation, is crucial,” Howarth says. “But I think he may be too cynical because there is real scope for improving the performance of financial institutions. Whether that represents a real revolution remains to be seen, but we are moving into a dynamic new era of shareholder activism that will start to hold individual directors and chairmen accountable. They are going to have to be willing to put the environment and human rights first.”

The future of sustainable investing

Millennials, who number more than 79 million in the US and are now entering their peak earning period, are overwhelmingly in favor of values-driven investing. Nine out of 10 millennials active in the markets say they believe in sustainable investing, according to a 2019 study by Morgan Stanley. Market experts say they’re a big reason why ESG funds surged more than $285 billion in 2020, a 96% jump over 2019. With the cohort set to inherit $30 trillion in generational transfers over the next several decades, you can bet ESG has only begun to reshape the capital markets.

It doesn’t hurt that some ESG funds are beating benchmarks. The Baillie Gifford Positive Change Fund, which focuses on companies that make a “positive impact” on society like Tesla and Moderna, has soared more than 50% in the 12 months ending June 30 compared to the 38% jump in the S&P 500 Index. It looks like many funds are getting a lift as companies in their portfolios with good ESG ratings garner more positive news coverage in the marketplace. Vanguard, BlackRock’s iShares unit, and lesser known names such as Stewart Investors and Parnassus have also attracted billions in assets from investors who believe ESG isn’t just the right thing to do, it’s more profitable too. In January, a Morningstar study found that three out of four sustainable equity funds finished 2020 in the top half of their categories. “It is increasingly clear that companies that are run in a sustainable way are more likely to have sustainable earnings, and therefore make better investments,” says Susannah Streeter, a senior investment and market analyst at Hargreaves Lansdown, the biggest retail markets platform in the UK.

Now Engine No. 1 is taking its activism to retail investors. On June 22, it launched an ETF with the ticker VOTE. Its mission: to take stakes in 500 of the biggest US companies and press them to embrace ESG values. In just 10 days, the fund amassed more than $112 million in assets. While the efficacy of ESG remains an open question, the arrival of ultra-cheap funds like this one could usher in a new phase for the decades-long movement.

“I believe shareholder activists are going to find a lot of support with funds like this,” says Jonathan McCullagh, the founder and CEO of Arcturus, a British ESG analytics firm. “There are trillions of dollars in capital ready to rotate into greener investments.”