When Morningstar observed a slowdown in new ESG fund launches last quarter, it seemed like big news. Could the public interest in sustainable investing be waning?
In the long run, there’s little to no chance of that. Climate change, deforestation, water scarcity, pay inequality, employee upheaval at home, and human rights in emerging markets—all these concerns are long-term market risks and opportunities, and they will be understood as nearer-term business risk as individual companies get singled out for their behaviors, protocols, or exposures to them.
In the meanwhile, is a reset or reckoning in the market for “ESG investing” really a bad thing?
A moment to build investor trust
As the industry continues defines itself under the gaze of an anxious public, it will continue to be pummeled by charges of greenwashing due to metrics that are inadequate or still in development, or marketing that fails investors trying to do the right thing. (Green “hushing” can also be an issue when politics invades boardrooms.)
What’s clear is that after a period of significant growth, ESG investment vehicles need to evolve, both to keep pace with changes in the whole ecosystem of business, including new regulations, and to earn investors’ trust.
Under pressure from EU regulators, a good number of ESG funds have already rebranded or will exit the “ESG” space, recognizing they may sound like they are environment friendly but are more about —as Ken Pucker put it in a recent piece for Harvard Business Review—“the impact of the planet on the company and not the impact of the company on the planet.”
In the US, the SEC is responding to market demand for greater clarity as investors get more sophisticated about sustainability and what’s needed to meet both public expectations and private goals on climate. It is now poised to announce its own fund disclosure requirements to address greenwashing. Disclosure by companies themselves may also evolve with new international standards.
Next, ESG has even bigger-picture headwinds to confront
Pucker’s piece in HBR notes that passive index funds—estimated to account for 20% to 30% of US equity markets—are ill-suited to the time-intensive task of influencing business strategy. Indexing keeps costs to investors low by eliminating the services of a traditional stockbroker or the costs of high-touch asset managers to pick individual stocks. It’s essentially the opposite of funds that market “alpha” or that seek to outperform the market. The focus of index funds is on the needs of mainstream investors and pensioners, not how to influence the decisions or choices of a specific company.
It’s also important to acknowledge that the idea of “doing well by doing good” isn’t axiomatic, automatic, or able to produce returns now. It requires a steady hand and long-term vision. There are rewards for investing in companies with clear strategies and the operational chops to pursue carbon-reducing innovations and practices, or that have superior workforce practices, but don’t expect to see an upside in a year or two. The stock price typically still goes down when a company raises wages; it goes up if a company announces a layoff.
And let’s not forget, 2022 was a loser for those light on fossil fuels. Demand for fossil fuels is high and projected to grow until better alternatives kick in at much larger scale. Oil and gas stock valuations went up in a bad year for the stock market, and this was based on actual earnings growth, not just sentiment. Chevron, for example, announced record profit in 2022.
ESG demand in the long run
Here’s the good news.
First, we are experiencing significant growth in primary investment. As this McKinsey research lays out, fresh capital for green investment, especially through private markets, is now hot—and more is needed.
McKinsey puts the need at a net increase of $3.5 trillion annually; the trends are promising and meaningful to meet the need for innovation in everything from battery storage to next generation nuclear to decarbonizing the use of fossil fuels. Incentives are now better aligned and capital for new infrastructure is flowing. McKinsey writes: “The current momentum in climate-focused investing suggests that the space is breaking out—not breaking down—in the face of market complexity.”
Second, we require and are seeing more investors and asset managers attuned to a company’s real performance—i.e., its business model, and the choices it makes—over the performance of its stock in the secondary market. This kind of investing calls for a long-term orientation, paired with active engagement with companies. And the asset management industry—now including private, not just public markets—is gearing up by hiring specialists equipped to analyze the real-world performance of companies.
It is time for serious investors to get serious about ESG, ideally to the point that it is no longer an investment “category” but, rather, a mainstream strategy. Perhaps it’s the only logical one for a market concerned with returns for individual shareholders in the transition to a carbon-neutral economy.
There are real opportunities to make a difference through sound use of investor capital, and more capital is needed. But strap in. It’s going to be a wild ride.
Judy Samuelson is executive director of the Aspen Institute’s Business and Society Program and author of “The Six New Rules of Business: Creating Real Value in a Changing World.”