More than 30 US states have proposed or implemented legislation in recent years to prevent the government and its pension funds from investing in environmental, social and governance (ESG) funds. These products integrate ESG issues into their investment strategies, mainly purchasing stocks but also bonds.
American conservatives claim so ESG has too great an impact on companies and the entire economy – hence the recent moves to ban the public investment strategy. But critics in Europe argue that ESG funds are not doing enough to make a positive impact in the real world.
Both cannot be right. So, who is that?
Us recently published research examines this question by looking at the actual sustainability impact that these funds have. although Financial industry groups argue that With a third of all investment assets already sustainable, our research shows that most ESG investments do not actually create a significant sustainability impact.
Most ESG funds take conventional investment funds as a basis and adjust their capital allocation according to ESG criteria. The funds that stick closest to their conventional peers are called “broad ESG” or “ESG integration funds.” Broad funds are sensitive to this accusations of greenwashing because their capital allocation differs only slightly from that of conventional funds.
For example, these funds typically exclude thermal coal producers from their portfolios and place slightly less weight on oil companies. As a result, large tech companies such as Amazon, Microsoft and Alphabet often make up a larger portion of these funds’ portfolios due to their enormous market capitalization and relatively small emissions footprint (at least compared to fossil fuel producers). Overall, however, changes to their portfolios are more cosmetic than anything else.
Our market analysis of ESG funds shows that 88% of all index-tracking ESG funds are broad ESG funds. But there are also ‘light green’ and ‘dark green’ ESG funds, which do not track conventional or benchmark stock indexes as closely. Light green funds represent 7% and dark green funds 5% of the market.
When it comes to companies offering these ESG funds, our research shows that Blackrock is the largest provider, but its market share is just 15%, followed by Fidelity with 12% and Pictet with 8% of the pie. This suggests that ESG asset management is a rather fragmented market, making it less likely that asset managers will be able to set the standard for ESG themselves.
Who really sets the ESG standards?
Instead, we found that asset managers like Blackrock, who are passive investors, essentially delegate their investment decisions to ESG indices. And most large active managers like Fidelity barely deviate from their non-ESG index benchmarks. What is ultimately important in defining ESG capital allocation are the indices.
Indices are essentially a basket of specific stocks that aim to represent a specific economic entity. There are many, but for example the S&P 500 represents the US stock market, while the MSCI ESG Leaders USA Index would represent the leading US companies with respect to ESG criteria.
These index providers play a key role in this era of passive asset management. We discovered that ESG funds often do that only track existing stock indices Today, investment decisions are effectively delegated to the companies that create these indices. As a result, the ESG standards are actually set here.
One company in particular is dominating the development and supply of ESG indices: MSCI is in a stunning position global market share of 57%, compared to just 12% each for its nearest competitors, S&P Dow Jones and FTSE Russell. This is largely because MSCI is one of the few companies that provides not only ESG ratings, but also data and indices. By offering a number of related products in this way, a strong one is created “network” effect.
Furthermore, most ESG funds are based on companies’ ESG ratings, which do not aim to measure a company’s sustainability impact on the environment or society. In fact, she measures exactly the opposite: the potential impact of ESG on the company and its shareholders.
Broad ESG investing based on MSCI and other rating and index providers is therefore really just a risk management tool for investors. Instead of monitoring how a company influences or helps the escalating climate crisis and other ESG issues, it actually tracks how ESG factors impact companies.
This means that broad ESG funds, which form the lion’s share of the market, often make only a fairly weak attempt to manage ESG. Their typical capital allocation – the amount of money invested in a fund – hardly differs from conventional funds.
How ESG funds can drive sustainability
However, capital allocation is just one of the possible ways in which ESG investing can promote sustainability. Shareholder involvement could be even more powerful. This can be pursued by investors through their proxy voting behavior at the annual general meetings of the companies that are part of their portfolio, or through other forms of interaction (such as private arrangements) with the management of these companies.
Research has shown that funds can create significant impact through these routes. But currently, shareholder engagement is not a standard part of ESG methodologies, nor of ESG indices. Our research shows that this can be a crucial factor in ensuring ESG funds have maximum impact, but there is a need for significant changes in the regulation of the sector.
This should include clear criteria for broad-based ESG funds to dictate how capital allocation should differ from conventional funds, plus favorable tax or regulatory arrangements to increase the market share of light and dark green funds. International regulators should also develop minimum standards for the proxy voting behavior and private engagements of ESG funds.
In its current form, ESG will not decarbonize our economies. The volume of “real” ESG funds is still so small that they cannot possibly change contemporary capitalism, suggesting that US conservatives’ “war” on ESG is just election fraud. Instead, the EU discussions about ESG greenwashing seem a much more appropriate description of what is going on in the world of (so-called) sustainable finance.