Investing according to environmental, social and governance criteria has been one of the key macro investment themes in the last decade. Growing at over 40% per year since 2015, the ESG sector now has nearly $20 trillion assets under management, and is expected to double again by 2026. However, a reaction against ESG has been gathering force, especially in the US.
Most recently, Florida governor and potential US presidential candidate Ron DeSantis has slammed ESG investing in his book The Courage to Be Free, and spoken of withdrawing $2 billion of state assets from the management of BlackRock because of the latter’s ESG investing focus. On Capitol Hill, the US Senate voted on 1 March to overturn a Labor Department rule allowing retirement plans to consider ESG criteria when making investment decisions. The resulting Congressional bill, however, was vetoed by President Joe Biden on 20 March – the first veto of his presidency.
Despite the veto, the whole concept of ESG investing is under scrutiny. The Economist, in an editorial last year, argued that investors should concentrate on the “E” of ESG, and within the “E” focus it on reducing emissions. And last year, thanks partly to Vladimir Putin’s invasion of Ukraine, fossil fuel stocks surged in price, rewarding investors who ignored ESG considerations. So ESG is down. But is this the right time for US Republicans (and others on both sides of the Atlantic) to kick it?
Freedom and disclosure
There is an inherent tension between the quest for economic actors to be able to make their own decisions free of government diktat – as suggested by the title of DeSantis’ book – and the idea that politicians should be able to ban funds from using ESG criteria to help pick their investments. Either it’s a free market, or it isn’t.
The DeSantis camp argue that the only thing that really matters to investors is that their money should produce the best possible financial returns, and that therefore those returns should be the only criterion – “business of business is business” mantra that has links to the core of US liberalism. However, part of the idea of ESG is to exactly support this thesis – investors should look more closely at the impact of environmental, social and governance factors on corporate profits. The ESG theme encourages investors to look around the corner on the low-carbon transition, and forces companies to make greater disclosures on their performance against these metrics.
A deeper justification for ESG lies in the broader role corporations play in society. The puritanical pursuit of profits, while relying on governments to intervene to address “externalities”, misses the connection between corporations and government. Governments are strongly influenced by corporates, not least through the murky world of lobbyists, and as result are often too slow to drive change. The stuttering progress to curb carbon emissions over the last 20 years is evidence of this. Maximising profits while waiting for regulations to change will not be enough.
None of that is to say that ESG investing is perfect. The subjectivity of sustainable investing has been highlighted in the last year by the Ukraine War – some indices and investment mandates exclude defence companies, but without Western defence industries, Ukraine might already have succumbed to the Russian invasion.
Awkwardly, at present many ESG indices closely track conventional indices such as the S&P 500, except that they exclude a few coal and firearm companies. This means that the funds that track those indices still have large weightings in oil and gas stocks. Moreover, if the ESG movement succeeds in tightening the screw on the fossil fuel industry by excluding such companies, the more they could force those industries off stock markets and into the hands of private owners, who may have fewer scruples about how those businesses make their money.
However, it is one thing to point out the complexity of the ESG issue, and to say that it needs to evolve to be more effective. It is quite another to say that the sustainable investing baby should be thrown out with the ESG bathwater.
Impact on voluntary carbon credit market
If ESG mandates are under attack by the US Republican Party and others, does that mean that companies should row back on their sustainability efforts? And what might this mean for corporate demand for voluntary carbon credits?
At present, many companies ‘retire’ voluntary credits as a way of offsetting their emissions, in order to be able to chart a course towards long-term targets such as net zero by 2050. If the ESG comes under pressure from the DeSantis crowd, those companies could in theory decide to water down net-zero or emission reduction targets.
This however, would be a myopic perspective. In practice corporates have many reasons to tell the world they are good social and global citizens. Firstly, ‘greening’ their brand makes it more attractive to young, environmentally conscious customers. Secondly, it makes it easier to recruit sustainability-minded employees. Even amongst Republican supporters concern about climate change is very apparent. According to a 2022 Gallop poll, 59% of Republican voters under the age of 34 are fairly or greatly concerned about climate change. This figure falls 46% for voters 55 and older. For the non-partisan crowd 83% of voters under 34 are fairly or greatly concerned about climate change. These patterns manifest in how younger employees chose their products and employers.
There may also be a more Machiavellian benefit to corporates following a pro-ESG route. If corporates voluntarily take on environmental targets and can prove they are delivering on them, it may avert future tighter regulation – something many companies try to avoid.
Even if investors decide not to look at securities through an explicit ESG lens, they will still be trying to second-guess the impact of future emissions policy and climate change on company profitability. Companies that offset their emissions by retiring voluntary credits will not directly be boosting profits in the short term, but they are signalling their awareness of the climate challenge facing their businesses. This shows strong management, foresight and a connection to the broader world in which they operate.
If you want to be a highly regarded CEO, it’s better to be seen to have your eyes open than your head in the sand.