ESG. So far, a triumph of form over substance

Tom Steffen talks about poor definitions, low bars and why ‘green-hoping’ is now one of the biggest problems in sustainable investing

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ESG, the abbreviation that has taken the investment world by storm over the last few years, is plagued by vague use of terminology, untargeted solutions, and half-hearted commitments. The term’s use by the investment community has increasingly become one of form over substance: too often claims of ‘responsible’ behaviour matter more than evidence. Does loose interpretation and implementation of the term do more harm than good for the sustainable investment movement and thereby hinder the efficient reallocation of capital?

In this article we look at what the investment community needs to do better in order to use its substantial influence to lead the transition to a sustainable and just future more decisively.

Cynics could point towards ESG investing being the most significant marketing initiative to seize the industry in recent years. With falling margins and active management under severe pressure, surely asset managers wouldn’t just be taking advantage of this trend to add more ‘value’ for their investors? The number of conferences, talks, and online seminars on offer each week underline the boom in ESG investing and all major asset managers and top tier banks are vying to prove that they can be responsible with our savings. Sadly, for the most part, this is a triumph of form over substance. While some are creating and applying ESG frameworks that offer quality and expertise, many are simply trying to jump on the ESG bandwagon to capitalise from the trend. In order for the growth in sustainable assets under management not to lose momentum, through breaking the trust of investors and society at large, investment managers will need to start understanding and addressing the key issues surrounding the way in which they define and apply ESG.

Confusion over definitions

‘ESG investing’, ‘sustainable investing’, ‘socially responsible investing’, ‘ethical investing’, and ‘impact investing’ are terms often used interchangeably. They describe, however, heterogenous investment approaches that have important differences. ESG investing refers to a broad concept of considering Earth’s ecosystem but also societal implications and the governance responsibilities of companies.

Sustainable investing mostly refers to investing within the limits of the regenerative capacity of our planet. Socially responsible investing aims to invest in a socially conscious way to avoid doing harm and bring about positive social change. Ethical investing is the practice of allocating capital based on ethical or moral principles. Impact investing on the other hand is more focused, aiming to generate a measurable beneficial impact to the environment or society. By being unclear about the above concepts — using vague definitions and loose terminology, investors’ expectations about the non-financial benefits of these investment approaches might not match the actual objectives targeted by the investment manager. A socially responsible investment fund and an ethical investment fund sound relatively similar at the outset, but the first fund’s selection criteria might avoid addictive substances while the second fund might shun animal testing; two substantially different non-financial outcomes. Comparing funds with different strategies and aims, on a like-for-like basis, will lead to erroneous conclusions. Without a universally agreed taxonomy, each investment manager has a responsibility to be clear about the meaning, intent, and outcome of each investment strategy, no matter the sustainable or responsible lens that is applied.

On complexities

E, S and G are three connected categories. Yet, each category covers a wide-ranging set of distinct challenges. ESG rating agencies use hundreds of indicators to measure a firm’s performance on the numerous diverse concepts within each category —carbon emissions, water usage, and generated waste in the E, workplace safety and human rights in the S, and board independence and executive compensation in the G, to name a few. Not only are there many different ways of measuring E, S and G, but the task is further complicated by the fact that the three categories are also often closely interlinked. Climate change clearly impacts society directly; droughts and water security, for instance, will have geopolitical implications threatening social justice, education, and equality. Yet, the issues within each category are by themselves extremely complex, and it is becoming increasingly difficult to address them all within the overarching ESG framework.

Are the different E, S, and G categories equally important, or do some concepts outweigh others? How do we objectively assess a company with strong pollution prevention but poor diversity credentials or alleged tax avoidance? Moreover, companies often operate in different business segments. Is it justifiable to buy a company with 55% of its revenue derived from oil & gas exploration but 45% from renewable energy? And what about a rail vehicle manufacturer that is also active in the defence industry, or a hotel chain that operates casinos?

While this article does not argue in favour of any of the three categories, and recognises the merit of each, the aggregate ESG concept means that addressing the concerns within E, S and G simultaneously is an inherently difficult, if not impossible, task. The issue is even more evident when operating within the confines of a well-diversified and risk-controlled portfolio. The interrelations and complexities of ESG issues caution against a general-purpose approach, where impact is lost by trying to solve too many issues at once. Choosing a specialised over a generalised approach can lead to a big advancement on a single issue, which may be more impactful than small advancements on many fronts.

Adequate expectations

‘Doing well by doing good’. The decade old question of whether ESG investing is beneficial or detrimental to investment performance is difficult to answer without being more specific about the category that is studied, its definition, and the targeted outcome. Is the aim to address E, S and/or G issues while also improving financial performance? Or is the objective to solely do good but potentially accept financial sacrifices in favour of non-financial benefits? As outlined above, ESG aggregates many different concepts with varying definitions and measurement approaches. As such, the question of whether ESG considerations are value-enhancing strongly depends on the targeted outcome of risk, return, or non-financial benefits. It is therefore necessary to distinguish between those ESG signals with evidenced risk or return characteristics and those that target non-financial objectives alone. Again, this article does not argue in favour of prioritising financial over non-financial benefits or vice versa but highlights the importance of clarity on the targeted objective.

Few endeavours generate a benefit without an associated cost— there is no free lunch, not even in ESG.

Do ESG metrics only have merit if they improve performance? No. It is, however, important that investment firms offer investors clarity about the objectives (and potential trade-offs) of including ESG considerations in their investment strategies. When it comes to the question of whether all elements of ESG improve returns, the answer is also no, and the costs and benefits should be evaluated. Few endeavours generate a benefit without an associated cost— there is no free lunch, not even in ESG. That said, specific indicators within the E, S, and G categories can be statistically related to return as well as risk. If the objective is to achieve both financial and non-financial benefits, ‘doing well by doing targeted good’ should be the preferred approach. For example, accruals as a governance measure positively predict returns. Moreover, employee satisfaction generates excess returns and eco-efficient stocks significantly outperform eco-intensive stocks. There is also evidence that addressing ESG issues reduces downside risk; again, more so for some categories than others as risk reduction is particularly effective when addressing environmental topics such as climate change. The devil is, as ever, in the detail.

No one-size-fits-all approach

Addressing ESG concerns can be achieved using different techniques: negative screening, positive screening, tilting, integration, active engagement and shareholder voting, to name a few. These techniques have widely different impacts on portfolio construction and outcomes. For example, negative screening generally reduces the investable universe while tilting impacts portfolio weighting. Engagement, on the other hand, does not affect the portfolio construction itself, but takes place after investment decisions have been made. Given societal pressures, the exclusion of companies from portfolios that operate in sectors that are ethically undesirable, or that are in their current form incompatible with a responsible future, is currently the approach most frequently adopted. Arguably, it is also easiest to implement. Yet, negative screening is not the only way of achieving a transition to a sustainable and responsible future.

The impact of exclusions on investment performance is subject to active debate, with some studies demonstrating no impairment and others finding a detrimental impact. Evidence suggests that negative screening can impose a financial cost on investors. Often, stocks that are shunned by investors – so-called ‘sin stocks’ – in industries such as alcohol, tobacco and gambling have higher expected returns than otherwise comparable stocks.

The suggestion that $30trn of assets are now assigned to ESG strategies dramatically overestimates the actual state of the industry

Engagement, on the other hand, can be a powerful tool to achieve positive excess returns as well as improving the ESG behaviour of companies. Many sectors that are increasingly judged inappropriate—oil & gas, utilities, airlines, and chemicals etc – are needed in some form or another (although substantially transformed and at a smaller scale) for the modern economy to survive in an environmentally and socially just future. The companies that are best positioned in all necessary sectors to achieve the transition to such a future should be encouraged to undertake the required changes. Positive screening, integration, and tilting therefore present effective alternatives to further the transformation of our economy. While every approach has its advantages and disadvantages, the investment community should build on the strengths of the diverse ESG investment techniques to successfully address the obstacles in the way of a transition to a sustainable and responsible economy.

About data

Data is key. ESG investing should be evidence-based using high-quality and detailed data with a wide coverage. Data is most useful when retrieved directly from reliable, objective sources and when measuring quantifiable indicators. Data that has already been adjusted and aggregated is difficult to combine and to compare with other sources, and transparency on the processing that has been done is limited. As such, the high reliance of investment managers on aggregated ESG scores from third-party vendors is both surprising and disconcerting given that correlations are low, transparency on backfilled, corrected, and extrapolated data is poor, and many data points are generated by qualitative and subjective means.

Organisations such as the PRI and CA100+ inadvertently aggravate the situation as their minimum compliance requirements are currently too low, leading to the exploitation of their memberships as marketing ploys by the investment community

That being said, for those investment managers that collect and use detailed proprietary ESG data and who develop their own models to derive investment signals, the low correlations and data discrepancies will generate mispricing opportunities that can be traded on. In the future, more granular E, S, and G data will become available and more efforts should be made to collect relevant, accurate information and to process it in appropriate models to better distinguish the leaders from the laggards.

On human capital

Human capital will provide an edge. While it is a considerable achievement that ESG concerns are increasingly acknowledged by professionals in the financial industry and many make valuable efforts to build their expertise in this domain, it is crucial that the broad generalist knowledge is supplemented by specialist knowledge. The time when ESG was a peripheral issue and financial analysts were individually responsible for the inclusion (or not) of non-financial criteria in the investment process has come to an end. ‘ESG-trained’ financial analysts and CFA-offered ESG certificates alone are insufficient to do justice to the many complexities of the environment and society. While ESG training of existing staff is important, these high-level qualifications are an incomplete substitute for expert knowledge of extensively trained scientists. What is needed is the qualified expertise and skills of environmental scientists, engineers, sociologists, anthropologists, environmental economists, and many other experts from a range of academic disciplines. Their knowledge will become invaluable in navigating the complexities of the ESG space and should actively flow into the data collection, analysis process, and construction of investment strategies.

Walk the walk

Cut through the noise: nowadays many investment managers offer ESG solutions, but today’s environmental challenges and societal developments call into question the adequacy of most of the solutions on offer. A conventional investment strategy with a standard aggregate ESG overlay does not allow for today’s complexities. Such strategies allow investment managers to do little while claiming a lot. More targeted investment strategies, run by specialist teams with adequate expertise and knowledge, are needed to successfully navigate the dynamic and complex ESG environment. 

Green-hoping, or valuing intent over action, might currently be the most pressing issue in the investment community. Going forward, corporate action rather than corporate intent is what matters.

The suggestion that $30trn of assets are now assigned to ESG strategies dramatically overestimates the actual state of the industry and is misleading about the level of dedicated assets. While contributing many positives to the sustainable investment movement, organisations such as the Principles for Responsible Investment and Climate Action 100+ inadvertently aggravate the situation as their minimum compliance requirements are currently too low, leading to the exploitation of their memberships as marketing ploys by the investment community. In addition, while many are aware of the risk of greenwashing, few are aware of the problem of ‘green-hoping’—the reliance of the ESG community on promised targets and corporate non-financial reporting quality to evaluate companies, rather than achieved ESG improvements. Green-hoping, or valuing intent over action, might currently be the most pressing issue in the investment community. Going forward, corporate action rather than corporate intent is what matters.

Quid pro quo

Pay-to-play is a concerning development for the sustainable investment movement and could prove detrimental to innovation in the industry. ESG conference presentation time and sustainable investment awards are increasingly linked to event sponsoring fees threatening to bias the discourse in favour of those with the most generous marketing budgets rather than those with the most relevant messages to share. Conferences and awards should aim to shine the spotlight on the most meritorious advancements, and the most knowledgeable individuals across the industry, in order to evolve the sustainable investment movement together.


Overpromising on ESG achievements and investment performance will do substantial harm to the sustainable investment agenda; investors and society will lose faith in both the managers and the strategies on offer. This will in turn draw criticism and cynicism regarding the role of the financial sector in driving the transition to a sustainable and responsible future. Self-service and opportunism could sabotage the continuing development of the sustainable investment sector. The problem of greenwashing and green-hoping is ever-present, and it is debatable whether investors are doing enough to distinguish those that walk the walk from those that merely talk the talk. As such, specialist investment teams, evidence-based investment signals, and well-defined strategies are needed in order for substance to triumph over form and to drive the global transition to a sustainable and just future.

Dr Tom Steffen is a Quantitative Researcher at Osmosis Investment Management. He holds a PhD in Sustainable Finance.