Morningstar on what the critics have right – and wrong – about ESG investing

This article is sponsored by Morningstar Indexes

“A cynic is a [person] who knows the price of everything, and the value of nothing”

Oscar Wilde

As ESG investing has matured, AUM has grown across asset classes, investor types and geographies. Not surprisingly, it has attracted more scrutiny as it gains influence and a wider audience. Today, it is fashionable to find fault with the field for variety of perceived shortcomings. I thought it would be useful to examine three common criticisms from the perspective of what the critics are saying, what they get right, and what they get wrong. Then, we step back from the specific concerns to discern a broader perspective.

ESG investing doesn’t make a difference

What the critics are saying: Critics observe that problems such as climate change are systemic, and that the system is resistant to addressing them. An example is Duncan Austin’s critique of ‘externality-denying capitalism’ and the futility of market-based solutions. Others suggest that sustainable investment – however well-intended – is a dangerous distraction because it deludes people into believing they’re taking meaningful actions to address problems. Sustainable investment hasn’t ‘fixed’ the problems. And some cynics portray ESG as case of the asset management industry appropriating and corrupting the concept of sustainability simply to make money rather than create change.

What the critics have right: If we characterise sustainable investment as a critical response to systemic problems, this meta-critique has appeal. No doubt, the system that produced climate change is resistant to changing the dynamics that create problems in the first place. Economists recognise negative external costs as a form of market failure, the remedy for which is government intervention to ameliorate cause(s) of the problem. There are reasons for the persistence of externalities, including capture of the political process by corporate interests, subsidies, lax oversight and enforcement, disinformation campaigns, etc.

What the critics have wrong: Investors never claimed that constructing portfolios using sustainability standards and engaging with companies is sufficient to resolve problems like climate change. That’s one reason why they collaborate to change public policy. They also organise collective actions, such as CA100+, to bring to bear their power as asset owners to pressure companies to change. And while some asset managers undoubtedly see ESG simply as a commercial opportunity, many more have dedicated significant resources to transform their investment practices to integrate sustainability considerations. Could it be more effective? Of course. Would we be better off without these efforts? Absolutely not.

The data, ratings and indexes are not fit for purpose

What the critics are saying: Sophisticated analysis requires current, comparable and complete data. Critics lament that ESG data do not meet these criteria. Gaps may be filled with estimates, as is the case with GHG emissions. ESG rating methodologies are proprietary, and ratings from different providers have low correlations compared to credit ratings. Ratings depend on company-reported information, which is biased in their favour. Criteria for including and removing companies from ESG indexes are opaque. These data-related issues contribute to the view that ESG investing is difficult to define, and the industry lacks clear standards.

What the critics have right: There is some validity to these concerns. Let’s start by distinguishing data from ratings and other analysis. Data is, and will continue to be, a challenge for the industry. The issues are complicated, some things that can be measured don’t matter a lot, and some things that matter a lot can’t be measured. Accurate, high-quality data will certainly contribute to better analysis and comparability. Since voluntary company disclosure may be biased, regulators have a duty to mandate consistent disclosure on material issues from companies. For example, when companies accurately report the full scope their CO2e data, it will have notable benefits for analyzing net-zero pathways. The EU’s Corporate Sustainability Reporting Directive (CSRD) will require emissions reporting and the US Securities and Exchange Commission is considering similar rules.

What the critics have wrong: The data have never been better – they are more comprehensive, address more issues in more depth, cover more asset classes and support more sophisticated analysis. ESG data, ratings and indexes developed to meet an entirely new set of client needs. ESG rating methodologies are proprietary because the industry evolved in the absence of established standards. Ratings methodologies are complex, so there is no reason to expect – or even desire – highly correlated ESG ratings if the differences are attributable to analytical frameworks rather than inconsistent data. ESG indexes exist because new investment practices require new benchmarks. ESG indexes such as Paris Aligned Benchmarks are highly engineered to incorporate a range of ESG and climate metrics in addition to financial considerations. Index methodologies may be more or less complex, but they are all rules-based and transparent in keeping with industry best practice and regulatory obligations.

It’s rife with greenwashing

What the critics are saying: The claim that ESG investing can change corporate behaviour and sustainability outcomes for the better is an overreach. Companies selectively provide data to make themselves look more sustainable than they really are. Fund managers exaggerate how effectively they integrate ESG into their investment process, how ‘green’ their funds are, and the impact their funds have. Regulatory efforts have not created enough clarity, leaving investors as confused as ever.

What critics have right: Investors should not be subject to “materially deceptive and misleading use of ESG terminology”, a standard cited by the US SEC. In the absence of clear standards, companies are free to overstate their contributions to a more sustainable world and underplay the negative impacts of their operations and products. Similarly, some fund managers have misled investors about the sustainability characteristics of their products. In response to these problems, regulators are intervening to ensure that companies report the relevant data in useful ways and are cracking down on asset managers who misrepresent their sustainable investing products and process. High-profile cases, such as the raid on Deutsche Bank, are evidence that there is reason to be concerned about greenwashing.

What critics have wrong: We’re in a period of adjustment to new regulatory regimes. It’s not surprising that as markets move away from voluntary disclosure and standards, instances of greenwashing have surfaced. Greenwashing by companies is being addressed by regulation. Greenwashing related to funds warrants attention but does not describe the totality – or even the majority – of ESG investment products. Now that the rules are getting sorted, and regulators and investors are more vigilant about greenwashing, it’s less likely to be a widespread problem going forward. Investors should always do their diligence, whether they’re evaluating a mid-cap growth fund or a mid-cap ESG fund. All the key stakeholders have a role to play to ensure greenwashing recedes as a concern, and its incumbent on industry and regulatory bodies to align investor expectations with what can realistically be accomplished through sustainable investment strategies.

What can we learn from the criticisms?

The field of ESG investing has ambitious aspirations, and its practices developed organically over the past several decades. As regulators codify standards for sustainable investment, the market is transitioning from voluntary practices to a regime governed by regulations. Its future success will be determined by adopting standards that enhance transparency about processes and outcomes, altering incentives that drive corporate executives and asset managers to focus on the short term and ignore risks from externalities, and mitigating the controlling influence of corporations over policy makers and public policy.

Investors are attracted to sustainable investing because they recognise that the prevailing system is failing in fundamental ways. This is especially apparent to asset owners who view themselves as universal owners. ESG investing is a response to a global economy that misallocates resources due to significant negative external costs that threaten the long-term viability of plan assets. It is based on the proposition all investments have an impact – good, bad or indifferent – so it is essential to be intentional about how you invest. It recognises that systems-level change ultimately depends on effective action from a range of stakeholders. Sustainability objectives are intrinsically long-term and are often undermined by capital markets driven by short-term considerations.

Though characterised by multiple approaches, ESG investing has meaningfully influenced investment practices. One of the most profound is its ability raise issues to the level of materiality – think climate change, supply chain management or human rights. Asset owners and managers successfully pressured corporations to disclose ESG information, paving the way for regulators to ensure that investors get uniform material ESG information. Sustainable investors pioneered engagement practices, which for all their limitations, provide opportunities for collective action on ESG issues that have replaced inaction and a free pass for corporate management. These advances should be acknowledged as progress.

When considering the adequacy of ESG data, ratings and indexes, we should recognise that the expectations of investors and rules of the game as propounded by regulators are constantly evolving. This effort requires substantial investments in human and financial resources to gather, analyse and process at scale. Global accounting standards evolved over 70 years, starting in the 1930s in response to conditions that contributed to the Great Depression. Global ESG standards have been developing for less than three decades.

Investors alone cannot reasonably be expected to turn the tide when it comes to addressing climate change with a just transition, but they have a critical role to play. So, practitioners do not claim that ESG investing alone is a sufficient response. Systems change is complex and hard to achieve, and impact is difficult to measure. But the premise that investors can leverage their position as owners and creditors to bring about change is valid. Being intentional in this way enables them to register their issues and concerns with companies and signal priorities through allocations in the capital markets.

Sustainable investors have taken on challenging and important goals. The way forward is not always obvious, so we should approach the hard work with humility and persistence. Let’s debate what to do, how to do it better and be open to legitimate questions and criticism. But this work is too important to play into the hands of those who seek to derail the project altogether. So, let’s remain sceptical, but not become cynical. And then get on with it – too much is at stake!

Thomas Kuh, head of ESG strategy, Morningstar Indexes