ESG investing has risen to meteoric heights during Covid. Investors can now choose from 435 ESG ETFs globally (about half of which were launched in the past year), and assets of the signatories of the PRI have risen to over $100trn USD.
Index fund providers are euphoric: Larry Fink assured his shareholders “that sustainability and climate integrated portfolios can provide better risk-adjusted returns,” and recently BlackRock’s US Carbon Transition Readiness ETF took in $1.25bn — the biggest ETF launch ever. Yet the fund’s top holdings were a familiar cluster of American tech monopolies, with virtually the same weights as those of the much cheaper cap-weighted index funds.
Part of the initial justification for sustainable investing was the additionality concept – attracting capital to opportunities the market may not fund on its own. But despite index providers marketing differentiated ESG products, most ESG ETFs and mutual funds largely resemble the holdings of any cap-weighted index, overweighting the largest technology companies and other oligopolistic industries.
With ESG interest at an all-time high, investors should seize this historic opportunity to return to the original aspirations of the ESG movement: active management, engagement with companies rather than exclusion, and offering real alternatives to conventional investment strategies. At the very least, ESG investors should not undermine their own stated goals. As a start, they should focus on three overlooked issues which matter to the middle class and have a direct link to inequality: jobs, taxes, and competition.
"The more humans a firm employs, the more reprehensible behaviours will be committed: robots and algos do not engage in sexual harassment, do not get injured on the workplace, and cannot be discriminated against"
First, jobs. Based on the holdings of the 20 largest ESG ETFs, the 15 most popular stocks with ESG funds employ just 1.9 million workers, against 5.1 million for the most underrepresented stocks.
ESG funds’ bias against workers is unintentional, but it is a feature rather than a bug. The more humans a firm employs, the more reprehensible behaviours will be committed: robots and algos do not engage in sexual harassment, do not get injured on the workplace, and cannot be discriminated against. Top tech firms also employ significant numbers of contract workers, leaving many settling for lower pay and fewer, if any, benefits. At Google, contract workers outnumber full-time employees. Small companies, which cumulatively employ the vast majority of workers, often cannot handle the cost and complexity of reporting, leaving high-margin technology and healthcare monopolies in the ESG spotlight.
Second, taxes. As shown in the chart below, there is an almost perfect inverse relation between companies’ ESG ratings and their effective tax rate – despite the fact that companies with a high ESG rating tend to be more profitable.
Third, competition. A raft of evidence in recent years has pointed to the detrimental effects of oligopolistic and uncompetitive industries: workers have less bargaining power which contributes to wage stagnation, markups for consumers have risen from 21% above cost in 1980 to 61% today, and startup rates are at historic lows in the US as entrepreneurs face seemingly impenetrable barriers. Concentrated industries, now largely owned by concentrated asset managers, also payout shareholders at a higher rate and do more stock buybacks, leaving less for productive investment. ESG investors have profited from investing in concentrated industries, despite evidence that they undermine many of the long-term objectives ESG investors purport to care about.
With this in mind, a new framework is required to avoid the pitfalls of impact-washing and to sever the ESG movement from a handful of tax-avoiding, low-employment tech monopolies.
Investors should first realise that “passive ESG” is an oxymoron: issues like inequality, climate change, and good governance cannot be outsourced to a handful of rating agencies, giant index fund providers, and proxy advisers. ESG is inherently active and requires engaging with companies and pushing for regulatory reform, not just screening out old economy stocks and checking corporate governance boxes.
Second, governments need to step up. Private initiatives have had mixed success, and only governments can enforce effective reporting standards, fight tax evasion, block anticompetitive mergers, prosecute abusive conduct, and potentially even re-write incorporation law to inspire a race to the top.
Third, a re-imagined ESG movement should examine the role that investors, themselves, play in exacerbating negative outcomes. The win-win narrative that has dominated the industry obscures the issues we have highlighted, and holds the movement back from being a real agent of change. A new paper by The Predistribution Initiative, ESG 2.0: Measuring & Managing Investor Risks Beyond the Enterprise-level, foregrounds potential negative impacts from capital structures themselves, not just portfolio companies.
ESG investors should no longer hide behind glossy marketing materials, ignoring material issues that ultimately create systemic risks like inequality. If investors are serious about creating additionality in a sea of undifferentiated products, it’s time to take seriously taxes, jobs, and competition.
Denise Hearn is the co-author of The Myth of Capitalism: Monopolies and the Death of Competition, and Board Chair of The Predistribution Initiative
Vincent Deluard is the Director of Global Macro Strategy for StoneX and teaches a module on ESG investing at McGill University