When Morningstar observed a slowdown in new ESG fund launches last quarter, it seemed like big news. Could the public interest in sustainable investing be waning? Tim Quinson of Bloomberg focused on asset manager Blackrock:
“If BlackRock Inc.’s largest ESG-labeled exchange-traded fund is a bellwether for the sustainable investing industry, it’s fair to say the US sector may be in for a bumpy ride” he wrote.
Time will tell if the public interest is softening, or not. Meanwhile, is a reset or reckoning in the market of ‘ESG Investing’ really a bad thing?
After a period of significant growth, ESG investment vehicles need to evolve, both to keep pace with new regulations, and to earn investors’ trust. Investors and savers of all shapes and sizes are still keenly interested in “putting your money where your mouth is” – including more opportunities to help finance the energy transition.
One day, if current trends continue, we can hope ESG investing will no longer be an investment category at all. As the industry matures, climate change, deforestation, water scarcity and quality, the growth in inequality, and company performance when it comes to just and inclusive employment and pay policies—all these concerns—will be embraced as long-term market risks and opportunities, and they will be understood as nearer-term business risk when behavior and protocols for an individual company can be singled out. Doing so will be the norm in asset management.
We can look forward to breaking down the walls between simplistic, but false, labeling of a company as good or bad, vs. ignoring these questions altogether—and to putting the funky acronym, “ESG” out to pasture.
In the meantime, as Bloomberg’s Quinson says, we are in for a bumpy ride.
Why do we need a reset in ESG investing?
In this recent piece by Ken Pucker, the brouhaha over Vanguard pulling out of a coalition of “net zero asset managers”, known as NZAM, offers a window into the issues with ESG investing. Ken knows his critique will irritate some, which is why he borrows Al Gore’s language of inconvenient truths in taking a closer look at the wisdom of using investment to influence business priorities—specifically capital allocation in pursuit of lower carbon emissions.
These ideas are indeed inconvenient for those of us who would like to feel good putting our retirement savings into ESG-labelled funds. Three things to consider (but that usually aren’t):
1. Index funds are ill-suited to the time-intensive task of influencing business strategy. Vanguard is synonymous with indexing, a form of passive investing that mimics market benchmarks like the S&P 500. Indexing appeals to small investors with little inclination or time for stock-picking. It also attracts institutions managing other peoples’ money, keeping costs to the investing-consumer low by eliminating the services of a traditional stockbroker or high-touch asset managers. It’s essentially the opposite of funds that market “alpha” or that seek to outperform the market. In both cases, the focus is on the investor, not how to influence decisions of a specific company.
A coalition of asset managers dedicated to NetZero Asset Management seems like a good thing, but to be serious about it requires careful analysis of the business, how the company makes its money and its upstream and downstream impacts and leads to direct engagement. This level of analysis and engagement is fundamentally at odds with Vanguard’s traditional value proposition to its customers and their choice to stick with the ups and downs of a broad market index.
Vanguard, Blackrock, and its peers have ramped up staffing to address these concerns, and to contend with activism on many fronts, including a significant uptick in proxy ballot issues. But by exiting NZAM, Vanguard acknowledged its principal objective: maximizing return, and “helping our investors navigate the risks that climate change can pose to their long-term returns.”
The focus is on delivering value to the investor.
2. “Doing well by doing good” isn’t automatic—or able to produce returns now. It requires a steady hand and long-term vision. There are rewards for investing in companies with clear strategies and the operational chops to pursue carbon-reducing innovations and practices, or have superior workforce practices, but don’t expect to see an upside in a year. The stock price goes down when a company raises wages; it goes up if a company announces a layoff. And 2022 was a loser for those light on fossil fuels. Demand for fossil fuels is high, and growing, and oil and gas industry stock valuations went up in a bad year for the stock market. (Chevron, for example, announced record profits and earnings 2022, and engaged in a $75 billion share buyback.)
Finally, don’t forget this inconvenient truth:
3. The company got their money at the IPO. Marjorie Kelly, author of The Divine Right of Capital, first published in 2001, starts her book with this simple clarification about the stock market: “Stockholders fund major public corporations—true, or false?”, and then answers her own question: “False. Or…a tiny bit true—but for the most part massively false.” Initial Public Offerings serve the purpose of taking out early investors, and sometimes raise capital for expansion, but from that moment, the purpose of trading stock is just that, buying and selling shares among investors looking for return.
Pucker reminds us that the stock market ups and downs may delight or disappoint investors, but don’t (or shouldn’t) matter to the issuing company. The stock market is a secondary market—an aftermarket. Shareholders trade amongst themselves.
The fact that we pay executives in stock confounds things, but the essential truth is the ups and downs of the stock price shouldn’t change behavior in a company committed to net zero.
Here’s the good news:
ESG investing is not dead, or even in decline. It is growing up.
Under pressure from EU regulators, a good number of ESG funds have already rebranded or will exit the ‘ESG” space, recognizing they may sound like they are environment friendly but, are more about —as Pucker calls it— “the impact of the planet on the company and not the impact of the company on the planet.” The SEC, which exists to serve the investing public is responding to market demand for clarity as investors get more sophisticated about sustainability. It is now poised to announce its own fund disclosure requirements to address greenwashing. Disclosure by companies themselves may also evolve with new international standards.
Investors are not turning their backs on putting their money to good use. They are getting smarter. How?
First, we are experiencing significant growth in PRIMARY investment. As this McKinsey research lays out, fresh capital for green investment, especially through private markets, is now HOT—but more is needed. McKinsey puts the need at a net increase of $3.5 trillion annually; the trends are promising and meaningful: “The current momentum in climate-focused investing suggests that the space is breaking out—not breaking down—in the face of market complexity.”
Investment is needed in everything from battery storage to next generation nuclear to decarbonizing the use of fossil fuels. Incentives are now better aligned and capital for new infrastructure is flowing, but we need more.
Second, we also require and are seeing more investors and asset managers attuned to a company’s real performance over the performance of the stock in the secondary market. This calls for a long-term orientation, paired with active engagement with companies.
What’s ahead?
This piece by Laura Peterson reminds us of what’s at risk if investors don’t lean in to support the internal change agents who are critical to staying the course within companies. She talks about the ‘unwelcome guest making its presence felt in board rooms’ where directors and their executives are vulnerable to pulling back on commitments, with the old excuse of short-term pressures and simplistic measures of fiduciary duty.
It is time for serious investors to get serious. There are good opportunities for those with the means to use their capital for good, long-term ends. The asset management industry—now including private, not just public markets—is gearing up by hiring specialists equipped to analyze the real-world performance of companies. The ‘impact’ end of the ESG investment market is becoming more mainstream as serious investors pay attention to material ESG issues, and the opportunity in the transition to a carbon neutral economy beckons.
As Peterson points out, proxy season is upon us, and that means more annual meeting showdowns between a green future and the denial of climate as a business risk. States are now battle grounds in this fight and the 2024 presidential campaign is already underway.
There are real opportunities to make a difference through sound use of investor capital, and more capital is needed. But strap in. It’s going to be a wild ride.
