What are ESG investing and why do some hate them so much?

The Senate on Wednesday voted to repeal a Labor Department rule that allows retirement plans to consider environmental, social and governance factors in investment decisions, after a similar vote by House Republicans on Tuesday. It sets the stage for a possible first veto by President Joe Biden.

Critics say ESG investing raises money based on political agendas, such as B. the fight against climate change, instead of generating the best returns for savers. They say ESG is just the latest example of the world trying to “wake up”.

The ESG industry, meanwhile, says it helps highlight companies that may be riskier than traditional investment guidelines alone suggest. That could lead to more stable and secure returns for savers. It also says that using an ESG lens could help investors find better, more profitable opportunities.

ESG has become popular with a wide range of investors, from ordinary people with smaller pockets to pension funds responsible for the retirement of millions of workers.

WHAT IS ESG?

It’s an acronym, with each of the letters describing an additional lens that some investors use to decide whether a particular stock or bond looks like a good buy.

Before risking their money, all investors, both traditional and ESG investors, look at how much revenue a company is bringing in, how much profit it is making, and what the prospects are for the future.

ESG investors then apply some more specific considerations.

WHAT IS E?

Surroundings. It may be worth avoiding companies with poor environmental records, the reasoning goes, because they are at greater risk of large fines from regulators. Or their businesses could be at particular risk of being turned upside down by future government attempts to protect the environment.

Such risks may not be as appreciated by those using only traditional investment analysis, which could result in stock prices being too high, ESG advocates say. That in turn would mean too much risk.

On the other hand, measuring a company’s environmental awareness could also uncover companies that could be better positioned for the future. Businesses that care about climate change may be better prepared for its impacts, whether it’s potential flood damage at factory sites or the risk of escalating wildfires.

WHAT IS S?

Social. This is a broad category that focuses on a company’s relationships with people, both inside and outside.

For example, investors who measure a company’s social impact often look at whether the pay is fair and working conditions are good at the grassroots level, as this can lead to better employee retention, lower turnover costs and ultimately higher profits.

Others consider a company’s data protection and privacy record, where lax protocols could lead to leaks that drive customers away.

Companies are also increasingly being asked to take a stand on major social issues such as abortion or the Black Lives Matter movement. Some ESG investors encourage this, saying companies’ employees and customers want to hear it.

Not every ESG investor considers all of these factors, but they are all grouped together under the “S” umbrella.

WHAT IS G?

Governance, which basically means that the company runs itself well.

This includes tying executive pay to company performance, whether that is defined by stock price, earnings or something else, and having strong, independent directors on the board who act as effective scrutiny for CEOs.

HOW IMPORTANT IS ESG?

Investors applying one or more ESG criteria or pushing companies on such issues controlled as a group $8.4 trillion in US-domiciled assets in 2022. That’s according to the latest census from US SIF, a trade group representing the sustainable and responsible investing industry.

That’s enough money to buy Tesla, one of the most valuable US stocks, more than 11 times. This also means that ESG accounts for $1 in $8 of all professionally managed US assets.

As equity and bond markets plummeted over the past year, dollar flow into ESG funds has slowed since peaking in early 2021. According to Morningstar, US sustainable funds raised $3 billion net over the course of 2022.

Not only have sharp falls in all types of investment prices raised concerns, but so has the mounting political backlash. In the final three months of 2022, which was a particularly difficult time for financial markets, investors pulled nearly $6.2 billion more from sustainable funds than they invested, according to Morningstar.

Despite the slowdown, demand for sustainable funds is still higher than their traditional counterparts.

DO ONLY MILLENNIALS DO IT?

No, the vast majority of money in ESG investing comes from large investors such as pension funds, insurance companies, endowments at universities and endowments, and other large institutional investors.

WHAT EFFECTS DOES IT HAVE?

ESG investors are pushing for more engagement with companies and discussing their environmental, social and governance concerns. They also cast their votes at annual shareholder meetings on ESG issues.

In 2021, a relatively small fund called Engine No. 1 hit American companies after convincing some of Wall Street’s biggest investment firms to agree to his proposal to replace three directors on Exxon Mobil’s board, citing a decarbonized world.

Investors are also urging business leaders across America to provide more details on their carbon emissions, human rights impact measurements and racial justice audits.

It’s all an evolution since the industry’s infancy, when “socially responsible” investing was fairly simple. Early funds would only promise not to own stocks in tobacco companies, gun makers, or other companies deemed distasteful.

AND THE COUNTERGAME?

Some politicians have denounced ESG as politicizing investing.

Some in the business community have been particularly critical of rating agencies that try to break down complex issues into simple ESG scores.

For example, Tesla CEO Elon Musk last year called ESG a fraud “weaponized by fake social justice fighters.” His criticism came shortly after Tesla was kicked out of the S&P 500 ESG index.

The index attempts to hold only companies with better ESG scores within each industry, while holding similar amounts of energy stocks, technology stocks, and other sectors as the broader S&P 500 index. That means Exxon Mobil could stay in the S&P 500 ESG Index even if it pulls fossil fuels out of the ground to burn because it outperforms its peers in energy.

ARE THESE THE ONLY CONTROVERSIES?

No. With every boom comes opportunists, and regulators have warned about some potentially misleading statements.

This could include companies that claim to be ESG-focused but own stocks in companies with low ESG scores. It is reminiscent of how products in supermarket aisles are accused of “greenwashing” or their goods are advertised as “green” even when they are not.

Part of this may be due to how big the ESG industry has gotten, with some players taking a lighter approach.

For example, some funds commit not to own stocks in companies that are considered dangerous. Others will seek to only own companies that receive the highest ratings on ESG issues from scorekeepers. Still others try to only buy companies that perform best within their specific industry, even if the overall score is very low.

Such nuances can be confusing for investors trying to find the right ESG fund for them.