Has ESG’s Moment Passed?

T he House of Representatives resumed its session on July 11, and some congressional Republicans are calling July “ESG month.”

It’s not hard to see why: After a year of setbacks, environmental, social, and governance (ESG) investing is under fire, with a new report by the Republican ESG Working Group highlighting how ESG has been letting investors down with unclear goals, politicized portfolios, and disappointing returns.

This backlash has even the most ardent pro-ESG voices softening. Late last month, BlackRock CEO Larry Fink walked back his use of the term “ESG,” saying he was “ashamed” for being a part of the political discussion. He’s right to feel that way: These ideologically tinged investment products left consumers shortchanged.

“Sustainable” portfolios reflect 13 percent of America’s managed investments, and with 75 percent of adults investing for retirement in some fashion, ESG may compromise the savings of a large swath of Americans. These comments from the head of the largest U.S. asset-management firm should be welcomed as a sign that the attention now finally being paid to ESG by those outside the ESG “ecosystem” is proving embarrassing and, perhaps, bad for business. Despite years of industry leaders’ telling us ESG is the future, it may be that the movement’s moment has passed its peak.

However, Fink didn’t define the term “ESG” in his remarks. That’s no surprise. Defining what precisely it means is far from straightforward. Different companies interpret the term in different ways. And there’s enough room within this concept for different aspects of it to be stressed to different audiences. Some potential investors will be told that a particular firm’s definition of the concept is in line with their values, while others will be told, to use a common phrase, that it is a way of doing well by doing good. Others will be told that it is simply a risk-mitigation process.

As money managers profess varied definitions, GOP representatives Andy Barr and Rick Allen have proposed the Ensuring Sound Guidance Act to define and rein in ESG. This will require investment advisers and group retirement plans such as 401(k)s to focus on their investors’ financial returns instead of “non-pecuniary factors” — including ESG precepts that don’t contribute positively to returns. If the argument is that considering environmental, social, and governance factors can reduce risk and thus enhance risk-adjusted returns in a particular investment product, it should be acceptable to investors, regardless of their view of the cultural battle over ESG.

But such factors haven’t helped reduce risk and, instead, have often been a hindrance.

Environmental screens can severely limit investment in sectors such as energy or materials, thereby limiting the ability to diversify portfolios away from other risks. What’s more, professors at Yale and Boston College showed last month that ESG doesn’t even improve the environment. Rather, keeping capital out of environmentally unfriendly sectors only made companies more short-termist, depriving them of resources that could have been invested in newer and cleaner technologies. For an investing schema that claims to prioritize the long term, forcing companies to focus on staying above water hardly sounds like a success.

Decisions driven by diversity, equity, and inclusion “social” concerns may well not mitigate risk either, as Bud Light’s misguided collaboration with Dylan Mulvaney shows. We’re left with a jumbled mess of acronyms and high-minded claims that lack substance, embarrassing those who staked their professional reputations on packaging progressivism as a risk-management process for investments.

Those risk factors were misguided (E), ideologically captured (S), or so obvious as to hardly merit a new movement (G). Whether asset managers acknowledge it or not, ESG’s effect on returns is highly disputed. Studies have shown over- and underperformance over different periods, and when returns are higher, there is no proof that this is due to ESG. Tech companies have tended to score more highly in ESG tables, but ESG is not why they outperformed in 2020. There is little overall evidence to suggest that ESG reduces risk. And if a high ESG score has contributed to a higher investment return, that will quickly be reflected in a premium valuation, reducing the prospects of future outperformance.

It’s easy to understand why ESG promoters like Fink want to change course, but consumers should remain wary of what comes next. Fink said he would still like to promote “conscientious capitalism” in his investments. This may be the latest euphemism employed, and those who rightfully called out ESG should be careful about viewing Fink’s statements as an outright capitulation. He notes that he’d still like to consider decarbonization and governance in BlackRock’s investments, which is fine if they mitigate risk to his investments’ bottom lines, but the change in tone and his new hands-off approach to proxy voting are a far cry from BlackRock’s prior aggressive support for shareholder resolutions nudging companies toward environmentalism.

Nevertheless, Fink clearly recognizes that most people won’t accept investing that prioritizes agendas over results. Hopefully this will mean that ESG is not the future — it may even be the past.