As COP28 gets underway in Dubai and tackling climate change is again brought front and centre of the political debate, ESG investing may receive fresh attention.
It could certainly do with a boost, with sceptical investors increasingly shunning ESG funds. British investors have pulled billions of pounds out of responsibleinvestment fundsthis year.
Record amounts have been withdrawn, with concerns over greenwashing, “woke capitalism” and thecost of living crisisall sharing the blame. So is the party over forethical investingor can it stage a comeback?
In this article, we explain:
- What is ESG investing?
- How popular is ESG investing?
- Is the popularity of ESG fading?
- What are the potential downsides to ESG investing?
- Will ESG investing make a comeback to former glory?
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What is ESG investing?
ESG is a framework used to measure how ethical or socially responsible a business is. It can cover a broad range of issues from climate risk to transparency, board diversity and working conditions.
ESG investing refers to putting your money into the shares and bonds of companies which meet a set of criteria evaluating its impact on the environment, society and how the business is run.
Sustainable investing is a closely-related sub-category which is particular concerned with the environment. “Responsible” investment is another similar term that is widely-used.
What does ESG stand for?
ESG stands for environmental, social and governance.
- E stands for environmental. This refers largely to the impact that a company has on climate change through its carbon emissions. It also encompasses other important issues, though, such as air and water pollution.
- S stands for social. This is the way a company influences wider society and treats staff and customers. For example, companies which exploit workers, or indirectly hurt people such as weapons makers can be excluded on ESG grounds. Similarly, tobacco companies can be excluded due to the harm smoking causes.
- G stands for governance. It refers to how companies are run internally. Having proper whistleblowing and anti-corruption policies in place, for example, is important. The make-up and effectiveness of a company’s board is another factor.
The great promise of ESG is that investors can make the world a better place and help put the brakes on climate change, while also making money.
How popular is ESG investing?
Over recent years ESG, investing has become wildly popular. There was estimated to be around $2.5 trillion (£2.05 trillion) held in ESG funds at the end of 2022.
Institutions and other large money managers have enthusiastically embraced ESG and, in some cases, put a majority of their money into ESG compliant investments.
Institutional investors, such as pension funds, are often mandated to invest ethically, with a specified proportion of their money going into such investments.
Consumer-facing investment platforms all offer ESG options which are easy for you to find and access. As climate change has become a much bigger issue, more people have wanted to steer away from fossil fuel producers and related companies, for example.
“Three years ago ESG was everywhere, fund groups were launching new products and marketing them like crazy, and the saturation point was probably found pretty quickly,” said Laith Khalaf, head of investment analysis at AJ Bell.
“All that money flowing in helped ESG funds perform well, attracting more cash from those who follow fund performance tables. After that initial goldrush, ESG funds are now part of the furniture and having to fight hard for inflows like all other sectors.”
Is the popularity of ESG fading?
To some degree, the answer is yes. The Investment Associationrevealed that investors pulled £448m from ESG funds in August 2023 alone. This followed hefty withdrawals in July and June.
“It feels like the ESG party is running out of steam, with investment flows drying up and actually going into reverse,” said Khalaf.
“We’ve now had three months of continuous outflows, and in August a record amount was withdrawn from responsible investment funds. Part of the explanation for the ESG slowdown is likely to be the cyclical nature of fund flows.
“The cost-of-living crisis has also shifted the ESG debate somewhat. Energy security and price are now back in the game, competing with green priorities. It’s also become increasingly clear how murky and nuanced some environmental questions can be. A prime example is the decision on whether to licence more drilling in the North Sea rather than import energy from overseas.”
The success of ESG investing depends in some part on government policy. If legislators make a law which rewards ethical investing decisions, the funds can benefit greatly. A good example is policies which incentivise electric car purchases.
On the other side of the coin, when governments change tack on formerly ESG-friendly policies it can be costly for these funds.
“We’ve also recently seen the UK government rowing back on some of its environmental pledges, so investors might well be wondering why they should bother seeking out green funds when the country is being steered in the opposite direction,” said Khalaf.
What are the potential downsides to ESG investing?
The largest criticism of ESG investing levelled by some is that in many cases it amounts to something called “greenwashing”.
That is to say, it is used as a marketing technique which increases the appeal to investors. However, the underlying investment decisions do not truly help the environment or have social and governance benefits.
There is a wide and contentious debate over how prevalent greenwashing is, and the actual extent to which ESG investing is having a positive impact.
It is clear that there are huge benefits in some cases, and also that it is simply used for marketing purposes in others.
The other controversial aspect is the extent to which investment returns improve or decrease by ESG criteria. Proponents argue investing ethically will increase returns over the long run, particularly in the case of climate change mitigation.
Detractors argue that investors would be better served by focusing purely on companies’ financial performance rather than incorporating ESG filters into buying decisions.
Will ESG investing make a comeback to former glory?
This is hard to say for certain. It is certainly plausible that when market conditions improve in general, ESG funds will see money flowing in again.
The stock market has been hit hard by the cycles of rising interest rates implemented around the world over the past two years. It is perhaps unfair to single out ESG when equities funds in general have suffered.
Working against an ESG comeback is the political landscape.
ESG has become very controversial in the world’s biggest investment market, the United States. Many politicians there and a good portion of the electorate are not supportive of ESG. The Republicans, who are currently leading in the polls ahead of next year’s elections, tend to be largely against ESG and associated government policy.
In the UK, the political support for ESG has become more questionable recently, given the government’s recent changes in stance on some elements of climate policy. The short-term direction travel on ESG related law-making appears unfavourable.
The counter to this is that the opposition Labour party is leading in the polling and an election is due by the end of next year. This means government priorities could shift once again.
An easing of inflation and the cost-of-living crisis could also help ESGinvesting to regain popularity. People can only invest when they have spare money. Should the economy improve over the next year or two, there might be more retail investors buying stocks and funds again overall, with ESG funds benefiting too.
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