ESG Moving Forward: Lessons from the Past, Visions for the Future

History and Some Recent Challenges

Environmental social and governance (ESG) refers to corporations and investors integrating environmental, social, and governance considerations into their traditional business models. In practice, it involves using ESG-derived metrics as ways to assess potential investments. The term was introduced in a 2004 report by 20 financial institutions in response to a call from the then Secretary General of the United Nations, Kofi Annan.[1] Since the launch of the Principles for Responsible Investment (PRI) Association in 2006, the number of financial entities who have signed a commitment to integrate ESG information into their investment decisions has grown steadily — from 734 in 2010 to 3,038 in 2020, with total assets under management of $21 trillion in 2010, rising to $103 trillion in 2020.[2]

Broadly, ESG investing is tied to the increasing focus on sustainable development, which has resulted in several goals adopted by international agencies in the last decade. For example:

• In September 2015, the United Nations General Assembly identified a list of sustainable development goals (SDG) for individual countries, to be achieved by 2030.[3]
• In October 2018, the International Panel on Climate Change released an influential special report that calls to limit global warming to 1.5℃ in order to reduce the extreme risks associated with climate change.[4]

While the stated goals and the resulting international agreements do not constitute legally binding contracts, they have contributed to an environment in which governments, corporate firms, and investors are expected to respond with tangible commitments to meet them.

ESG Compared to Green Finance

Importantly, ESG investing is a broader concept than green finance, which refers to the financing of green assets — assets related to the infrastructure for a low-carbon energy transition, renewable energy technologies, sustainable water management, biodiversity protection, etc. ESG, on the other hand, is not limited to environmental goals. It also includes social and governance considerations. Indeed, one important question raised in recent years considers whether placing these three very distinct goals under the same umbrella creates additional challenges that might hinder progress toward the stated goals.

New Focus on Sustainable Investing

Seen through the environmental lens, sustainable investing has grown rapidly since its inception — becoming a focus area of large institutions such as insurance companies, pension funds, sovereign wealth funds, and more recently wealth management and retail investors. Mutual funds that invest according to ESG ratings have seen sizable inflows.[5] In line with the increasing investor concerns about the consequences of climate change, BlackRock CEO Larry Fink wrote in a recent annual letter that climate change will force businesses and investors to rethink their strategies, resulting in a “fundamental reshaping of finance” and a “significant reallocation of capital.”[6]

Are ESG Activities Beneficial to Shareholders?

The question then arises as to whether ESG activities are beneficial to shareholders. While this is an underlying belief among ESG proponents, the premise that such investments can be profitable, or even socially desirable, has recently come under some pressure, especially in the U.S. At the heart of the recent backlash against ESG is the issue of whether the green component of ESG-related investments is measured in accurate and consistent ways that cannot be intentionally or unintentionally misinterpreted or manipulated. Examples from around the world:

• In an unprecedented event, German police launched raids at DWS Asset Management and Deutsche Bank over “greenwashing” allegations, in which asset managers were accused of misleading investors about ESG factors in their financial products.[7]
• The Australian Securities and Investments Commission recently charged Vanguard with greenwashing.[8]
• Partly in response to related concerns, U.K. regulators are currently considering new rules to counter greenwashing, which are expected to substantially reduce the number of funds that are labeled as sustainable.
• In the U.S., the Securities and Exchange Commission has recently announced that it will increase scrutiny and enforcement in ESG investing.

Uncertainties About Assessing ESG Performance

In a related decision, S&P Global recently stopped publishing numerical ESG scores, which it previously used to evaluate exposure to ESG risks. While high-profile escalations are uncommon, instances of greenwashing appear to be increasingly prevalent and troublesome. Indeed, ESG-focused funds are currently experiencing a storm of negative sentiment, with total assets under management in ESG funds falling by about $163 billion globally during the first quarter of 2023 compared with the previous year.[9]

As ESG objectives become a primary focus in asset management, the resulting reallocation of capital has major implications for portfolio decisions and asset pricing. However, in the absence of a reliable measure of ESG performance, investors often face a substantial amount of uncertainty about the ESG profile of a firm. This uncertainty, which is often reflected in the divergence across ESG rating agencies, could be an important barrier to sustainable investing. Indeed, the role of ESG uncertainty in portfolio decisions and asset pricing has not been sufficiently explored. Jurisdictional considerations add another layer of complexity; as an example, what qualifies as a “green bond” varies from country to country.

What follows is a summary of related findings in recent corporate finance literature and a discussion about the future evolution of the ESG concept.

The Current Wisdom

Issues of Correlation and Causality

Several studies by both academics and asset management practitioners have investigated the links between ESG activities and different characteristics of firms, such as the market in which a firm operates, its ownership, and various risk and performance measures. It is fair to say that the main finding of this research is that the sign of the correlation between ESG characteristics and financial performance is inconclusive.[10] Some studies have found that ESG investing has penalized investors early on, but the trend might have reversed, especially outside the U.S.[11] However, even when a positive correlation between ESG focus and financial performance is identified, the underlying economic mechanism that led to this correlation and even the direction of the causality relationship are far from obvious.[12] Too often, a correlation between ESG and financial performance is interpreted as evidence that ESG is the cause, although the direction of the transmission could be easily reversed. For example, one can argue that companies with high ESG scores are subject to fewer risks as a result, which in turn leads to higher valuations. Alternatively, companies facing fewer risks, or managing existing risks more effectively, will have higher market valuations, and, therefore, might be more prone to invest in improving their ESG profiles, leading to higher ESG scores. In short, while there is some evidence that ESG activities can reduce risk and increase value in some firms, the question remains widely open.[13]

Interestingly, there is some intriguing evidence that high sustainability firms might better mitigate downside risks and are more resilient during turbulent times, such as financial or public health crises.[14] Indeed, high-ESG portfolios generally outperformed low-ESG portfolios during the recent COVID-19-induced crisis in China.[15] However, even in these cases, the underlying mechanism and the direction of the causality remain to be firmly established. This is an active topic of ongoing research, and more structural studies that explicitly identify the potential transmission channels from ESG to financial performance are needed.[16] Similarly, the impact of ESG scores on corporate bonds, credit ratings, and spreads is a topic that deserves additional investigation.

ESG Investors’ Appetite and Returns

Investors’ growing ESG appetite in the last decade has resulted in significant changes in the asset management industry and to the establishment of numerous ESG-linked funds. Several economic models of ESG investments have been proposed.[17] These models typically assume that investors directly derive utility from holdings of green firms and/or disutility from holdings of brown firms. Some models also assume that investors care about firms’ aggregate social impact, and possibly about climate risk. Of course, investors also care about their financial wealth. Stocks are priced using versions of the capital asset pricing model (CAPM), a workhorse in modern finance theory. These models find that ESG preferences has the potential to significantly affect movements in asset prices. Stocks of greener firms are predicted to have lower ex ante expected returns (CAPM alphas), especially when risk aversion is relatively low and investors’ preferences for green investments are strong.[18] Naturally, investors with stronger than average ESG tastes are predicted to hold greener portfolios relative to the market portfolio. Unlike brown stocks, green stocks can even have negative predicted alphas. Investors with stronger ESG preferences are predicted to earn lower expected returns, especially when risk aversion is low and the average ESG preference is high. Many of these findings are in broad agreement with actual observations about ESG investing.

Sources of ESG Information Lack Consistency

One consideration concerns how potential investors gain information about firms’ ESG credentials. This question leads to the important role of various ESG rating agencies. ESG ratings providers have become influential as more investors rely on third party assessments of corporations’ ESG performance. As a result, ESG ratings have far-reaching implications for both asset prices and corporate policies. The large number of firms covered by ESG rating providers seems to suggest that these ratings are of some value. Indeed, several studies in both developed and developing countries have documented some positive effects of ESG certification on lowering a firm’s cost of capital, while increasing their Tobin’s Q — Tobin's Q refers to the ratio of a company’s market value to the replacement value of its assets and a higher Q indicates a higher value of the company relative to the book value of its current assets.[19] Such evidence is perhaps not surprising, as it is consistent with the benefits of certification in resolving uncertainty in other contexts, such as the food, chemical, and automotive industries.

At the same time, it has been well documented that there are often sizable inconsistencies across ratings by different providers.[20] Multiple recent studies used data from leading ESG rating agencies and found that correlations between ESG ratings range from 0.38 to 0.71, with the variations being persistent across sample periods.[21] There is also evidence that the majority of the apparent divergence is due to differences in measurement methodologies across different agencies. This is a concerning finding, as it points to fundamental limitations in defining and measuring ESG activities. The possible implications are far-reaching. What is the use of ESG ratings if they cannot provide consistent information to investors? Noisy information can affect firms’ portfolio choices and reduce the desire to invest in ESG, as such investments are unlikely to be fully reflected in market prices. [22] As a result, ESG rating uncertainty reduces ESG-sensitive investor demand. This, in turn, could increase the cost of capital for green firms.

A Possible Future for ESG: Greater Consistency and Focus

Over the last decade, corporate managers have come under pressure to replace their focus on shareholders with a wider vision, one where they also serve broader societal goals. This is often accompanied by the belief that such goals will also create value for investors, as well as benefit the reputation of the company and thus will also be good for the shareholders. As argued earlier, the evidence that investors in socially responsible firms enjoy higher profits or growth is weak, at best. Many of the firms that promote ESG are successful for a variety of reasons. The evidence is stronger that firms that are perceived as “bad” are punished, either through higher discount rates or with a greater incidence of adverse market shocks.[23] Additionally, even the most favorable evidence on ESG investing has so far failed to solve the causality question. It seems just as likely that successful firms adopt ESG-related goals, rather than that adopting ESG goals is what makes firms successful.

There are some signs that the ESG bandwagon might have run its course, with some insiders publicly expressing skepticism. Tariq Fancy, Blackrock’s former chief investment officer of sustainable investing, has recently argued that ESG thinking might even prove a distraction in the case of climate change mitigation.[24] Economic theory advocates government intervention through a carbon tax to internalize externalities associated with greenhouse gas emissions.[25] ESG, he argues, is akin to a belief that the market can self-correct, by amending firms’ objectives in the absence of any such government intervention. Perhaps, as Milton Friedman has advocated, firms can do more social good by maximizing shareholder value than by trying to act as a substitute for government policy.[26]

Need for Consistent Taxonomy and International Standards

It is crucial for policy makers to establish a consistent and verifiable taxonomy of ESG performance, as well as binding and unified disclosure standards for sustainability reporting. It is particularly important to adopt international standards that consistently identify which investments should be classified as green, and to what degree, avoiding double-counting and including detailed measurements of all ESG components. This, of course, is especially hard to accomplish outside the narrow boundaries of companies, especially if they are engaged in long and complex supply chains across multiple countries or regions, end of product-life considerations, etc. Even if they were to be established, international standards would be of limited value in the absence of consistent weights of the environmental, social and governance components. In banking, there is the additional challenge of evaluating the climate impact of underwriting deals since, unlike loans, they do not remain for long on banks’ balance sheets.

Improving Evaluation With MRV Technology

Although the impact of ESG evaluations on firms’ market value will always be subject to some uncertainty, research shows that reducing uncertainty about ESG evaluations would reduce the cost of acquiring capital for green firms.[27] Given the wide space currently covered by the ESG umbrella, this is proving to be a daunting task. There is clearly an urgency associated with the climate and environmental crisis and consistent and measurable environmental criteria are somewhat easier to establish and verify than those associated with social and governance goals. Since environmental challenges can often be separated from broader social and governance objectives, separating evaluations of E from those about SG may prove less controversial and more fruitful.[28] ESG-related data based on intended ex ante impacts is not as reliable as rigorous ex-post impact analysis and, as argued earlier, corporate ESG ambitions have not so far been matched by proper standardized measurements. However, there are indications that technological developments in measurement, reporting, and verification (MRV) will make this task more effective in the future.[29] To address the massive data collection challenges, intelligent MRV solutions increasingly make use of new technologies such as satellite imagery and real-time remote sensing, machine learning, and distributed ledgers. As companies are digitizing their supply chains, real-time MRV is rapidly becoming accessible to both market participants and regulators. This will enable ESG performance data to be automated and packaged, thus increasing standardization. Of course, the challenge of selecting the criteria that need to be standardized remains.

ESG Focus for the Future: Environmental Risk Management

Historically, ESG investors favored funds that stayed away from industries perceived as contrary to ESG stated goals, as well as those investing in companies that took measures to clean up their act. Perhaps the future lies in a more focused version of ESG principles, one that resembles environmental risk management. Even if an asset managers’ job is not to make the world a better place, managers will need to take into consideration the risks resulting from climate and environmental change, as well as the effects of the resulting regulatory risk for their assets’ returns. In this sense, environmental ambitions will remain relevant for investors for years to come.

Notes

[1] United Nations Global Compact Financial Sector Initiative, Who Cares Wins, 2004, https://www.unepfi.org/fileadmin/events/2004/stocks/who_cares_wins_global_compact_2004.pdf.

[2] Principles for Responsible Investment, Annual Report 2020, accessed March 7, 2024,https://www.unpri.org/annual-report-2020/.

[3] For background information see “The Sustainable Development Agenda,” Sustainable Development Goals, accessed March 7, 2024, https://www.un.org/sustainabledevelopment/development-agenda-retired/.

[4] For a summary of the report see: “Summary for Policymakers of IPCC Special Report on Global Warming of 1.5°C Approved by Governments,” IPCC, October 8, 2018, https://www.ipcc.ch/2018/10/08/summary-for-policymakers-of-ipcc-special-report-on-global-warming-of-1-5c-approved-by-governments/.

[5] Samuel M. Hartzmark and Abigail B. Sussman, “Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows,” The Journal of Finance 74, no. 6 2019): 2789–837, https://doi.org/10.1111/jofi.12841.

[6] “A Fundamental Reshaping of Finance: Larry Fink’s 2020 Letter to CEOs,” BlackRock, accessed March 7, 2023, https://www.blackrock.com/us/individual/larry-fink-ceo-letter. More recently, BlackRock has been criticized for backtracking some of its commitment to ESG. Larry Fink said that he had stopped using the term ESG, as it has become “too divisive.” See Nicholas Megaw, Brooke Masters, and Madison Darbyshire, “BlackRock Hit by Backlash after Fall in Environmental and Social Votes,” Financial Times, August 26, 2023, https://www.ft.com/content/dfc22003-93cc-4a4a-bb94-ac80fa6a84d5.

[7] “Greenwashing” refers to a situation when an investment is presented as being greener than it really is. More recently, the contrasting term “greenhushing” was introduced to indicate that certain companies might choose to be quiet about their green initiatives due to lack of support by some investors; see John Letzing, “What Is ‘Greenhushing’ and Is It Really a Cause for Concern?” World Economic Forum, November 18, 2022, https://www.weforum.org/agenda/2022/11/what-is-greenhushing-and-is-it-really-a-cause-for-concern/.

[8] Australian Securities & Investments Commission, “ASIC Commences Greenwashing Case against Vanguard Investments Australia,” media release, July 25, 2023, https://asic.gov.au/about-asic/news-centre/find-a-media-release/2023-releases/23-196mr-asic-commences-greenwashing-case-against-vanguard-investments-australia/.

[9] Nicole Goodkind, “ESG Investing Is Dying. That’s Not a Bad Thing,” CNN, April 28, 2023, https://edition.cnn.com/2023/04/28/investing/premarket-stocks-trading/index.html.

[10] Stuart L. Gillan, Andrew Koch, and Laura T. Starks, “Firms and Social Responsibility: A Review of ESG and CSR Research in Corporate Finance,” Journal of Corporate Finance 66, art. 101889 (February 2021), https://doi.org/10.1016/j.jcorpfin.2021.101889.

[11] Leila Bennani et al., “How ESG Investing Has Impacted the Asset Pricing in the Equity Market,” Social Science Research Network, January 28, 2019, http://dx.doi.org/10.2139/ssrn.3316862.

[12] Indeed, some of the studies have been criticized for “correlation mining,” where nontheoretical models are over-fitted to a specific dataset, resulting in observing correlations that would not be present out of sample. Campbell R. Harvey, Yan Liu, and Heqing Zhu, “ … and the Cross-Section of Expected Returns,” The Review of Financial Studies 29, no. 1 (January 2016): 5–68, https://doi.org/10.1093/rfs/hhv059.

[13] Andrew King and Ken Pucker, “Clear Thinking about ESG — A Response to Witold Henisz,” LinkedIn, July 25, 2022, https://www.linkedin.com/pulse/clear-thinking-esg-response-witold-henisz-ken-pucker.

[14] Marica Millon Cornett, Otgontseteg Erhemjamts, and Hassan Tehranian, “Greed or Good Deeds: An Examination of the Relation between Corporate Social Responsibility and the Financial Performance of U.S. Commercial Banks around the Financial Crisis,” Journal of Banking & Finance 70 (September 2016): 137–59, https://doi.org/10.1016/j.jbankfin.2016.04.024; Karl V. Lins, Henri Servaes, and Ane Tamayo, “Social Capital, Trust, and Firm Performance: The Value of Corporate Social Responsibility during the Financial Crisis,” The Journal of Finance 72, no. 4 (March 2017): 1785–824, https://doi.org/10.1111/jofi.12505.

[15] David C. Broadstock et al., “The Role of ESG Performance during Times of Financial Crisis: Evidence from COVID-19 in China,” Finance Research Letters 38, art. 101716 (January 2021), https://doi.org/10.1016/j.frl.2020.101716.

[16] Rui A. Albuquerque et al., “Resiliency of Environmental and Social Stocks: An Analysis of the Exogenous COVID-19 Market Crash,” European Corporate Governance Institute, Finance Working Paper no. 676/2020 (June 22, 2020), http://dx.doi.org/10.2139/ssrn.3583611; Guido Giese et al., “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk, and Performance,” The Journal of Portfolio Management 45, no. 5 (July 2019): 69–83, https://doi.org/10.3905/jpm.2019.45.5.069.

[17] Ľuboš Pástor, Robert F. Stambaugh, and Lucian A. Taylor, “Sustainable Investing in Equilibrium,” Journal of Financial Economics 142, no.2 (November 2021): 550–71, https://doi.org/10.1016/j.jfineco.2020.12.011.

[18] For explanation of “ex ante expected returns (CAPM alphas)” see the “Ex-Ante Definition” and “A Deeper Look at Alpha” pages on Investopedia.com, accessed March 8, 2024: https://www.investopedia.com/terms/e/exante.asp and https://www.investopedia.com/articles/financial-theory/08/deeper-look-at-alpha.asp.

[19] Woei Chyuan Wong et al., “Does ESG Certification Add Firm Value?” Finance Research Letters 39, art. 101593 (March 2021), https://doi.org/10.1016/j.frl.2020.101593.

[20] Aaron K. Chatterji et al., “Do Ratings of Firms Converge? Implications for Managers, Investors and Strategy Researchers,” Strategic Management Journal 37, no. 8 (August 2016): 1597–614, https://doi.org/10.1002/smj.2407.

[21] Florian Berg, Julian F. Kölbel, and Roberto Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings,” Review of Finance 26, no. 6 (November 2022): 1315–44, https://doi.org/10.1093/rof/rfac033; Doron Avramov et al., “Sustainable Investing with ESG Rating Uncertainty,” Journal of Financial Economics 145, no. 2, part B (August 2022): 642–64, https://doi.org/10.1016/j.jfineco.2021.09.009.

[22] Itay Goldstein et al., “On ESG Investing: Heterogeneous Preferences, Information, and Asset Prices,” National Bureau of Economic Research, working paper no. 29839 (April 2022), http://www.nber.org/papers/w29839.

[23] Bradford Cornell and Aswath Damodaran, “Valuing ESG: Doing Good or Sounding Good?” The Journal of Impact and ESG Investing 1, no. 1 (Fall 2020): 76–93, https://doi.org/10.3905/jesg.2020.1.1.076.

[24] The Economist, “ESG Investing Is in Need of a Rethink,” podcast, July 20, 2022, https://www.economist.com/esg-pod.

[25] Internalizing externalities refers to “any method of getting those producing external costs or benefits to take account of them in their decision-making” (“internalizing externalities,” Oxford Reference, accessed March 11, 2024, https://www.oxfordreference.com/display/10.1093/oi/authority.20110803100007230).

[26] Milton Friedman, “A Friedman Doctrine — The Social Responsibility of Business Is to Increase Its Profits,” New York Times, September 13, 1970, https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html.

[27] A recent report by Environmental Resources Management (ERM) presents some interesting data documenting investors’ skepticism around ESG ratings and the resulting need for transparency. See Emily K. Brock, Justin Nelson, and Aiste Brackely, Rate the Raters 2023: ESG Ratings as a Crossroads, The Sustainability Institute by ERM, March 2023, https://www.sustainability.com/thinking/rate-the-raters-2023/.

[28] A recent series of articles in The Economist suggests replacing the ESG label with “natural capital investing.” See, for example, Henry Tricks, “A Broken Idea: ESG Investing,” The Economist, July 21, 2022, https://www.economist.com/special-report/2022-07-23.

[29] Soh Young In and Kim Schumacher, “Carbonwashing: A New Type of Carbon Data-related ESG Greenwashing,” (working paper, Sustainable Finance Initiative, Precourt Institute for Energy, Stanford University, April 25, 2021), http://dx.doi.org/10.2139/ssrn.3901278.

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