The past three years have seen a surge of investment in environmental, social and governance (ESG) funds and the launch of many new ESG-labelled products. However, criticism of the movement took off in 2022. The Ukraine war exposed the economic dangers of the drive to renewables, while concerns over greenwashing, the threat posed to the defence industry and underperformance added to the critique facing ESG. In the US, ESG is also increasingly controversial from a political standpoint.
Why ESG is facing a backlash after entering the mainstream
Ukraine war triggers criticism of ESG
ESG concerns have moved from being a fringe concern into the mainstream during this decade. In a report published in autumn 2022, PwC argued that ‘as ESG mandates fast become the default – not just in Europe but the US – the race is on to shift allocations and retrofit existing funds to keep pace with investor expectations’. 1
Global ESG AUM has exploded in recent years
Yet even as PwC’s ‘Exponential Expectations for ESG’ report hit the press, an anti-ESG backlash was gathering steam, creating ‘big headaches for some of the most powerful corporate leaders’, according to the Financial Times. 2
Criticism of ESG began following Russia’s invasion of Ukraine in February 2022. As energy supply shortages hit economies, and stocks reliant on fossil fuels outperformed, some began to question the wisdom of the drive to renewable energy. In May 2022, for example, the asset manager BlackRock – which has launched dozens of ESG funds in recent years – suggested ‘some short-term boost to fossil-fuel output was required despite its broad support for net zero objectives’, according to a Financial Times report. 3
Meanwhile, European governments scrambled to find alternative fossil fuels to shift away from Russian gas. Germany, for example, imported 44.4 million tons of coal in 2022, an 8% increase from the previous year. The country also brought around a dozen coal plants back onstream and extended the lifespan of several that were meant to be shuttered. 4
ESG has come under further criticism for excluding or heavily restricting investment in defence companies on ethical grounds. That undermines the ability of democracies to defend themselves, the argument goes. There’s also a case that a distinction should be made between weapons used for defence and those amassed for attacks. The higher defence spending initiated by the Ukraine war also means that investors are potentially missing out on opportunities for outperformance. The asset manager SEB Investment Management has lifted restrictions to allow some of its funds to buy into companies that make non-banned weapons. 5
Defence companies lift off following Ukraine war, adding to pressure to ease ESG restrictions
Questions have also been raised about the credibility of ESG investing. One of the central tenets of ESG is that companies with strong ethical standards and good corporate social responsibility have a competitive edge, and thus are inherently better investments. However, critics say the evidence on this is mixed at best. A report in the Harvard Business Review (HBR) in May 2022, for example, reported that ESG funds ‘perform poorly in financial terms’. The report cited research by the University of Chicago, which analysed the Morningstar sustainability ratings of more than 20,000 mutual funds representing over $8 trillion of investor savings. Although the highest-rated funds in terms of sustainability certainly attracted more capital than the lowest-rated funds, ‘none of the high sustainability funds outperformed any of the lowest rated funds’, according to the research.
Moreover, ESG funds ‘don’t seem to deliver better ESG performance either’, according to the HBR. It reported findings from a study by researchers at Columbia University and the London School of Economics, who compared the ESG record of US companies in 147 ESG fund portfolios with that of US companies in 2428 non-ESG portfolios.
HBR said: ‘They found that the companies in the ESG portfolios had [a] worse compliance record for both labor and environmental rules. They also found that companies added to ESG portfolios did not subsequently improve compliance with labor or environmental regulations’. 6
Then there’s the growing concern about greenwashing, with fund managers accused of simply using ESG labels as a marketing tool. There have been numerous allegations of this practice in recent years. In February 2023, for example, Australia’s corporate regulator launched its first court action against greenwashing, accusing the pension fund Mercer Superannuation Australia Ltd of misleading investors in the marketing of some sustainable products. 7
The US is also seeing a political backlash against ESG. Officials in Republican-led US states have launched investigations into BlackRock and State Street over their votes on shareholder proposals. Meanwhile, some states are considering passing, or have passed, laws requiring government pension funds to divest from money managers who consider climate or racial equity concerns in their investing. 8
Florida Governor Ron DeSantis, a leading contender for the Republican nomination in the next US presidential election, has called for politicians to suppress ‘woke capital’ by ‘crippling’ the ESG movement.9
Will ESG prove yet another fad?
The investment management industry is well known for embracing particular themes, only to move on a couple of years down the line as another trend emerges to capture investors’ attention. Supporters of the ESG movement have long claimed that ESG is different – that it reflects existential concerns about the future of the planet and views on social justice that are deeply held by many people. However, it’s undeniable that the cynicism surrounding ESG is growing, and that funds marketed by asset managers will be under ever-increasing scrutiny in the coming years.
1 https://www.pwc.com/gx/en/financial-services/assets/pdf/pwc-awm-revolution-2022.pdf
2 https://www.ft.com/video/f88d79bf-8119-449a-a293-cb77151da402
3 https://www.ft.com/content/b2869451-0899-4e02-8fc8-23d6d2ba9d17
4 https://www.dw.com/en/germany-coal-imports-increase-in-2022-amid-ukraine-war/a-64818198
5 https://www.reuters.com/breakingviews/ukraine-yet-make-defence-safe-investor-haven-2023-02-20/
6 https://hbr.org/2022/03/an-inconvenient-truth-about-esg-investing
7 https://www.bloomberg.com/news/articles/2023-02-27/australia-watchdog-sues-mercer-pension-fund-for-greenwashing
8 https://www.ft.com/content/f5fe15f8-3703-4df9-b203-b5d1dd01e3bc
9 https://www.cnbc.com/2023/02/28/ron-desantis-calls-for-crippling-the-esg-movement-in-new-book.html
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