ESG investing faces challenges from all sides. Can it survive?

The problem with ESG as an investment approach is the lack of standardized criteria for what makes an investment sustainable. An ESG approach ostensibly yields guilt-free returns—for example, by excluding fossil fuel and defense investments, or prioritizing sectors like green energy. But in fact, it could really refer to any strategy that results in a fuzzily defined positive impact somewhere in the world.

A recent paper from researchers at MIT and the University of Zurich, for instance, found very little consistency in the assessments of ESG rating agencies, making it tricky to evaluate the ESG performance of companies, funds, and portfolios.

“That’s confusing for companies and for investors. So many different standards are being thrown at them,” says Desiree Fixler, former sustainability chief of DWS, Deutsche Bank’s asset management arm, and whistleblower who now serves as ESG adviser to the U.K.’s Financial Conduct Authority. 

Criticism on both ends

Although first coined in 2004, ESG has sparked a feeding frenzy in the financial sector over the past few years. The fever reached its peak during last year’s UN Climate Change Conference, when green finance was feted as a key tool in the fight against climate change. Since then, it has lost some of its shine.

Growth in ESG investment products outpaced all other segments of the asset management industry in 2021. According to Morningstar, assets in global sustainable funds hit a high of $2.97 trillion last year but were down to $2.24 trillion by the end of September.  

An anti-ESG movement has sprung up in the red heartlands of the U.S., with Florida Gov. Ron DeSantis among those decrying “woke” asset managers like BlackRock, even though they remain major bankrollers of the fossil fuel industry. Republican officials in Florida, West Virginia, Texas, Louisiana, and Missouri have already divested billions of dollars from BlackRock funds in protest. Anti-ESG bills are planned in at least 15 states next year, and House Republicans plan to continue the fight in Congress. 

On the other end of the spectrum, ESG investing faces criticism of greenwashing. BlackRock, Vanguard, and other asset managers have been accused of watering down their ESG commitments. 

BlackRock voted for less than one quarter of U.S. shareholder proposals on environmental and social issues during the annual meeting season this year, saying such proposals were becoming too prescriptive “with little regard to the disruption caused to [companies’] financial performance.”

Asset manager Vanguard recently exited the Net Zero Asset Managers initiative, the world’s largest climate finance group. 

A 2021 Greenpeace study found that sustainability-focused funds in Luxembourg and Switzerland redirected only a sliver more capital toward sustainable activities than did conventional funds, while a study this year from Reclaim Finance found that 30 leading asset managers—25 of whom were members of the Net Zero Asset Managers initiative at the time—still hold a combined $550 billion in coal, oil, and gas companies with new projects planned. 

‘A safe topic to exaggerate’

A lack of standardized rules around ESG investing lets marketing departments inflate companies’ climate credentials without necessarily changing much on the ground.  

But this tendency is now being challenged. After being fired from her position as sustainability chief at DWS, Fixler blew the whistle on the firm for allegedly making misleading statements about ESG investing. The company denies the allegations. She said that, across the financial sector, companies’ outsize climate claims stemmed from the assumption that ESG was “a safe topic to exaggerate.” 

“Because it’s aspirational, many executives felt that when it comes to impact and ESG, ‘We’re all trying to do good here,’” says Fixler. “‘We’re all trying to make the world a better place.’”

Fixler points to the police raid on the offices of asset manager DWS and Deutsche Bank earlier this year as an overdue “day of reckoning” for the sector. She likens it to the dotcom bubble before it burst—an overly exuberant market that had to be brought to heel.

EU regulators aren’t the only ones taking action. In the U.S., Goldman Sachs paid a $4 million fine in November for failing to comply with ESG policies and procedures. In May, BNY Mellon paid $1.5 million for “misstatements and omissions” around its ESG-related claims. These cases, brought by a freshly formed SEC ESG task force, indicate there could be a major crackdown on the horizon.

As a result of increased regulatory scrutiny, Europe’s top asset managers including Amundi and Axa, along with New York-based BlackRock, have downgraded ESG funds that were previously listed as having the highest levels of sustainability to categories with less stringent criteria.

“A lot of these issues, I think, are the consequence of the fact that we use the ESG acronym to mean a huge range of things,” says Alison Taylor, executive director of Ethical Systems at NYU Stern School of Business. 

Stronger rules, definitions 

The U.K. and the European Union are leading the charge to strengthen rules for ESG rating agencies.

Yet more transparency and data alone won’t be enough to solve some of the issues facing the industry, Taylor says. Fund managers argue that environmental impact data would be the easiest to quantify. But even taking a measure that seems simple, such as the volume of water used by Coca-Cola, involves complex judgments about its environmental impact. “Do we mean the water that goes into the Coca-Cola?” Taylor asks. “The water that’s used to grow the sugar? The water in the manufacturing process? The water that was used to make the plastic bottle?” 

Taylor predicts that the ESG acronym will not survive, and that differentiated investment strategies focusing on either the “E”, “S,” or “G” will emerge instead. While there are examples of overlap between the different areas, there are also areas where what’s good for one category may not benefit another. 

This is the argument used by BlackRock and some other investment companies against fossil fuel divestment in light of Russia’s war on Ukraine. Europe must rely on fossil fuels in the short term to reduce reliance on Russian gas and achieve energy security, they say: pitting the “E” against the “S.” Surging oil and gas prices are also a likely factor, given the company’s commitment to clients’ long-term financial interests.

Among investment companies, there is a renewed emphasis on engagement with polluters rather than outright divestment, and on so-called transitional energy sources such as natural gas in addition to renewables (the latter strengthened by the EU’s recent controversial decision to classify natural gas as a green investment). 

Despite this year’s setbacks, industry watchers say that accusations of greenwashing will ultimately force companies to be bolder and more transparent in their climate commitments. Some even say that BlackRock and Vanguard diluting their climate rhetoric can be reframed as a boon for the sector. ​​

”Hopefully, Vanguard’s decision will cast a light on the chasm between many asset managers and banks’ affiliations with aspirational, acronyms-laden consortia and their unchanged mandate to deliver investment returns,” wrote Ken Pucker, a senior lecturer at Tufts University’s Fletcher School. 

Although the Republican backlash and the Russia-Ukraine conflict have impacted the sector this year, Fixler points to macro trends exemplified in government policy like the U.S.’s Inflation Reduction Act as signs that the ESG ethos is here to stay.

“It’s shallow and knee-jerk to say this was just the latest acronym, and it’s all going to be over in a couple of years, and we’ll all pivot to cyber or the metaverse,” Taylor agrees. “There’ll be some of that going on. But I think our expectations of the role of business in society are transforming.”