The origins of the environmental, social and governance (ESG) label date back to the 1960s. But a concept that was conceived with the noble intentions – namely to address climate change, compliance, and diversity, among other issues – is facing increasing scrutiny.

This is partly due to the exponential growth of these funds. ESG has boomed in the last couple of years. According to the Harvard Business Review, as of December 2021 ESG funds were worth $2.7trn, with $143bn in new capital entering the market in the fourth quarter of 2021 alone. Of these, 81% are European and 13% US-based.

Criticisms

But despite the inflow of investment, organizations and individuals have been critical of an overuse of jargon and acronyms, while ESG has faced accusations of values-driven marketing and greenwashing. The former head of responsible investment at HSBC Asset Management, Stuart Kirk, has been one of ESG’s most vocal critics, calling it contradictory and saying it has an existential defect. The GRIP team also saw the topic raised by a panel at AFME Optic in October.

“ESG can refer to the consideration of ESG risks within an investment process, where such risks may have a material financial impact on an investment. It can also be used to describe investments with real-world impacts.”

Daniella Woolf, director, Danesmead ESG

There is a desperate need for an industry agreed terminology. “ESG can refer to the consideration of ESG risks within an investment process, where such risks may have a material financial impact on an investment. It can also be used to describe investments with real-world impacts,” says Daniella Woolf, director at Danesmead ESG.

“Current and proposed regulation is working to provide clarification to investors in financial products as to how sustainable those products really are – whether they’re impact funds, or simply considering ESG as a risk factor. If the term wasn’t ESG, it would be something else, and still confusing – responsible investment, socially responsible investment…”

The Economist opined in July that ESG has had a negligible impact on carbon emissions, and predicted tighter regulatory oversight in Europe. The UK’s Financial Conduct Authority (FCA) announced in October it would crack down on greenwashing in ESG, saying “exaggerated, misleading or unsubstantiated claims about ESG credentials damage confidence in these products”. This follows the November 2021 release of a strategy based on ‘transparency’ and ‘trust’, linked with the British Government’s commitment to a net zero economy by 2050.

And European dominance in ESG has led to the Sustainable Finance Disclosure Regulation (SFDR), implementing pre-defined metrics for measuring ESG. The first phase was introduced in March 2021, with the second to come in January 2023.

“It’s only a form of greenwashing in our opinion, if a manager is unclear or misleading about what ESG means for them, and how they are implementing ESG. Regulators are scrutinising how managers are handling ESG claims, ensuring consistency across policies, marketing materials, offering documents, RFP responses and of course actual process,” says Woolf.

Impact investing goals

There is broad agreement on the goals of impact funds and impact investing, of which ESG is one approach, alongside socially responsible investing (SRI). The Global Impact Investing Network identifies four elements or tenets to this type of investing: intentionality, investment with return expectations, range of return expectations, and impact measurement. In these ways it differs from traditional investing, which is purely profit driven.

“Third party ratings providers are playing an important role in collecting ESG data, applying a methodology, weighting and scoring logic, and coming up with ratings for different elements of ESG.”

Daniella Woolf, director, Danesmead ESG

A scoring system can help keep ESG in check. “Third party ratings providers are playing an important role in collecting ESG data, applying a methodology, weighting and scoring logic, and coming up with ratings for different elements of ESG,” says Woolf.

“It’s important to understand what a ratings provider is actually telling you with their scores. Some are assessing the level of ESG risk on a company, some are telling you more about the climate impact of a company (ie is the company good or bad for the environment), whilst others are flagging up dynamic controversies and news stories relating to ESG issues. Greater transparency around what each rating provider is doing and how they are doing it may help the industry to know when and how to use the different services.”