Sustainability & ESG - An Investor's Perspective

I contributed this article to the book "Sustainable Business and Sustainable Transport" - also the 'conference proceedings' for the annual conference of the Dutch Royal Association for Commercial Law / Koninklijke Vereeniging Handelsrecht.?

Introduction and key concepts

ESG, or ESG investing, means taking into account environmental (E), people (S for social) and governance (G) issues in investment processes. It is also referred to as 'responsible', 'sustainable' or ‘socially responsible investment’ (SRI). Interest in ESG is sky-high these days and it is almost impossible to imagine today that only recently this was a relatively obscure phenomenon.

Before going into the details and effectiveness of the various ESG instruments, it is therefore useful to take a brief look at their origin. And before that, I will briefly explain a number of key concepts and core standards and regulations that are important for investors, and will touch on a few key concepts and regulations that play an important role in what follows.

The first of these are the Principles for Responsible Investment (PRI), which were developed in 2005 by investors at the invitation of the Secretary-General of the United Nations (UN). Today more than four thousand investment institutions have signed up to these principles. (See www.unpri.org ). A second important core standard is the Sustainable Development Goals (SDGs) established by the UN in 2015. Those 17 goals include eradication of poverty and hunger, promotion of health and education, gender equality, promotion of clean energy, environmental protection, climate protection, and so on. (See https://sdgs.un.org/goals ). Whereas these initiatives are primarily intentional, there is also an increasing number of initiatives and regulations that provide for (mandatory or voluntary) reporting of investor practices.

In the European Union (EU) the Sustainable Finance Disclosure Regulation (SFDR) 2019/2088 is of particular importance. It entered into force on March 10, 2021 and imposes reporting requirements on the financial services sector. This regulation is explicitly partly intended (see the first SFDR considerations) to promote the realization of the seventeen SDGs and the climate goals agreed upon in the Paris Climate Agreement.

1. Brief History

The type of investment that takes into account environmental, social or governance considerations has been around for centuries, although the term ESG was introduced much later. For example, around 1700, American Quakers and Methodists avoided investing in certain sinful activities, such as slave trade, weapons, alcohol or tobacco. In the 1960s and 1970s, responsible investment played a role in the American civil rights movement, in the protests against the Vietnam War (e.g. by excluding Dow Chemical, the producer of napalm) and in the boycotts against South African apartheid. While the direct effects of these investment activities are disputed, it is generally believed that they did contribute indirectly to the success of these movements.

The term ESG was introduced around 2004 and has become popular primarily because in 2005 the initiators of the Principles for Responsible Investment (PRI) included it in the first principle of the PRI: “We will incorporate ESG issues into investment analysis and decision-making processes”. The PRI now have around four thousand signatories, including asset owners (pension funds, insurers), asset managers, banks, consultants and data providers, who have all undertaken to invest ‘responsibly’, in other words, by taking ESG factors into account.

The Dutch Wikipedia indicates that by 2007, SRI 'seems to have escaped from the tree-hugger realm’. Although this obviously cannot be determined objectively, from about that time there has been increasing talk of ‘mainstreaming’ ESG. From about 2013, ESG benefitted from additional tail winds due to a number of developments:

-?????????Climate change, in the “E” category, became an increasingly important societal theme and is now so dominant in ESG discussions that other themes sometimes remain completely obscured. This trend was given a further boost by the Paris Climate Agreement in 2015 which has the aim of limiting global warming to 2°C or even 1.5°C.

-?????????Also in 2015, the UN adopted the Sustainable Development Goals (SDGs); these development goals have been embraced by many investors as a framework for demonstrating that investments have impact, or to measure impact.

-?????????In 2017, the Taskforce on Climate-Related Financial Disclosures (TCFD) issued recommendations for reporting climate-related risks. Although TCFD, unlike the PRI, is not a membership organization, these recommendations have also been widely embraced and were subsequently also (partially) incorporated into the PRI reporting requirements.

-?????????In 2018, the EU introduced the Sustainable Finance Action Plan, which has since resulted in a Taxonomy (2021), indicating which investments qualify as ‘green’, and the Sustainable Finance Disclosure Regulation (SFDR, 2020) that, based on a fund classification (Art. 6, 8 and 9 funds), sets requirements for reporting ESG aspects of investments.

There is also a close link between ESG and corporate social responsibility (CSR); the CSR themes that are high on corporate agendas today are roughly the same themes that investors look at under the header of ESG.

Finally, the ESG discussion is influenced by two other societal themes of recent years: the alleged short-termism in business and particularly among investors; and the ‘stockholder vs. stakeholder’ debate where one side of the table takes the view that corporate management is accountable only to shareholders – who, as 'owners' of the company generally seek to maximize profits – and the other side insists that the interests of other stakeholders, such as customers, employees, and society in general, should be taken into account more, even if this is at the expense of profit.

This latter discussion is also very much influenced by criticism of capitalism, where it is often argued that companies operating in the free market – influenced by the ideas of the economist Milton Friedman and under never-easing investor pressure – are too focused on profit and growth and have little regard for other interests, thus harming the environment and human rights, and fostering economic inequality. There are also ESG advocates who would prefer to see capitalism abolished altogether.

After this stormy growth, particularly over the past decade, ESG is now often at the top of the priority lists in the investment industry; for example, it is an important criterion in the selection of asset managers by pension funds, many investors have ESG departments with dozens of people and there is a sizeable and ever-growing market for ESG funds.

2. ESG Terms

The term "ESG" refers to a whole universe of other concepts and investment approaches, all of which have their own origins and definitions. However, there is no consensus on the various definitions, and today ESG is often used as an umbrella term for all these concepts without further clarification of what it meant exactly. Therefore, a brief indication of the various terms may be useful:

Responsible investment: mainly due to the introduction of the PRI there is actually some clarity in what is meant with this term, which generally refers to the following two concepts: ESG integration and active ownership, that are also the two main principles of the PRI.

1. ESG integration: taking into account ESG factors in the investment process. What is usually meant here specifically is an assessment of ESG risks, by investment analysts or by an ESG analysis team.

For example: the possibility that a company will be sued because of environmental pollution (E), can be less productive due to unsatisfied employees or lack of diversity (S), or has less effective decision-making due to a board with no or few independent members (G). ESG integration is the first principle of the PRI: “We will incorporate ESG issues into investment analysis and decision-making processes”.

2. Active ownership / stewardship / engagement: playing an active role in the governance of a company, for example by engaging in regular dialogue with management, attending shareholders' meetings or exercising voting rights. Shareholders have had this responsibility for centuries, but it has received renewed attention with the emergence of ESG, and it has also been implemented in various countries, mostly through stewardship codes and at the EU level in the Shareholder Rights Directive. Although active ownership is now usually seen as an ESG tool, engagement – strictly speaking – does not need to be about ESG issues; the original intention is that the (relevant) ESG factors are made part of the discussion. Active share ownership is the second principle of the PRI: “We will be active owners and incorporate ESG issues into our ownership policies and practices”.

Sustainable investment/SRI: while responsible investment is often focused on managing investment risks, what is called sustainable investment, or socially responsible investment, often emphasizes outcomes. In other words, by selecting companies or investment projects on the basis of ESG filters or themes, investors claim they can achieve a higher return (alpha or outperformance) or make companies or the world a bit more sustainable (impact).

Sustainable investments are often offered in funds that have 'sustainable', 'ESG' or similar terms in the fund name. Often these funds also have a specific ESG or SRI label.

Impact investing: also seen as a subcategory of the previous concept, but then specifically aimed at making companies, or the world more broadly, more sustainable. Impact investors usually use the seventeen SDG goals as a framework, and seek to measure the extent to which their investments have contributed to, for example, combating poverty, hunger or climate change.

Ethical investment: this term has fallen into disuse somewhat, even if – like with the Quakers around 1700 – there is still a strong emphasis on ethical aspects of ESG, especially in Europe. For example, it is common practice in many European countries for pension funds, insurers and asset managers to have exclusion lists that prohibit investments in coal, oil and gas, nuclear weapons, cluster munitions, alcohol or tobacco. The effectiveness of this approach is disputed: after all, selling shares in companies assumes that they are bought by someone else and therefore this usually does not affect the financing of the companies in question. Supporters of this approach, however, often seem to do this more to achieve peace-of-mind or for virtue-signaling, than to bring about change or solve societal problems.

3. Objectives of ESG investing

Investors seem to have different objectives with ESG. I say 'seem' intentionally, because the objectives are usually not explicitly named. Nonetheless, it is usually one or a combination of the following:

1. values alignment: bringing investments in line with (ethical) standards and values;

2. financial: managing risks and/or increasing returns;

3. impact: contributing to a better world, solving societal problems or making companies more sustainable.

The American ESG commentator Matt Moscardi calls this “saving your soul, saving your pension or saving the planet”. In the United States, the term “better investor or better world” has also been used to describe the distinction between objectives 2 and 3.

It is important for investors to be clear about their objectives, because the various ESG instruments are not all equally effective and can even have contrary effects.

4. ESG instruments

Investors who want to ‘do’ ESG can choose from a number of instruments.

a. Exclusions / divestment

This is the oldest ESG instrument, used by the Quakers as early as 1700: excluding or divesting companies or governments that do not act in accordance with the investor's moral convictions. The exclusions are usually documented in an exclusion list that is set by the board of the pension fund or the asset manager. Examples of businesses that are typically excluded are tobacco, alcohol, controversial weapons (such as cluster munitions or nuclear weapons) and nuclear energy.

Countries (government bonds) are often excluded based on sanctions imposed by the UN or the EU, usually in the area of human rights violations.

In recent years exclusions have been particularly prevalent on climate change; most (European) ESG investors exclude investments in coal and are increasingly doing so for oil and gas. In the US there are various divestment campaigns, especially at universities: students call on their endowment (university fund ) to exclude fossil fuels.

For exclusions, the risk management argument is also often used: because of government policies to combat climate change there is a certain likelihood that these business activities will eventually become stranded assets and so, besides the ethical motive, it could also be better from a financial perspective to avoid these avoid these investments.

However, there is little evidence that exclusions actually result in better risk management or higher returns. Indeed, a number of large pension funds have been reporting over the years on the effects of their exclusions policies and often they report a significant negative impact on earnings. Apart from the US university campaigns, exclusions are therefore not a popular instrument in Anglo-Saxon countries, where investors take the view that, in light of fiduciary duty, exclusions can only be applied if the client explicitly agrees to, or requests, them and understands the advantages and disadvantages.

In addition, there is little evidence that exclusions contribute to a better world: the investor who sells shares or bonds in the secondary market generally does not deprive companies or governments of the capital they need for their activities. In addition, these investors no longer have a voice in company policy and therefore there are also many ESG investors who, when considering whether to 'exclude or engage', opt for the latter.

b. ESG Integration

The inclusion of ESG factors in the investment process. This usually refers specifically to the assessment of ESG risks, either by investment analysts or by a dedicated ESG analysis team. For example: the possibility that a company could be sued for environmental pollution or is not well positioned for the energy transition (E), is less productive due to dissatisfied employees (S), or has less effective decision-making due to a board with no or few independent members (G).

‘Best-in-class’ is a form of ESG integration: the best-performing companies are selected based on ESG scores.

Investors often talk about materiality: the extent to which (ESG) factors are actually relevant to investment decisions; it is assumed that there is materiality if, by taking the information into account, the investor arrives at a different investment decision than if this information were not available. In practice, G factors tend to be by far the most material, and ESG advocates point to this to underscore the importance of ESG integration, but ESG skeptics argue that governance factors have always, i.e. even before the introduction of ESG, played an important role in investment analysis.

There seems to be consensus in the academic literature and among investors that ESG integration can be a useful risk management tool, also because the ESG movement has made much more company information and data available that can be material. However, the numerous studies examining whether ESG integration contributes to improved returns are ambiguous; the conclusion seems to be that it has a neutral or slightly positive effect, depending on the chosen approach. Critics argue, however, that even if there is correlation between ESG factors and returns, this does not necessarily mean causality.

Whether ESG integration contributes directly to a better world is even more difficult to establish; based on experiences of the past fifteen years, since the launch of the PRI, it seems unlikely.

c. Active ownership: engagement & voting

Active ownership, engagement or stewardship, i.e. maintaining dialogue with management of the company or exercising voting rights. Of all ESG instruments, active ownership appears to be the most effective, because it can result in better risk management, higher returns and a better world. However, the approach also has a number of drawbacks:

- It is difficult to do well, because it is knowledge- and labor-intensive. Many investments today are passively managed, which means that the portfolios follow an index on an automated basis and therefore this does not require a team of portfolio managers and analysts who must get to know companies inside out. This means that passive managers who still want to be active owners often set up separate functions for this, typically with people who have relatively little investment experience and therefore also little knowledge of the companies they engage in dialogue with.

- The ESG movement has put a lot of emphasis on engagement on ESG factors that are not always (financially) material. This allows the investor to meet its PRI obligations, but does not always produce discussions that enable investors and companies to achieve better results (either financially or in terms of sustainability). After all, active ownership has been around for centuries – the Dutch East India Company had active, and even activist, shareholders as early as the 1600s – but before the emergence of ESG the emphasis was more on holding management to account in the areas of finance and strategy.

These factors have contributed to a type of ESG engagement that, today, often has a high degree of window-dressing.

In a recent development, an activist hedge fund, Engine No. 1, succeeded in filling three board seats via a proxy battle at ExxonMobil's shareholder meeting in May 2021, and will now try to force the company to adjust its strategy, which is now largely fossil-fuel oriented. However, Engine No. 1 in its reasoning relied more on economic factors (long-term value creation) than ESG factors, and also indicated it wants to restore trust in the capitalist system and the balance between power of shareholders and management. It is therefore somewhat ironic that the greatest "ESG successes" are achieved by activist shareholders who are supporters, rather than critics, of Milton Friedman.

d. Impact investment

Impact investment is a broad category of investments, for which there is no single agreed definition. The Global Impact Investment Network (GIIN) defines it as follows: “Impact investments are investments made with the intention to generate positive, measurable social and environmental impact alongside a financial return.” From this, a number of elements can be distilled that are often used to assess whether if the impact investment is genuine:

- intentionality: the investor must have the intention to make a positive contribution through the investment, although this is difficult to prove in practice;

- additionality: although this element is disputed, the investment must bring about a change that otherwise would not have occurred. In other words, there must be some degree of causality;

- measurement: the investor must measure, and report on, the positive contribution. This is usually done with reference to the SDGs;

- financial return: there must also be a financial return. If this is lacking, it is not an investment but philanthropy. If the return is in line with similar (non-impact) investments in the market, then this is called market rate. If not, then the investment is concessionary; in other words, the investor is willing to accept a lower return in exchange for the positive social contribution.

Particularly in the past year, there has been increasing discussion about the distinction between impact-alignment and impact-enabling. The former category refers to investors seeking out companies that are impactful in some way and invest in them, without this investment enabling the company to develop impactful activities or to be even more impactful than before. In other words, there is no causality and this is also called company impact.

The second category refers to investors looking for companies that could have impact but have limited access to financial markets. The idea is that by making capital available, the investor will enable the company to do business in a way that is (more) impactful. In this case there is causality, so this is also called enabling impact investment, or investor impact.

In recent years there has also been growing interest in blended finance: a type of investing where governments invests together with private investors. After all, many high-impact activities are too risky or too small-scale for institutional investors (pension funds or insurance companies) who have strict investment criteria in light of their obligations to beneficiaries or clients. In addition, many problems encapsulated by the SDGs are prevalent mostly in emerging markets, whereas most institutional investors barely invest in emerging markets, if at all. As a result, the investors with the deepest pockets can often not be brought to the table to solve societal problems – the potential investments are not market rate after all. To get around this problem a co-investment or guarantee from the government can make the risk/return profile of the investment more attractive so that these investments can also be made by institutional investors. This is also called mobilizing private capital, and this allows impact investments to be scaled up.

e. ESG funds/ESG & SRI labels

ESG funds, strictly speaking, are not a separate ESG instrument, but are investment funds in which one instrument or a combination of the instruments discussed above is used. Again, no clear definition can be given here as the market for ESG funds is enormously broad – there is a whole range of funds with different strategies, with a wide variety of ESG designations in the name: 'ESG', 'sustainable', 'SRI', 'impact', and so on.

A number of countries have developed ESG and SRI labels, that provide a certain direction through their set of criteria. However the requirements for these labels are not consistent and sometimes conflicting.

Most ESG funds are marketed with the claim that the chosen investment strategy, because of its ESG approach, contributes to better returns or a better world, or both. It is therefore in particular in the context of this ESG instrument that there is increasing discussion about greenwashing: claiming to be greener or more sustainable than the company or fund actually is. After all, studies show that even if the return is higher than the benchmark, this is usually due to factors other than ESG factors, but also often that the return was only temporarily higher. The extent to which the type of investing that is often packaged in ESG funds contributes to a better world is probably also very limited, even if this is difficult to measure.

However, there is increasing demand for ESG funds, and for asset managers these funds are often more profitable than regular funds, so the commercial pressure to label as many funds as possible 'ESG' is great.

f. Influencing public policy

For most of the problems included under the headers of ESG/SDG, one can observe that they will not be solved without government intervention. The best example of this is climate change, where climate scientists and economists have for years been arguing for a combination of carbon-pricing (e.g. through taxation), sector-specific regulation, and the stimulation of new technologies that are currently too small-scale, too risky or too unprofitable for private investors. In other words, solutions that can only can be implemented by governments. Investors can, of course, make a contribution, for example by encouraging oil and gas companies to respond to the energy transition, or by investing together with the government, for example through blended finance.

However, there has been increasing discussion, particularly over the past year, of another role that investors can play in this area: contributing proactively to effective public policy. Because investment institutions cannot directly participate directly in the political process, there are currently few good avenues to facilitate this but the more forward-thinking governments and investment institutions are trying to find to find solutions for this.

g. Climate-specific instruments

Climate change has gradually become the most prevalent ESG factor, to the extent that ESG discussions or conferences sometimes seem to be about climate change exclusively. A few ESG instruments have therefore been developed specifically for climate change:

Carbon footprint: measures the greenhouse gas emissions for which a company is responsible. It usually looks at Scope 1 (direct carbon emissions, caused by own sources within the organization), Scope 2 (indirect emissions caused by the generation of consumed electricity or heat) and Scope 3 (indirect emissions caused by the business activities of another organization in the supply chain: by customers or suppliers).

Portfolio temperature: determines whether the business activities in an investment portfolio are aligned with the targets of the Paris Climate Agreement (maximum 2°C or ideally only 1.5°C warming), by using carbon footprint data to determine the temperature increase with which the business activities are associated.

Scenario analysis: the investor tries to determine, based on various future scenarios, what developments can be expected, for example in further global warming or government policies aiming to combat climate change, and what effect these will have on market values. This usually involves looking at physical risk (e.g. the effect that further rising sea levels will have on certain investments, such as real estate) and transition risk (the risk that companies — for example, fossil fuel suppliers —will be less well positioned due to the energy transition). Incidentally, scenario analysis is not a new ESG tool, but stems from a long tradition of scenario planning in business (Shell, for example, was a pioneer in this field) and for military purposes.

Net zero investing: the aim to reduce to zero the net emissions of the business activities in which investments are made. The investor usually achieves this by divesting from the most polluting activities, engaging in dialogue with companies to encourage them to reduce their emissions as far as possible, and possibly using carbon offsets (e.g. planting trees) to offset the remainder. In the past year many investors have committed to net zero investing by joining the Net Zero Asset Owner Alliance or the Net Zero Asset Manager Initiative.

The effectiveness of these tools is also contested. Provided they are properly implemented they can contribute to better risk management but the contribution to climate action seems to be marginal. Often these tools result in the removal of emissions 'from the portfolio', but because they end up in someone else's portfolio, they are not removed 'from the atmosphere'. Over the past year climate scientists have therefore also been increasingly critical of these practices, particularly the concept of net zero (for example, by calling it a "dangerous trap"[1] ) and offsets (a "dangerous distraction"[2] ).

It thus remains to be seen how credible and how effective these climate-specific investment instruments are.

5. ESG data, reporting and disclosure

ESG Data

The growing interest in ESG and burgeoning ESG activity have been accompanied by the increasing demand for scores, data and research to enable investors to assess companies' ESG risks, position themselves as active shareholder, measure impact, exercise voting rights, and so on. This has resulted in a huge number of specialized providers, of which MSCI, Sustainalytics and ISS are the current market leaders.

Like in other areas of ESG, there is little uniformity here: the different providers all use their own methodologies, research methods and criteria, and the ESG scores of different companies can therefore vary greatly — to such an extent that some companies are seen as 'ESG leaders' by one provider and as 'ESG laggard' by another. The fact that much company data is self-reported, and usually not verified by external parties, contributes to this.

There also seems to be a large company bias, in that large companies often have larger CSR teams and larger budgets for reporting, which often leads to more disclosure and better ESG scores.

Smart investors therefore do not rely blindly on ESG data and scores, but research the underlying methodologies and rationales, to reach their own judgments about the relevance and materiality of the data, taking into account their specific investment objectives.

Reporting/Standard Setters

In recent years, several organizations have been set up to create frameworks, reporting standards and platforms to aim for more consistency in ESG reporting. Because these organizations also have differing methodologies, the best-known five (CDP — Carbon Disclosure Project; CDSB — Climate Disclosure Standards Board; GRI — Global Reporting Initiative; IIRC — the International Integrated Reporting Council and SASB — the Sustainability Accounting Standards Board) agreed in 2020 on a closer cooperation, towards one global reporting standard.

Disclosure

Many ESG-related regulations are aimed at promoting the reporting and disclosure of ESG-relevant information by investors. This is based on the theory of change that, once investors have full transparency, and know which activities are 'green' or sustainable, they will automatically steer their investments towards the most sustainable activities, and in doing so, steer the rest of the economy towards sustainability and carbon neutrality as well. And when investors provide the necessary insight in their portfolios, regulators and clients can verify that things are moving in the right direction.

The EU Sustainable Finance Action Plan, mentioned above, that resulted in the Taxonomy and the Sustainable Finance Disclosure Regulation (SFDR), therefore sets specific requirements for investors to report on the degree of sustainability of their investment portfolios and the extent to which investments are 'green'.

This regulation has only been introduced very recently so it is too early to answer the question whether it is effective; but what is also relevant here that it is impossible to determine exactly what the objectives of the regulation are. The regulation itself mentions very disparate goals, including countering short-termism, enabling companies and investors to take into account climate-related risks, mobilizing private capital to combat climate change, and countering greenwashing. It is interesting to note that the SFDR, that entered into force earlier this year, and referred to by EU officials primarily as an anti-greenwashing tool, has been appropriated by the asset management industry as a convenient ESG and SRI labeling scheme, that – if anything – is fuelling greenwashing.

The SFDR has three categories of funds:

-?????????article 6 (integrates ESG factors focused on risk management, or has no ESG approach);

-?????????article 8 (“promotes ESG characteristics”) and

-?????????article 9 (has sustainable investments as its objective).

The legally imprecise and not very stringent way in which these criteria are formulated, especially the “promotion” in article 8, has led to a kind of contest in who can classify the most funds as Article 8 and 9. The fact that article 8 and 9 funds also come with the heaviest reporting burden does not seem to deter asset managers from this; large asset management firms may even have an advantage here over smaller investors who are less able to bear the significant reporting costs. Moreover, the reporting requirement does not apply until 2022.

At the same time, article 6 has been stigmatized because funds that (pursuant to, for example, the PRI) do ESG integration — by now the majority of the market — are lumped together with funds that have no ESG approach at all; now that the norm in the market has become that investments must be 'ESG', many clients want nothing to do with article 6 and therefore asset managers opt for article 8 or 9. And given that the criteria for these categories are so loosely formulated, the underlying investment strategies need little or no adjustment. In other words, regulation that was intended by the EU as a means to counter greenwashing seems to have facilitated it on a massive scale.

All in all, the SFDR is an interesting case study and the experiences with the SFDR will contribute to the testing of the theory of change based on the idea that transparency and reporting for and by investors will 'green' financial markets on a large scale, and whether this will subsequently also ‘green’ the economy, and thereby contribute to solving problems like climate change.

In the meantime, the EU has also launched the European Green Deal that addresses climate change more directly, i.e. not through the intervention of investors, but through direct industry-specific regulation and carbon pricing. In the coming years, these two completely different types of regulation will have all kinds of direct and indirect, and intended and unintended, effects, so the question about the theory of change will probably never be answered in a fully satisfactory way.

6. Does ESG investing ‘work’?

Answering this question depends, of course, on the underlying question of what the investor is trying to achieve and that may be, as discussed above, one or a combination of the following objectives:

1. values alignment: aligning investments with (ethical) standards and values;

2. financial: controlling risks and/or increasing returns;

3. impact: contributing to a better world, solving social problems or making businesses more sustainable.

It should also be clear from the paragraphs above that many of the ESG instruments have emerged out of a desire for values-alignment, but that the links to financial and impact outcomes are often hard to establish, even though these are also often cited as motivations for deploying ESG instruments. And of course these motivations play an important role in the marketing of ESG funds. However, especially the early years of the ESG movement it was not done to ask the question “does ESG work?” More than once the ESG movement has been compared to a religion, and a too rigorous analysis of the underlying hypotheses, and therefore questioning the effectiveness of ESG tools, can then be compared to blasphemy.

Undoubtedly, this also has to do with the fact that ESG has become an important marketing tool for asset managers, especially active managers who — with an ever-decreasing market share — have grasped onto ESG as one of the means to demonstrate that active investment is better than passive. In addition, an entire industry has mushroomed around ESG and impact conferences, often sponsored by those same asset managers and by the ESG data providers who generally like to present their own research at these conferences, which usually shows that ESG does in fact increase returns and does improve the world, regardless of whether this research can stand the test of academic rigor.

However, in recent years an increasing amount of research has been published in the more serious peer-reviewed scientific publications which shows that the relevance of ESG is highly nuanced. In 2018, academics Julian K?lbel, Florian Heeb, Falko Paetzold and Timo Busch published the paper “Can Sustainable Investing Save the World? Reviewing the Mechanisms of Investor Impact"[3] in which they review much of the academic literature and conclude that active ownership and investment in impactful companies that have little access to capital markets do contribute to a better world, but that ESG integration and other forms of impact investing do not.

In 2020, Pedro Matos published “ESG and Responsible Institutional Investing Around the World: A Critical Review”[4] in which, based on the serious financial academic literature available at that time, he paints a very nuanced picture. Matos, too, concludes that active ownership is probably the most impactful tool and that there is no evidence that ESG investment strategies have produced higher returns, although ESG can be a useful risk management tool. In the paper he also makes the following, sobering, observation: “'I am aware of almost no academic research in top-ranked finance journals on how ESG investing is contributing to the achievement of the SDGs”.

Those who view the ESG movement from some distance would expect this type of publication to land as a bombshell, and that ESG investors would be quick to return to their drawing boards to revise ESG strategies, and marketing materials containing promises to clients. However, the opposite seems to be true; these publications were hardly discussed at ESG conferences, and many ESG practitioners seem to be unaware of such findings, or counter them with research (often published by consultants or ESG data providers) that shows that ESG does increase returns and/or contributes to SDG goals.

A recent development that may carry more weight is that ESG professionals, often once they leave the investment industry, share their experiences and insights regarding the effectiveness of ESG, almost like whistleblowers.

In 2019, Duncan Austin, until 2018 a partner at the firm Generation Investment Management founded by Al Gore and David Blood, wrote the essay “Greenwish: The Wishful Thinking Undermining the Ambition of Sustainable Business” [5] in which he argues that greenwashing (where companies pretend to be more sustainable than they really are) is less of a problem than greenwishing: “the earnest hope that well-intended efforts to make the world more sustainable are much closer to achieving the necessary change than they really are”. Austin concludes that most win-win ESG and CSR strategies contribute little to solving problems, also points out the limited usefulness of reporting as a change mechanism, and calls on companies and investors — if they do not contribute to public policy aimed at systemic problems such as climate change — then at least not to obstruct it.

Writing early 2021, Tariq Fancy, former head of sustainable investing at BlackRock, the world's largest asset management firm, published the article "Financial world greenwashing the public with deadly distraction in sustainable investing practices"[6] in USA Today, in which he concludes that “sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community” and notes that climate change can only be solved through the combination of scientific insights and public policy.

Finally, regulators in several countries including the United Kingdom, France, Switzerland and the United States are beginning to stir and, in the past year in particular, have issued guidelines for ESG funds and/or have created units with the specific purpose of investigate greenwashing. The expectation, however, is that this may put a stop ESG funds that are not very effective in achieving ESG goals, but that it will do little to promote approaches that are actually effective.

My own answer to the question in the title of this section, based on my own ESG experience and following the academic literature is shown in the following matrix.

What can be added to this matrix is that climate-related instruments can serve as a risk management tool, provided that the metrics (portfolio temperature, carbon footprint, etc.) are not mechanically applied as inputs in the investment process, but used to understand the broader investment context. There is justified interest among investors in scenario analysis, through which investors try to assess how investments will perform under different climate scenarios, even if this tool – like all ESG tools that really 'work' – involves a great deal of complexity.

Finally, there is the influencing of public policy, which – since public policy is is crucial to solving most ESG and SDG problems such as climate change and poverty – is increasingly mentioned as something that ESG investors can contribute to.

7. Recommendations for legislation and regulation

Surveying the entire ESG playing-field, with increasing criticism of greenwashing and a growing chorus questioning the effectiveness of the various ESG instruments – which often turns out to be very limited – the question is justified whether legislation and regulation can make a contribution here.

It seems to me that this can be the case in two areas:

1.??????Regulation that sets clear rules for the circumstances in which funds can be marketed as 'ESG' or 'sustainable'. Contrary to the existing rules (such as the SFDR), in my view this type of regulation should be linked to the three ESG objectives as described above (values alignment, financial, impact). The regulations could require the following from asset managers:

-?????????an indication of the ESG-related investment conviction: which of the three goals does the assset manager have in mind?

-?????????a qualitative narrative in which the asset manager explains how the investment process is set up (for example, with specialists on the team, with access to specific data or expertise) so that these goals are likely to be achieved.

Here, clarity can also be provided about what the investor cannot can expect from the fund – for example, that the goal of the fund is to achieve higher returns by investing in companies with a high ESG score, but does not pretend to also contribute to achieving the SDGs.

2.??????Regulation that promotes the use of the most effective ESG tools. Here I would think of active ownership in particular, but immediately note that, in my experience, it is rare for investors who most convincingly position themselves as active shareholders – such as the aforementioned Engine No. 1, which achieved success at ExxonMobil – do so because it is imposed by legislation or by soft law (e.g. the PRI or stewardship codes). Instead, they are most likely to do so if their belief is that it will result in better investment outcomes. Alex Edmans, professor of corporate finance at London Business School, notes in his book Grow the Pie[7] that the most successful active owners usually have three things in common: a concentrated portfolio (they invest in a limited number of companies); incentives (they have financial motivations: active ownership, if done well, will translate into returns); and resources (they have teams that have enagement expertise this and know the companies in which they invest from A to Z).

A similar reasoning applies to other ESG tools that have proven effective, including blended finance, scenario analysis or influencing public policy: it is difficult to enforce such practices through regulation. A well-known saying goes “You can lead a horse to water but you can't make it drink”.

In conclusion, it seems to me that governments that want to promote ESG investing or want to use the deep pockets of institutional investors to fund the energy transition or the SDGs are advised to do so by seeking closer cooperation with development banks, pension funds, insurers, asset managers and universities, rather than by pursuing more regulation.

This collaboration could focus on:

-?????????creating impactful projects and activities in which institutional investors, facilitated by governments (e.g. through blended finance) can invest;

-?????????conducting more research into the effectiveness of instruments such as active ownership and scenario analysis and developing platforms in order to share best practices in these areas;

-?????????creating platforms through which government agencies can draw on the expertise of investors, for example in designing regulations focused on addressing climate change.

8. Conclusion

In conclusion, the ESG movement has brought us a lot of good things: it has put themes such as climate change, biodiversity and human rights (higher) on the agendas of investors and companies; it has enabled investors to invest in line with ethical standards and values; by bringing truckloads of new data and information it has created a useful complementary investment risk management tool; and it has brought a new appreciation for the importance of active ownership.

However, the movement is now at a tipping point: does it want to make the case that ESG can systematically contribute to higher returns and, more importantly, to a better world – meeting the SDGs, solving climate change and so on – then it will have to be rigorous in applying insights from academia and focus on the tools that really ‘work’.

Governments can contribute to this through laws and regulations that counter the less effective – greenwashing – practices and that promote the more effective practices. But the latter can perhaps be better achieved by working more closely with pension funds, asset managers and universities.

In short, governments that would like the horse to drink, cannot force him. But they can ensure that ESG water is in ample supply, that it is clean, and easily accessible.

[1] https://theconversation.com/climate-scientists-concept-of-net-zero-is-a-dangerous-trap-157368 ??

[2] Carbon offsets might be a dangerous distraction from more effective climate action, experts say | CBC Radio

[3] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3289544

[4] https://www.cfainstitute.org/en/research/foundation/2020/esg-and-responsible-institutional-investing

[5] https://preventablesurprises.com/wp-content/uploads/2019/07/2019-07-19-Greenwish-Essay.pdf

[6] https://eu.usatoday.com/story/opinion/2021/03/16/wall-street-esg-sustainable-investing-greenwashing-column/6948923002/

[7] https://www.growthepie.net/