The ESG mirage: More about the hype than values

Over the past century, critics of pure capitalism and market economy have argued that corporations should not only seek profit for shareholders, encouraging a more progressive view of social responsibility within the business community.

Nowadays, this agenda has been condensed into three letters – ESG – standing for environmental, social and governance factors that can be embedded into business decisions. 

Despite being painted as something novel, ESG has been around for a while, it just had different names in the past. Antecedent theories include “corporate social responsibility”, “socially responsible investing”, “shared value creation”, among others, and they all successfully managed to generate more confusion than value-aligned capitalism, studies found. 

“A fundamental problem in the field of business and society has been that there are no definitions of corporate social performance, corporate social responsibility, or corporate social responsiveness that provide a framework or model for the systematic collection, organization, and analysis of corporate data relating to these important concepts. No theory has yet been developed that can provide such a framework or model, nor is there any general agreement about the meaning of these terms from an operational or a managerial viewpoint.” wrote Max Clarkson in an academic journal in 1995.

Fast forward 27 years and we’re basically in the same situation. Clarkson’s finding sounds eerily similar to current complaints from the finance community on how confusing ESG is in practice - an unregulated and inconsistent marketplace filled with data gaps. Structurally, there is no actual system in place to measure, monitor and regulate ESG.

But one thing that’s certainly different is the huge wave of interest in this area, triggered by the current climate crisis. The sustainability label is growing increasingly popular, and markets have taken note, developing all kinds of financial products and instruments to meet a rising demand from businesses, investors and stakeholders.

ESG funds have attracted more than $1 trillion over the past few years, and 2021 was deemed the year of ESG investing. At their current growth rate, professionally managed assets that consider ESG issues, called ESG-mandated assets, are on track to represent half of all professionally managed assets globally by 2024 according to a Deloitte report.

Given this sudden interest in ESG, one might think we’re in a new era of corporate social responsibility. 

Unfortunately, it turns out that it has little to do with that. Values and morals aren’t even on the list of reasons corporates are engaged in ESG, an HSBC survey suggests. It’s mostly about capitalizing on the hype by attracting capital and responding to peer pressure by staying ahead of competitors.

​​“Sustainable finance has moved into the mainstream of the capital markets faster than we expected, and as that happens, ESG deals are increasingly being judged as a traditional asset rather than a reflection of commitment to social and environmental issues,” said Daniel Klier, global head of sustainable finance at HSBC.

And this misalignment is starting to show. New analysis revealed that $1 trillion in ESG funds weren’t actually aligned with the values of ESG – consequently, around 20% of the funds had their ESG stamp removed, feeding concerns that asset managers are making misleading sustainability claims about their products.

An inconvenient truth

The Russia-Ukraine conflict has also surfaced some uncomfortable truths about the current ESG landscape. 

Vanguard Group and Northern Trust increased their interests in Russia's top bank through their respective index-based ESG funds in January, Bloomberg reported. Just before the invasion, ESG funds totalling $9.5 billion stood in Russia, rated by companies like Sustainalytics and MSCI. 

Elsewhere, reports are surfacing that some seemingly value-aligned investment funds actually contain some surprising holdings in Russia. CIBC Capital Markets analyzed $2 trillion in ESG fund AUM and found that Russian energy holdings within the ESG universe were held twice as much as Canadian energy at the end of 2021. Investments in Russia’s state-owned energy firm were six times larger than in Canada’s Suncor. 

“In our opinion, if ESG investors conclude that a state-controlled Russian company is more attractive from a corporate social responsibility perspective than Canada’s largest energy producers, something is lost in translation,” CIBC said.

Given Russia’s actions, it’s an awkward moment for ESG. 

“We need to do some kind of rethinking here. This disastrous war is an eye opener,” said Erik Thedeen, chairman of the Sustainable Finance Task Force at the International Organization of Securities Commissions, in an interview. 

The whole ESG community needs to think through how to handle state-owned companies in countries that violate human rights, Thedeen argued. 

Investing in companies and countries that violate human rights is not an ESG strategy, according to Alix Lebec, an impact and ESG investing corporate advisor. 

“It's a wake up call pertinent to ESG investors, because it is also re-emphasizing that divestment and screening out negative investments is not enough – we have to be proactively investing in ways that are creating shared value for people and the planet,” Lebec said.

It remains to be seen how these dynamics will play out in the future, and the conversation has only begun. 

The Russia-Ukraine crisis and ESG dominated earnings call transcripts in Q1 2022, according to GlobalData – the study found that the geopolitical tensions led to a rising emphasis from companies on meeting UN’s Sustainability Development Goal 16, which focuses on peace, justice and strong institutions..

This has partly been due to sell-side analysts and investors being prompted to ask more questions due to demand from the buy side, according to Brandon Sutcliffe, EY Americas sustainable finance leader.

“More specifically, asset owners are increasingly influencing asset managers to focus on longer time horizons. As they invest their funds with asset managers, such as passive index funds, asset owners will ask questions about the long-term sustainability attributes of the investment and cite ESG factors as important parameters for making investment decisions,” Sutcliffe said.

It is becoming increasingly clear that ESG needs a well-defined single global framework - regulation is currently fragmented globally, and you can’t effectively manage what you can’t measure. 

And perhaps this could be a new stage in capitalism – an opportunity to embed those century-long criticisms into a new corporate agenda for the next century. After all, a well-functioning market economy should mirror its society’s values.