ESG: How Perfect Became The Enemy Of The Good

London – The arrival of fifty German police officers outside the offices of DWS provided an interesting coda to a difficult month for the world of ESG and green investing. Were we witness to the first investigation into “green collar” crime? Or are we instead experiencing the problems created when finance is forced to do something it isn't (yet) designed to do?

After a decade of dragging its feet (and recourse to definitions of fiduciary duty well past their sell by date) the global fund industry woke up to the fact that the market for sustainable investment had undergone a seismic shift in sentiment. By March 2020, the collective AUM of UN Principles for Responsible Investment (PRI) signatories had increased by 20 per cent from $86.3trn to $103.4trn.

From research for my own book, “Crowdfunding and the democratization of finance”, this represents more than 90 per cent of the professionally managed financial assets on the planet (according to figures from PWC) and about a third of the world’s total asset wealth. This enabled the finance industry, under the leadership of Mark Carney, ex-governor of the Bank of England, to bring trillions of dollars of investment capital to the table at COP26, trumping the billions of dollars promised by nation-states.

Funds which claimed the ESG label saw an explosion of growth, with $963bn of net inflows, according to Morningstar, with the EU region accounting for 83 per cent of the total following the implementation of new ESG labelling and disclosure rules in March 2021. However, after the euphoria of that initial surge, a different story began to emerge.

'Ambiguous Language'

According to the Financial Times, Morningstar had initially included almost 6,500 individual funds in their ESG universe based on funds’ own statements relating to article 8 of the Sustainable Disclosure Rules, but then later revised down that number by more than 1200 (and over a trillion dollars of AUM). This followed further due diligence and the discovery of what Hortense Bioy, global director of sustainability research at Morningstar, described as “ambiguous language in their legal filings”.

At the same time, individuals from within the big fund managers started to call out what they saw as the hypocrisy and expediency behind the “ESG revolution”. The normally slow-moving supertankers of the fund industry were showing a remarkable ability to U-turn.

Tariq Fancy, who previously had been sustainable investment chief at Blackrock, saw the motivation as simply the opportunity to generate higher profits from higher fees rather than a desire to meet the growing challenges of environmental crises and social inequality. To paraphrase his lengthy critique, the industry was ignoring the difficulties finance faces when it shifts from simple measures of profit to more complex measures of purpose and ethics. In his own idiosyncratic way HSBC’s own sustainability chief tried to point out the limitations of finance when it came to pricing or responding to risks, which in his mind were at a specific point in the future rather than an urgent requirement to act now.

Quick Response

Regulators (and yes, the police) have been quick to respond - driven by the politics of the situation and perhaps painfully aware of their failure to act in previous crises of trust. But is there a danger that we build regulations that promote the mediocre and punish the pioneers of new and potentially better ways?

ESG is a classic case of how progressive movements are vulnerable to ‘the perfect being the enemy of the good’. Here, investment claims around the climate crisis are held to a higher standard of evidence and accountability than investment statements of the downside risks of financing, for example, new fossil fuel extraction. If the positive carbon impact is an issue for financial promotion regulations, then why isn’t negative impact also a matter of disclosure if an investor is going to act from a full understanding of the risks? In other words, why isn’t there a FTSE for Bad to balance the FTSE for Good? It is worth noting that Morningstar didn’t feel it relevant to good customer outcomes (in the language of the new FCA strategy) to disclose which 1200 funds they excluded from their ESG universe.

If the current generation of fintech pioneers have proven one thing, it is the value of putting information into the hands of consumers and investors, increasing agency, and shining the light of transparency on some of the more egregious practices of the global finance industry. Rather than relying on frameworks which are always going to have an element of political compromise, we should be rebalancing the information asymmetries which make it hard to tell the market “lemons” from the limes.

More Effective Action Needed

The reliance on labels and rules only gets us so far and as we have seen, is open to abuse. We need to find new ways for customers to look deeper and not just into a fund’s holdings. They need to be able to see the commitment of the fund manager to the overall philosophy and the actions they have taken to influence/force the companies whose shares or bonds they hold to act faster and more effectively in response to the climate crisis and other issues.

ESG is not just about the good governance of companies, it also puts the governance and ethics of the managers of the world’s wealth under the spotlight – which for some will be an uncomfortable experience.

The views and opinions expressed are not necessarily those of AltFi.

[Editor's Note: This story was originally published on AltFi]