ESG investing, or simply ‘ESG’, first emerged in the mid-2000s and began to accelerate appreciably in the 2010s. In the 2020s, it is coming of age. Much like with human beings, during ESG’s adolescence it struggled to define its identity and purpose. A coherent set of rules, norms and conventions had yet to develop. Stakeholders on both buy and sell sides, plus their regulators, had a general sense of what was to be achieved, but there were several schools of thought on how to get there. ESG in its naivety was known to be conned by charlatans. Today, however, the wisdom of experience is turning ESG into a serious proposition as an investment product, and as a purpose-driven activity. This article tracks ESG’s development in certain key areas and highlights issues that remain to be solved, in the context of what is seen as ESG’s positive development, particularly in recent years.
A persistent question with ESG over the years has been fundamental: What does it actually mean in practice?
At its broadest, ESG means the incorporation of environmental, social and corporate governance factors into their investment decisions. There is a whole universe in this statement. Refusing to invest in oil companies, investing in a company because of its treatment of workers, investing in an active climate change solution, divesting from companies with homogenous boards: These are all examples of approaches that are truly different, but all satisfy the statement. For ESG to produce the desired results and represent a serious investment strategy, different sub-categories had to emerge. Happily, this has occurred.
The broad goals of ESG are subdivided along numerous lines. Common approaches include making various combinations of the E, S and G, and categories that are defined by the goals of the investor, such as negative and positive screening, and impact investing. Screening seeks to direct capital based on an investment’s perceived worthiness or unworthiness. Impact investing goes further, with the investor aiming to make an investment that they hope leads directly to a positive outcome. Life being complex, worthiness and positive outcome can be difficult to define. Few if any investment opportunities are all good or all bad. Finding this balance can be difficult for the investor. It also creates a grey area which can be exploited. One way to mitigate this is through rating and scoring, which has emerged in abundance over the last decade. However, without established standards and regulation, rating and scoring have their own problems. Not only does this reduce their usefulness, but also provides opportunities for ‘greenwashing’, where investments present as aligned with ESG aims, but are tangentially related at best.
As a result, governments, regulators, trade bodies and international organisations are implementing standards and requirements for key investment elements like ratings, disclosures, and investment strategies.
Like much in the regulatory sphere, the European Union is ahead, and 2023 has seen the entry into force of two important pieces of legislation. The first is the Sustainable Finance Disclosure Regulation (SFDR), under which EU-connected “Financial Market Participants” and “Financial Advisors” must disclose how their investing may adversely impact sustainability; how they factor ESG risk into their investment; and provide sustainability information on certain financial products.
The second is the Corporate Sustainability Reporting Directive (CSRD), which requires a broad range of firms to report on their social and environmental sustainability, according to the European Sustainability Reporting Standards (ESRS). In the USA, the Securities and Exchange Commission has made a number of proposals and recommendations in recent years. These include climate, diversity and ESG-related disclosures for SEC registrants, as well as a rule that would require registrants with certain ESG-related names to show some substance to justify the name’s use. While none of these has yet been enacted, in 2021 the SEC did approve diversity and inclusion rules which the Nasdaq stock exchange imposed on listed firms. Examples of international disclosure-system efforts are the G20’s Task Force on Climate-Related Financial Disclosures, and UN’s Global Reporting Initiative. In the UK, the Financial Conduct Authority has proposed naming and marketing rules similar to the SEC.
As well as regimes to help investors assess the ESG-related risks and opportunities of their potential investments, there are also guidelines for firms seeking investors. Some of the most prominent are international in nature. The UN has had its Principles for Responsible Investment since 2005 and its Sustainable Development Goals since 2015 – though the latter is for humanity as a whole and not just investors. These are two of the most popular frameworks that ESG investment products align themselves with, both providing guidance to the product designers and a touchstone for their investors. For other non-investment firms, the OECD has produced Guidelines for Multinational Enterprises on Responsible Business Conduct. Again, this is a popular and useful framework for both investors and investees.
Bermuda and other offshore IFCs are beginning to introduce their own regulation to complement the efforts of the onshore giants. However, the focus is not so much on disclosure by the recipients of investment, but the powers of fiduciaries with respect to their clients. It is a well-established common-law principle that fiduciaries must act in the best interests of their beneficiaries, shareholders or other principals. It is equally well-established that when it comes to the conduct of a corporation, or the investment of assets, these “best interests” are solely monetary.
Fiduciaries can be held in breach of duty if they neglect profit in favour of following the consciences of their principals. This lags behind the global shift in thinking that gave rise to ESG, and is best rectified by statute. Bermuda is developing legislation to do just this. In the corporate sphere, this legislation provides for “benefit corporations” much like those pioneered in the USA. Directors and managers of such corporations have a positive duty to run the corporation in a responsible and sustainable manner, taking into account a range of public interests, and not just those of their members.
In addition, such corporations may provide in their memoranda of association to pursue one or more public benefits. In the trust space, legislation is being developed that allows trustees to take factors other than returns into account when investing the trust fund. Currently, this is possible, but to shield the trustees from possible liability, complex and expensive provisions are required. The new legislation would greatly simplify things, and open this ability up to all trusts, in turn greatly widening access to ESG for the average trust beneficiary. It is important to note that unlike similar onshore legislation, these would both be ‘opt-in’ regimes, for greater planning flexibility.
Now that ESG is becoming ever-more transparent, assessable, and accessible to fiduciaries, we return to the question: Is ESG “all grown up”?
It has matured significantly, but not quite. A number of problems remain with it as an investment philosophy. One of these is that there are still a great many assessment standards to choose from, complicating investors’ decisions. The Economist reported in 2022 that while credit ratings have a 99 per cent correlation across agencies, ESG ratings have just over 50 per cent agreement. With this in mind, greater consolidation may be desirable. However, that has its own drawbacks, potentially exposing ratings to manipulation and stagnation.
Greenwashing is still a risk. In 2021, the SEC’s examination of ESG investing found “some instances of potentially misleading” statements and representations by registrants, with respect both to their ESG investment processes and their adherence to global frameworks. Some high-profile names have fallen afoul of the authorities, such as BNY Mellon, Goldman Sachs, and DWS Group. Although regulation is improving, these regimes are all very new, and their effectiveness must be subject to the rigours of time, with examples made of bad actors, case law established, and loopholes found and closed. On the side of the investor, the market as a whole will need time to grow savvier and chasten bad actors with civil action. This is something we can expect, but patience is necessary.
Investors must also be wary of the coming risks inherent in greater regulation. While an unregulated market is clearly not desirable, disclosure requirements must be properly targeted and effectively enforced. Broad-brush disclosure resulting in endless filing raises costs for firms and investors while having a diminishing effect on ESG’s trustworthiness, and very little effect on ESG as a force for good. Banking and wealth-management professionals are painfully aware that dragnet AML and tax-transparency regimes have malfunctioned in a similar manner. This is a lesson that regulators would do well to heed.
We have seen that ESG will become increasingly safe and measurable. However, for ESG to be worth the investment, it must also surely do some good. Is ESG changing the world? The short answer is not yet. The earth is still warming, and labour still suffers. Diversity still does not go far enough in the C-suite, and biodiversity is decreasing at an alarming rate. Corporate governors still put profit before purpose. As ESG matures further and global issues become more pressing, it is to be expected that the sector will become better at allocating capital where needed. This in turn should move the needle. The biggest thing is to split up E, S and G, and further subdivide where possible, since these letters can sometimes be fundamentally at odds. This will become easier as the discussed regulation produces better data, hopefully producing a positive feedback loop.
In conclusion, although it has come a long way, ESG is not yet all grown up. However, it should not be dismissed and can be a serious option for investors. Whether or not this is so depends on your and your client’s intentions. If the goal is just not to be part of the problem, new disclosures will make negative screening more effective than ever. Positive-impact screening is also in a fairly good position and will be even more so with the introduction of proposed marketing rules. Impact investing still has some way to go.
One of the greatest signs of maturity is recognising one’s own limitations. The ESG world has begun to do so. For the present moment, investors must do the same to get the most out of ESG.
John Gibbons is Trust Manager at Harbour Trust Company Limited in Bermuda.