The term ESG is less than two decades old, but it may already be coming to the end of its useful life.

The acronym dates back to 2004, when a report commissioned by the UN called for “better inclusion of environmental, social and corporate governance (ESG) factors in investment decisions”. In the wake of corporate scandals such as Enron and WorldCom, and the Exxon Valdez oil spill, financial institutions eagerly signed on to the “global compact”.

It took a while to catch on. Between May 2005 and May 2018, ESG was mentioned in fewer than 1 per cent of earnings calls, according to analysis by asset manager Pimco. But once ESG became mainstream, it quickly became ubiquitous in the corporate landscape. By May 2021 it was mentioned in almost a fifth of earnings calls, after a surge in prominence over the pandemic.

Investing within an ESG framework is now the fastest-growing segment of the asset management industry. Assets in ESG funds grew 53 per cent year on year to $2.7tn in 2021, according to data provider Morningstar, amid a gold rush by asset managers to tap into rising investor demand by rebranding their funds as sustainable or launching new ones.

The term has become an increasingly broad catch-all for a range of approaches to investment: everything from negative screening (removing sectors such as tobacco or defence) to positive screening (picking sectors such as clean energy), to really any kind of strategy that promises to bring about positive social or environmental change.

Line chart of Corporate earnings calls mentioning ESG (%) showing ESG has been a rapidly increasing topic in earnings calls since 2019

This flexibility can be a positive thing, allowing such funds to collectively appeal to a broad range of investors and stakeholders”, wrote Elizabeth Pollman, a professor at the University of Pennsylvania Carey Law School, in a paper titled The Origins and Consequences of the ESG Moniker.

But there’s a fine line between flexibility and ambiguity, and ESG’s critics say some companies and investors are using the loosely defined term to “greenwash,” or make unrealistic or misleading claims, especially about their environmental credentials.

Those criticisms came into sharp focus on May 31, when German police raided the offices of asset manager DWS and its majority owner Deutsche Bank as part of a probe into allegations of greenwashing. It was the first time that an asset manager has been raided in an ESG investigation and signals a moment of reckoning for the industry.

It’s a “real wake-up call,” says Desiree Fixler, the former DWS executive who blew the whistle on her company for allegedly making misleading statements about ESG investing in its 2020 annual report (DWS denies wrongdoing). “I still believe in sustainable investing, but the bureaucrats and marketers took over ESG and now it’s been diluted to a state of meaninglessness,” she says.

On top of the allegations of greenwashing at the industry’s highest levels, there is the impact of Russia’s invasion of Ukraine, which is forcing companies, investors and governments to wrestle with developments that at times appear to pit the E, the S and the G against one another. For example, governments in Europe are reneging on environmental goals by turning to fossil fuels to reduce dependence on Russian gas, in order to fulfil ethical goals.

“The war in Ukraine is an incredible challenge for the world of ESG,” says Hubert Keller, managing partner at Lombard Odier. “This conflict is forcing the questions: what is ESG investing? Does it really work? And can we afford it?”

Some people wonder whether the term still has any meaning at all. “The acronym ESG is a bit of a confused compact because it muddies at least two things,” says Ian Simm, founder and chief executive of £37bn asset manager Impax Asset Management, a pioneer in sustainable development.

“One is an objective assessment, around risk and opportunity. And the other is around values or ethics. And so people get themselves tied in knots because they’re not really clear about what exactly ESG investing is about.”

Simm is among those investors who believe that while there have been huge benefits that have arisen from bundling together ESG — notably waking up the world to thinking about issues as varied as climate change, gender diversity and the impact of corporations on communities — the term has, in effect, come to mean all things to all people, and might be nearing retirement.

“I think we should dial down or even stop using the phrase ESG,” says Simm. “We should push very hard for people to be clear about what they want when they use it. And in an ideal world, ESG would disappear as an acronym . . . and we would find a better way of labelling the conversation.”

The fog of war

If this is a transformational moment for the investment landscape, some say it is also an opportunity to redefine what it means to invest sustainably.

The war in Ukraine ought to be considered “an evolution for ESG rather than muddying the waters”, says Sonja Laud, chief investment officer at Legal and General Investment Management. “It might not be the last time we have to reconsider the framework of what makes a sustainable investment.”

She points to three core areas — defence, energy and sovereign risk — where the shift has been most pronounced. “These are not new topics but they have been put into the spotlight because of these events.”

Defence presents one of the most immediate challenges. For years, many banks and investors across Europe have refused to back defence companies, as it goes against their ESG policies. Among them was Sweden’s SEB bank, which unveiled a new sustainability policy last year that included a blanket ban on any company deriving more than 5 per cent of its revenue from defence.

But the war prompted SEB to change its tune. From April 1, six SEB funds were allowed to invest in the defence sector. The bank says it began to review its position in January as a result of “the serious security situation and growing geopolitical tensions in recent months,” which culminated in Russia’s invasion of Ukraine.

SEB is one of the few financial services companies to have announced a change in stance, but the debate on the social utility of armaments is now a live discussion among many large stewards of capital. The war in Ukraine has accelerated a rearmament policy in Europe and defence companies have outperformed global markets by the greatest margin in almost a decade.

Some believe that defence companies ought to now be classified as sustainable, allowing ESG investors to support the armament of sovereign states against an aggressive neighbour.

Artis Pabriks, Latvia’s defence minister, recently took aim at Swedish banks and investors, who refused to give a loan to a Latvian defence company due to “ethical standards”. He said: “I got so angry. How can we develop our country? Is national defence not ethical?”

A thornier issue is energy. Just as defence companies have soared, the conflict has caused oil and gas companies to skyrocket, as prices surge on concerns over Russian supply. This has tested responsible investors — who typically are underweight oil and gas companies in their portfolios — as they have underperformed conventional funds.

This dilemma presented by rising energy prices was evident in separate statements in May by BlackRock and Vanguard, the world’s two largest asset managers, who between them have almost $18tn in assets under management.

Vanguard said it had refused to stop new investments in fossil fuel projects and to end its support for coal, oil and gas production. Meanwhile BlackRock announced that it was likely to vote against most shareholder resolutions brought by climate lobbyists pursuing a ban on new oil and gas production.

The warning appeared to mark a dramatic change in stance by the world’s largest asset manager, whose chief executive Larry Fink has been beating the drum for sustainability for years and presented the group as playing a central role in financing the energy transition.

Activists worry that BlackRock’s move could grant permission for other investors to loosen their grip on pushing companies to cut carbon emissions. Critics say that it reflects how, amid surging oil prices following Russia’s invasion of Ukraine, fossil fuel investments are simply too lucrative for investors to ignore.

From an investor perspective, some are becoming increasingly sceptical about the E in ESG. Stuart Kirk, global head of responsible investing at HSBC’s asset management division, was suspended by the bank on May 22 after stating in a speech that climate change does not pose a financial risk to investors.

But many investors remain optimistic about the longer term shift to renewables. Carsten Stendevad, co-chief investment officer for sustainability at hedge fund Bridgewater Associates, says that for the energy transition, the war in Ukraine is “short-term painful”.

“The consumption of fossil fuels will increase. For Europe in particular, green ambitions are now aligned with national security ambitions and securing energy sovereignty, and that’s a pretty strong trio,” he says. “This will accelerate the transition to renewables because never again will countries want to be reliant on another country for energy.”

The war has brought another question to a head: should responsible investors exclude entire countries from their investable universe?

Although Russia only accounts for about 1.5 per cent of global gross domestic product, data compiled by Bloomberg found that funds claiming to promote or pursue ESG goals under an EU regulatory framework held at least $8.3bn in Russian assets. Their holdings included Russian state-backed companies such as Gazprom, Rosneft and Sberbank, as well as Russian government bonds.

“For ESG investors, the conflict is something of a reminder that actually sovereign risk is a really important input in ESG analysis,” says Luke Sussams, ESG and sustainable finance analyst at Jefferies.

Since the war began, international corporations including Renault, Shell and McDonald’s have marked a retreat from Russia. Many investors disposed of the Russian sovereign debt holdings after the 2014 annexation of Crimea. And for most international investors, Russian holdings represent a small slice of overall assets. The majority have pledged not to make any new investments into Russian securities, but divestment is more complicated because the market is in effect closed.

But if investors push to exclude entire countries on ESG grounds, what does it mean for countries such as China — the world’s second-largest economy — and Saudi Arabia, which have dubious environmental and human rights records but considerably more strategic importance globally?

“I think there’s a really difficult judgment for an investor to make here because on the one hand, some would say it’s unfair to attribute all the ills of a government to its country’s business community,” says Chuka Umunna, a former MP and shadow business secretary, now leading ESG policy in Europe for JPMorgan. “But others say that by continuing to do business with firms in that jurisdiction, you’re helping to prop up the government . . . Where you draw the line in all of this is not always straightforward.”

​LGIM’s Laud says that investors should distinguish between a virtual pariah state like Russia and China, where geopolitical tensions are high but trade flows remain fluid. “Sanctions have been applied internationally to Russia and it’s in an open conflict — this provides a very different backdrop,” she says.

“There are reported issues in China but there have been in a lot of countries. In order to establish the right investment approach a fair and transparent sovereign scoring methodology needs to apply to every country. Investors should differentiate between the sovereign, state-owned enterprises and the broader corporate sector.”

Unstable environment

The war may have provoked a rethink in what ESG stands for, but the challenge is compounded by the fact that there is no universal, objective, rigorous framework for ESG investing.

Column chart of Assets ($tn) showing The global rise of ESG funds

In a recent paper, researchers at MIT and the University of Zurich examined data from six prominent ESG rating agencies and found the correlations between their assessments fall between 0.38 and 0.71 — relatively weak, compared with the 0.92 correlation between credit rating agencies. This, conclude the authors, “makes it difficult to evaluate the ESG performance of companies, funds and portfolios”.

Regulators are trying to catch up. The UK and the EU are planning to tighten the rules for ESG rating agencies, and the US Securities and Exchange Commission recently levelled a $1.5mn fine at the fund management arm of BNY Mellon for allegedly providing misleading information on ESG investments.

The investigation into DWS will be closely watched as a test case because it could herald a wider regulatory crackdown on ESG, which some have warned might be the next mis-selling scandal, similar to those in PPI, endowment mortgages or diesel cars.

Yet at the same time, the watchdog probing DWS — German financial regulator BaFin — recently shelved plans to lay out rules for classifying funds as sustainable.

“Against the backdrop of the dynamic situation in regulation, energy and geopolitics, we have decided to put our planned directive for sustainable investment funds on hold,” said BaFin president Mark Branson. “The environment isn’t stable enough for permanent regulation.”

Amid all this uncertainty, and with faith in ESG investing as a catch-all term eroding, how should investors react? David Blood, who founded sustainable investing pioneer Generation Investment Management with former US vice-president Al Gore, says the biggest mistake investors make is to try to boil down ESG to a checklist or an index.

“That checklist is a blunt instrument that doesn’t reflect the challenges, subtleties and trade-offs of ESG,” he says. “People say sustainability or ESG is always a win-win — of course it isn’t. There are trade-offs.”

Crucially, the war in Ukraine and the debate around ESG categorisation mustn’t allow investors to lose sight of the broader imperative to decarbonise rapidly, Blood says. “The urgency and the business case for the energy transition is absolutely intact and we mustn’t lose sight of that ever.”

Asset managers say that, in the absence of clarity from authorities or regulators, the key for them as responsible stewards of capital is to be transparent about the criteria by which they are investing. It is then up to clients to make a decision on whether to allocate money based on their own ethical stance.

“We must not mix up ethical with ESG, because they are two separate things,” says Saker Nusseibeh, chief executive of Federated Hermes. “Being ethical is the prerogative of the client.”

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​Letters in response to this article:

Sustainable investing needs more than a catchy acronym / From Anshul Rai, Dubai, UAE

Don’t be misled by the climate change claims of ESG funds​ / ​From Theo Vermaelen, Professor of Finance, Insead, Fontainebleau, France

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