The discourse on ESG has undergone a transformation, having started as a niche, and often underrated, area of interest to becoming a loud and tumultuous domain with a growing number of participants and increasing noise. This cacophony reflects the trajectory of ESG, which was once an appendage to the core considerations of finance, management, and strategy, and has now become of central importance to investors and those seeking their capital. (See part 1 of this series “The state of ESG: How did we get here?”)

With the realization that ESG is neither a fad nor passing, market participants have begun to explore ways to position themselves.  

In the U.S. in particular, “ESG investing” (along with most environmental and social issues) has become politicized. The attempts to conflate the ESG mandate with a “woke” agenda is an example of how far from the intention of value-creation and risk-mitigation the ESG narrative has strayed.  Increasingly, this narrow political narrative has deflected attention away from the core environmental, social, and governance issues that are fundamentally important to investors and other stakeholders and to empower incumbents uncomfortable with changing market dynamics.

Impact vs. integration

At the root of the politicization trend are a few issues, one of which is a fundamental confusion between ‘impact investing’ and ‘ESG integration’. Impact investing can be simply defined as an investment strategy with an intentional and measurable E, S, or G target. Whereas ESG integration is not an investment strategy in itself but is a means by which an investor can achieve a broader investment strategy. ESG integration can be thought of as expanded due diligence through the identification and assessment of the primary (material) E, S, and G issues that will impact the financial performance of an investment. The fundamental confusion between these two terms has added to the anti-ESG, anti- “woke” investing movements in the U.S. (and elsewhere) that pay political dividends for their proponents; the arguments made by the anti-ESG campaigners, however, often have little or no connection to the investment policies that they are targeting.

What’s in a label?

Another issue is the mislabelling and misuse of ESG to promote and sell products, an offense that has caught the attention of regulators as well as the ESG naysayers, leading to provocative headlines and dramatic predictions of the death of ESG, further demonstrating the need to recalibrate.  In recent years, often in response to the demands of beneficiaries, investors clamored for funds (and were willing to pay higher fees) that would help protect against many of society’s most pressing issues, and the number of ESG funds surged. At the same time, and unsurprisingly, incidents of ‘greenwashing’ also accelerated as many funds that claimed ESG credentials had unsubstantiated ESG practices or used exclusions and proxy voting and engagement practices, already in place, as a justification for the label.  These are symptoms of an approach to ESG that has strayed from value creation and is not subject to the rigours of materiality driven by strategy and analysis but is instead being left in the hands of marketing, IR, and PR. 

Where’s the alpha?

A third issue is the difficulty in attributing alpha or outperformance versus a benchmark to ESG integration practices. This “ESG integration paradox” poses a particular set of challenges to asset managers and capital allocators. If the relationship between a manager’s ESG-integration maturity and their risk‐adjusted excess performance, or alpha, were linearly correlated, then the decision to integrate ESG would be easy. 

The inherent difficulties in valuing and measuring the financial performance of many ESG issues (many being qualitative in nature), however, make this relationship difficult to substantiate. Going forward, as these issues are increasingly priced into the market, we expect to see the level of maturity of a manager’s ESG-integration practices being reflected in their longer-term performance results. Until then, asset owners and allocators can only ensure that their managers are integrating ESG through detailed due diligence and an assessment of the managers’ practices.

One thing we have learned at CGC working with asset managers and asset owners and corporates is this is not going to go away soon. Acronyms may change and political agendas will continue to create debate among market participants, but sound investment management will always prevail. No matter the rhetoric, politics, labels, or acronyms, identifying, assessing, and managing the material issues of an investment (including relevant E, S, and G issues) is simply a means to better risk mitigation, longer-term resilient returns, and more positive outcomes of an investment strategy. The controversy doesn’t end there either -- ESG has been around for a long time or is a relatively new approach to evaluating corporate performance. Others claim ESG either goes too far to advance the liberal social values of a “woke” agenda or is window dressing that does not produce any meaningful environmental, social, or governance impact.

[Read Part 1 here] [Read Part 3 here]