Unless you’ve been napping under a rock for the past couple of months (and no one would blame you for doing so), you’ve surely noticed the recent backlash against ESG. The cacophony reached a fever pitch in late May when S&P Dow Jones Indices removed Tesla from its ESG index, citing poor working conditions, safety concerns and other issues. In response, the automaker’s CEO Elon Musk called ESG a “scam” that is part of a leftist agenda. (See my direct response to these bogus claims here).
Soon after, former U.S. vice-president Mike Pence called on the Republican party to “end the use of ESG principles nationwide” and ignorantly compared ESG to China’s social credit system, a Communist Party–backed surveillance program that strips the civil and political rights of those who engage in dissent or subversive behaviour. Pence’s political peers have introduced or considered anti-ESG legislation in several U.S. states including Texas, Idaho and West Virginia. (It is worth noting that researchers have found Texas municipalities will pay an extra US$303–532 million in interest following the state’s introduction of an anti-ESG law).
Meanwhile, regulators are cracking down on greenwashing by asset managers. Goldman Sachs, Deutsche Bank and BNY Mellon have all found themselves in regulators’ crosshairs for allegedly making misleading claims about how they incorporate ESG factors into their investment processes.
So, it seems that ESG is under attack on several fronts.
However, this backlash is not a sign of ESG’s decline but of its growing pains. In particular, the regulatory crackdown is a welcome sign of a maturing market that will ultimately strengthen market integrity by penalizing bad actors. The development of standardized sustainability disclosures in the coming years will also drive market integrity.
Further, the movement to incorporate ESG issues into business and investment decisions will carry on because it has always been driven by the market; it has never been driven by politicians or billionaires who are bullish on Dogecoin.
Here are four concrete reasons why ESG is here to stay:
- Fiduciary duty
While specific legal definitions vary across regions, the concept of fiduciary duty is generally defined as a relationship in which one party (a fiduciary) is responsible for looking after the best interests of another party (a beneficiary). Corporate directors and officers have a duty to act in the best interests of the corporation, and institutional investors such as pension trustees have a duty to act in the best interests of those whose money they are entrusted with.
Fiduciaries are responsible for considering all material information in the execution of their duties — information that could impact financial performance or influence a reasonable investor’s voting or investment decision.
In the financial community, it is well established that ESG issues are material to varying degrees across sectors. For example, systemic issues like climate change will have economic impacts across many sectors, while issues like data security and labour practices are material for some sectors more so than others. (See the San Franciso–based SASB Standards’ Materiality Finder to learn which ESG issues are material for specific sectors).
For institutional investors, fiduciary duty has been a primary driver of their incorporation of ESG factors into investment decisions. In a 2021 survey of 805 global institutional investors by RBC Global Asset Management, a majority of respondents (57%) selected fiduciary duty as their top reason for considering ESG factors, followed closely by risk-adjusted returns (52%).
The materiality of ESG issues will not go away, especially in the era of climate change. And neither will a fiduciary’s responsibility to their beneficiaries.
- Financial sector commitments
The financial sector is committed to ESG. In 2006 the United Nations–backed Principles for Responsible Investment (PRI) launched, with an ask for institutional investors to sign on to its six principles. The first principle states, “We will incorporate ESG issues into investment analysis and decision-making processes,” and the others elaborate on several steps to do it.
Back in 2006, the PRI had 63 signatories responsible for US$6.5 trillion in assets under management. By the end of 2021, the PRI had racked up an astounding 3,826 signatories managing some $121 trillion in assets, and the growth continues.
In another demonstration of the financial force behind ESG, in 2021 Mark Carney and partners launched the Glasgow Financial Alliance for Net Zero (GFANZ) as a “forum for leading financial institutions to accelerate the transition to a net-zero global economy.” The GFANZ includes separate net-zero pledges for asset managers, asset owners, banks, insurers and service providers that have drawn support from more than 450 financial sector organizations representing $130 trillion in assets.
These initiatives show that there is an absolutely massive amount of financial capital committed to incorporating ESG factors into financial decisions, and the journey to net-zero portfolios is just getting started.
- Cost of capital
Corporations with strong ESG performance tend to incur a lower cost of capital. In other words, they have access to cheaper debt and equity financing because lenders and investors view strong ESG performance as an indicator of lower risk. Plenty of evidence backs this up.
A 2021 study published in the journal Critical Perspectives on Accounting examined the cost of debt in 6,018 cases across 15 European countries over an 11-year period. The authors found that firms with stronger ESG disclosures and stronger ESG performance had a lower cost of debt, concluding that “as ESG performance increases, the amount of interest that lending institutions are willing to receive for a pound of debt for such firms decreases.”
Similarly, a 2022 study published in the International Journal of Applied Economics, Finance and Accounting found an inverse relationship between cost of capital and ESG scores among 125 energy companies in 24 countries, coincidentally also over an 11-year period.
An MSCI study conducted between 2016 and 2019 showed similar results. Among companies in the MSCI World Index, the average cost of capital of the highest-ESG-scored quintile was 6.16%, compared to 6.55% for the lowest-ESG-scored quintile. In other words, the top 20% of companies got a discount of about 6% on their financing compared to their peers in the bottom 20%. The authors note the differential was even higher in emerging markets.
So, to secure the best possible rates for financing, capital-raising entities acting in their own rational self-interest will elect to optimize their ESG performance and disclosure — especially in a rising rate environment.
- Consumer demand
Last but certainly not least, consumers are one of the biggest drivers of demand for corporate ESG performance. Recent consumer surveys from Ipsos (2021) and Nielsen (2022) found a majority of consumers, 56% globally and 60% in the U.S., respectively, have been making more sustainable or ethical purchases over the past few years.
Not only do consumers want more sustainable products, they expect companies to step up and address sustainability challenges. A 2021 EY study found a strong majority of 69% of Canadian consumers expect companies to solve sustainability issues. Deloitte found similar results in the U.S. market, with 65% of consumers saying they expect CEOs to do more to make progress on societal issues such as reducing carbon emissions, tackling air pollution and making business supply chains more sustainable.
These consumer sentiments are also observable in the investment realm. A 2021 survey of 1,000 Canadian retail investors conducted by Ipsos for the Responsible Investment Association found that 78% of respondents would like a portion of their portfolios to be invested in companies that provide solutions to reduce carbon emissions. Similarly, 80% said they would like their fund managers to encourage Canadian corporations to reduce their emissions.
These data make clear that consumers are increasingly driving corporate ESG performance, and their rising expectations of corporations suggest that ESG and climate action are now a component of companies’ social licence to operate.
The above provides a summary of several market forces driving the incorporation of ESG factors into business and investment decisions. Innovation and market shifts rarely happen without growing pains, and ESG is no exception. Nonetheless, fiduciary duty, financial sector commitments, cost of capital and consumer demand will continue to drive ESG forward, regardless of who holds public office or pushes divisiveness.
Dustyn Lanz is Senior Advisor with ESG Global Advisors Inc.