McKinsey declared in 2019 that 90pc of America’s 500 biggest companies were now producing an ESG report – reams of paper meant to prove the businesses were saving society and the planet.
Consultants and analysts also spend a lot of time arguing that ESG was a more profitable way to invest. In a series of papers, McKinsey argued that companies with racially diverse leadership teams performed better financially.
“You cannot try to sell to somebody a concept to save the planet if you don’t have positive performance,” says Pierre-Yves Gauthier, founder of AlphaValue.
Yet there was a problem: performance didn’t always match the promise.
UK ethical funds for years delivered returns that were below a simple tracker fund of the FTSE 100. In 2022 that gap widened to 10 percentage points, according to LSEG Lipper.
That meant £1,000 invested in an ESG fund would earn £103.50 less than a tracker fund.
Underperformance reflects the way ESG fund managers invest: ethical funds are varied but on the whole they shun “sin stocks” like fossil fuels, defence and tobacco.
That means these funds have no exposure to oil and gas companies such as BP and Shell and weapons manufacturers such as BAE Systems.
These companies are among the largest in the world and pay large dividends, meaning owning them can boost the value of a portfolio.
The impact of ignoring these sectors was somewhat limited until 2022 when the Ukraine war broke out. A surge in the oil price drove up the shares of the likes of BP and Shell, while the war boosted defence stocks.
The war also raised questions over whether defence companies were now ethical – were the companies helping arm Ukraine and battle Russian aggression really bad for society?
“Investors still remember 2022, which was a bad year,” Hortense Bioy, Morningstar’s head of research, says. “There’s more scepticism about what ESG funds offer, both in terms of ESG credentials and performance.”
Researchers have also begun to question the validity of claims that ESG helps financial performance.
A recently published paper in academic journal Econ Journal Watch said the results of McKinsey’s claims on diverse management teams couldn’t be replicated, for instance. The authors said the claim could not be “relied on”.
Alex Edmans, a former Morgan Stanley investment banker and now finance professor at London Business School, says there is “mixed” evidence that ESG improves financial performance.
“ESG is not ‘go woke, go broke’ but the blunderbuss idea that ESG will make you loads of money is not the case,” he said.
Box-ticking fears
Investors have also become jaded by a series of ESG-linked scandals. A steady beat of news stories have exposed the fact that many ESG funds are not as ethical as they claim.
US regulators last year fined Deutsche Bank’s fund management arm DWS $19m for “greenwashing” after making “materially misleading” statements about how much it cared about ESG.
In another egregious example, following press reports about poor working conditions at factories Boohoo relied on, it emerged that many ESG funds had backed the fast fashion retailer. An independent report subsequently found “endemic” issues.
Instances such as this gave rise to a feeling that ESG was little more than box-ticking and rubber stamps.
Part of the problem was ESG was always a woolly concept. It blended three different concepts together, often oversimplifying it by giving companies a one-number or letter rating.
Edmans says ESG is so broad as to be meaningless, using the metaphor of food.
“You wouldn’t say food is good for you. Some food is good for you, broccoli is good for you, and ice cream is bad for you. So this blanket phrase ‘ESG’ is not particularly helpful.”
ESG boomed because people wanted to believe the idea they can make money and better the world, what he describes as “confirmation bias”.
The impact on society and the planet is open to question. Take, for instance, coal mining. Coal is bad for the environment so would harm your ESG score. But rather than shut these mines down, many companies simply sold off the assets to other operators who didn’t care as much. The coal kept being dug out of the ground and burned for fuel.
“Customer boycotts can have a large effect because if I boycott McDonald’s, then the burgers stay on the shelf and nobody is buying them,” says Edmans. “Investor boycotts don’t necessarily do that, because I can only sell if somebody else buys. There’s a limited effect you can have with an ESG fund.”
Republican backlash
Attempts by finance to impact society and the climate through the backdoor have also drawn criticism from politicians and campaigners.
A high profile US TV campaign by Consumers’ Research accused BlackRock of putting political goals over the needs of its customers. Fink and BlackRock were accused of “woke capitalism”.
In 2022, former Republican presidential candidate and Florida governor Ron DeSantis also announced he would pull $2bn of the state’s investments from BlackRock.
Observers say the backlash is largely “political theatre”, which is unlikely to have prompted the derailing of the ESG gravy train.
“If I had to guess, it would have to do less with Republican backlash and probably be more [down] to performance issues and fee issues,” says Oxford’s Eccles.
Amid the reckoning, the Wall Street titans who pioneered ESG have started to change their tone.