ESG stands for Environmental Social Governance. ESG investing describes investors and institutions that are proactive in investing funds in corporations that show they are doing “good for the world.” The acronym ESG is how a company’s goodness is monitored, measured, and scored.  The popularity of ESG investing has grown at a rapid pace over the last five years. A Harvard Business Review study by Sanjai Bhagat estimates that “as of December 2021, assets under management at global exchange-traded ‘sustainable’ funds that publicly set environmental, social, and governance (ESG) investment objectives amounted to more than $2.7 trillion. In the fourth quarter of 2021 alone, $143 billion in new capital flowed into these ESG funds.” Several recent studies have examined the compliance and performances of ESG funds.  In a 2019 Journal of Finance paper examining performance, Samuel M. Hartzmark and Abigail B. Sussman analyzed the Morningstar sustainability ratings of more than 20,000 mutual funds, representing over $8 trillion of investments. They found that “although the highest-rated funds in terms of sustainability attracted more capital than the lowest-rated funds, none of the high sustainability funds outperformed any of the lowest-rated funds.” In a 2021 study, Aneesh Raghunandar and Shiraran Rajgopal examined compliance to ESG standards by comparing the ESG record of U.S. companies in 147 ESG fund portfolios with that of U.S. companies in 2,428 non-ESG portfolios. They found that the companies in the ESG portfolios had worse compliance records for both labor and environmental rules. They also found that companies that added to ESG portfolios did not subsequently improve compliance with labor or environmental regulations.

ESG Fund Proponents

In spite of their lower returns, many fund advisors argue that ESG funds carry less risk. This is because they are less exposed to regulatory fines, public scrutiny, and future transitory energy costs. Proponents of ESG funds point out that as the Federal Trade Commission, Security Exchange Commission, Environmental Protection Agency, and other executive regulatory bodies become more active in the corporate landscape, a company with high ESG awareness will have less regulatory risk. They contend that ESG-focused companies have made environmental compliance and reporting a main priority—sometimes dedicating millions of dollars to measuring their greenhouse gas emissions, hiring personnel to keep up with compliance, and developing initiatives for their ESG mission. As more environmental concerns develop into standardized rules, the environmentally friendly companies are often the ones that escape federal fines.

Consumer spending decisions are an essential part of revenue growth drivers for ESG companies. Proponents of ESG funds further argue that young consumers are increasingly choosing to purchase from environmentally friendly companies. ESG has become a huge marketing tool for beauty products, clothing, food, and more. This has also become true for equity investing. Personalized index investing and ESG fund inflows have shown that people want to invest their money in companies that are advertised as ESG friendly.

Proponents also argue that there is merit in the ESG-friendly investing space. A long-term spotlight on climate change comes with expected future regulations coming from regulatory bodies—changes that can be swiftly implemented because regulations do not need approval from the legislative or judicial branches. Unless the judicial branch challenges the authority of the regulatory body to implement a regulation (in EPA v. United States), regulatory bodies can implement changes fairly rapidly. Proponents, in turn, maintain that this gives ESG-friendly companies an upper hand in complying with regulation quickly.

Finally, the growth drivers for ESG funds aren’t necessarily what attract investors to these types of funds. Xavier University Finance Professor, Dr. Jamie Pawlukiewicz, explains that “some investors are often willing to accept a lower level of return in exchange for peace of mind or knowing that their money is being used to fund companies that focus on improving the environment and the community.”

Both Xavier student investment funds—the D’Artagnan Capital Fund (DCF) and the Xavier Student Bond Investment Fund—adhere to ESG investment guidelines. The DCF includes ESG parameters in its investment policy statement. The guidelines address protecting human dignity, prohibiting investments in weapons of mass destruction, defending the sanctity of human life, and protecting the environment. The Fund looks at ESG scores relative to their peer groups in Bloomberg, as well as studying the company’s sustainability report. Daniel Joyce, an analyst for the fund and a Smith Scholar, believes in ESG investment: “It’s a long-term advantage for Xavier to invest with these principles. They want to invest in companies that are ethical.”

ESG Fund Critics   

One of the strongest critics of ESG investment is Cincinnati native and St. Xavier graduate, Vivek Ramaswamy.  In his book Woke Inc., Ramaswamy argues that corporations and advisors can use ESG branding in toxic ways to make money. He has some interesting takes on what the emergence of ESG really means.

“The modern woke-industrial complex divides us as a people. By mixing morality with consumerism, America’s elite prey on our innermost insecurities about who we really are. They sell us cheap social causes and skin-deep identities to satisfy our hunger for a cause and our search for meaning…. But my bigger beef is with the insincere woke capitalists. Here’s what the sincere guys miss: when they create a system in which business leaders decide moral questions, they open the floodgates for all their unscrupulous colleagues to abuse that newfound power.” (Ramaswamy, 30).

Often the companies that can afford to implement ESG compliance and initiatives are mega-cap corporations who currently contribute the most to environmentally unfriendly policies. But advertising “net-zero emissions by 2050” sounds very impressive to ESG investors. When exploring ESG fund holdings, you will see appropriate ESG giants such as NextEra, Broadcom, and Apple. However, you will also find companies like Phillip Morris International included in the ESG group. Phillip Morris is an international tobacco company with a presence in over 180 countries. How can a tobacco stock be in an ESG fund (especially when a majority of their consumer base consists of low-income individuals living in emerging market economies)? Shockingly, Phillip Morris scores well on many ESG rating services because of their high-level of reporting, ESG marketing, and ESG initiatives. They vow to work towards a “smoke-free future,” yet their combustible cigarette sales are growing. Combustibles still account for over 70% of their annual revenues, and they are still being advertised across the globe. This is just one example of how a core company mission can be marketed as something completely different with the resources of a multi-billion-dollar corporation.

Another criticism leveled at ESG investment is the misallocation of financial capital. In researching oil and gas exploration and production companies, Dr. Pawlukiewitz finds that oil and gas valuation models should now have higher discount rates and lower earnings multiples to reflect the ESG crowd’s efforts to constrain the companies’ ability to access to credit. These efforts have created pressure on banks not to lend to oil and gas companies. Dr. Pawlukiewicz points out that “when creditors like banks get themselves involved in fruitless ESG efforts, it often leads to a misallocation of capital. These are serious economic implications that can often be overlooked.” Critics have also pointed out that ESG investment funds often underinvest in small-cap companies that lack the resources to develop ESG marketing materials—even if their core purpose is ultimately doing good for the environment.

*The Bloomberg Cincinnati Index (BCIX) is a capitalization-weighted index designed to measure the performance of the Cincinnati area economy.