ESG (environmental, social and governance) is a framework embedded into an organization’s strategy that takes into account the needs of — and how to generate value for — all organizational stakeholders. Over the past several years, ESG investing has become a subject of debate, as investors have increasingly applied these non-financial factors to analyze material risks and growth opportunities.
In late November 2022, the Biden administration issued a final rule for its executive order that makes it easier for employers to consider climate change and other environmental, social and governance factors when selecting investment funds for their 401(k) plans. A cornerstone of the administration’s Inflation Reduction Act is addressing climate change, which could further bolster ESG investing opportunities.
Meanwhile, allowing retirement managers to consider environmental and social issues when making investment decisions has become a hot-button issue in Washington.
Many consider ESG investing a “passive activist“ approach, while critics believe it only serves a political purpose. Since sentiment and the flow of capital into ESG investments could determine the path of these products, the debate could impact value. Activist investors are shareholders that use a significant equity stake to pressure management to make a specific set of changes to the business. A massive pool of ESG investment funds could create a passive activist result where fund managers make decisions for the masses using retirement accounts.
The largest ESG ETFs in 2023:
- Dozens of ESG ETFs currently trade on the U.S. markets.
- At $90.39 per share on February 10, the iShares MSCI USA ETF ( Chart ESGU - $88.58 1.25 (1.431%) ) had over $20 billion in assets under management. In 2022, ESGU fell 21.46%, but in 2023, to date, it has recovered by 6.65%.
- At $71.33 per share on February 10, the Vanguard ESG U.S. Stock ETF ( Chart ESGV - $69.92 1.05 (1.525%) ) had over $6.13 billion in assets under management. In 2022, ESGV fell 25.1%, but in 2023 it recovered by 8.3%.
- At $19.68 per share on February 10, the iShares Global Clean Energy ETF ( Chart ICLN - $19.01 0.42 (2.259%) ) had over $4.986 billion in assets under management. In 2022, ICLN fell 6.24%, and in 2023 it has edged 0.86% lower.
- Many other ETF products and individual companies qualify as ESG investments.
ESG initiatives favor some companies at the expense of others:
- ESG portfolios include companies fighting climate change, preserving clean air, water, and forestry, reducing pollution and waste, training disadvantaged populations, and having strong governance and clean and transparent accounting.
- ESG portfolios typically exclude companies profiting from tobacco, alcohol, weapons, and gambling. Traditional energy companies that produce and service hydrocarbons are not part of ESG portfolios.
The argument for encouraging ESG investments:
- Value-based investing — aligning investment portfolios with investors’ moral and ethical values.
- Integration — inhibiting ESG risks and promoting opportunities for companies that score well on material ESG issues via sector-based analysis.
- Impact investing — employs investment capital by transcending traditional empirical, analytical metrics to achieve a measurable outcome. Impact investing is a derivative of activist investing. ESG investments aim to make a difference in the world and environment through companies that align with investors’ values and goals.
The case against ESG investment initiatives:
- Subjectivity — ESG investments depend on subjective criteria that rely on transparency, management, and fund allocator decisions regarding critical issues.
- Efficiency — ESG detracts from business investment and goals. ESG requires executives to work for activist causes, not shareholders. Profits are secondary to social and environmental initiatives.
- Anti-capitalism — A manager’s task is to maximize shareholder returns in a capitalist economy. ESG initiatives may not correlate with private ownership of the means of production in competitive markets for profits.
- Diversification — ESG investment funds and pools are often heavily invested in technology companies that experience boom and bust periods.
- Expectations of Underperformance — In a Bloomberg survey, 264 of 691 respondents expect ESG funds to “slightly underperform,” and 184 forecast they will “significantly underperform” the leading market indices in 2023.
Passive activism or political arm-twisting?
- The Biden administration could favor ESG-compliant companies with lucrative contracts to achieve its environmental and business policy goals.
- Senator Joe Manchin of West Virginia, a Democrat, has joined with Republicans to challenge the Biden administration’s rule allowing Wall Street firms to base investment strategies for Americans’ retirement funds on social issues rather than solely profits.
- The administration made significant pledges to address climate change and social issues. Support for and mandating ESG investments creates passive activism that may achieve the administration’s goals, but it also funds initiatives via retirement and investment assets.
- The debate over whether ESG is passive activism in the U.S.’s best interests or a political tool will continue, with the opposition’s majority in the House of Representatives a critical, if slender, bulwark.