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This post was authored by the Impact Investing Institute.

This article first appeared in the Financial Times on 13th July, 2022.

Fifteen years ago, An Inconvenient Truth sent a wake-up call to the world. The documentary featured Al Gore, former US vice-president, and shone a light on the climate crisis facing the planet. It had a huge effect on public awareness of global warming and helped spur the surge in sustainable investing, and what might be called the “ESG industry” as it exists today.

Now, though, it is time for proponents of sustainable investing to respond to some inconvenient truths of their own. The voices raised in criticism of ESG — investing with environmental, social and governance standards — are credible and powerful. Acknowledging their challenge is vital in finding the way forward — a way that must be found, for the climate crisis has only grown worse since Gore’s film was released.

The critics’ main claim is that ESG rules lack rigour — and too many investments are classed as ESG without sufficient evidence.

“Most of what the ESG cheerleaders wanted to believe should matter for portfolio managers did not matter in reality,” says Tariq Fancy, formerly of BlackRock. In an excoriating 2021 essay, he argues that climate change needs a broad systemic response, not an initiative led by the finance industry.

“Climate change is not a financial risk that we need to worry about,” says Stuart Kirk, HSBC Global Asset Management’s former head of responsible investing, who resigned last week. (and a respected colleague of mine at the FT). Climate change is real, he suggests, but is not a relevant consideration for investors.

“[ESG] has become a bureaucratic tax,” according to Desiree Fixler, who blew the whistle on investment manager DWS’s greenwashing, ultimately forcing the company to reduce its ESG-denominated assets by 75 per cent.

The criticisms are wide-ranging — and uncomfortably close to home. Companies do overclaim on their ESG credentials. Asset managers do make implausible judgments as to which assets can be described as “green”. Financial markets are indeed short-term, and climate change is a long-term issue. There is little evidence that oil stocks, for example, are “stranded assets” of declining value. The financial services industry cannot solve the environmental emergency or social injustice; at best it can play a supporting role to governments.

The whole term is ambiguous. For many professional investors, ESG investing is an approach through which to identify risks to a company’s financial health. Most individual consumers and retail investors, on the other hand, assume it means focusing on companies that act responsibly towards society and the environment. They are then often surprised to see a portfolio holding that has low exposure to ESG risk, but is not making a positive contribution.

To further complicate matters, professional investors typically assess a company’s ESG credentials based on a balanced scorecard across multiple factors, whereas retail investors tend to focus on a single issue — plastics, fossil fuels, living wage — so jib at the inclusion of, say, an oil producer in a list of ESG-approved companies, even if it is exemplary in governance and social issues.

The credibility of the ESG approach is under siege.

But there is a way to bring rigour and accountability to ESG, because a world in which financial profit is pursued at any cost to people and the planet will not be a world in which future generations can live. By 2070, as Tariq Fancy points out, barely liveable hot zones may rise from 1 per cent of the earth today to nearly 20 per cent, leading to mass starvation and migration. For this not to happen, everyone — governments, individuals, investors, businesses — needs to act.

I was a financial journalist for nearly 20 years, which taught me that markets are always ahead of those responsible for holding their participants to account. The explosion of ESG investing has been its — temporary — undoing. For decades, investment products or managers could describe themselves as “ESG” without having to do anything to prove it. That is changing fast. Regulators and policymakers have been catching up.

In the UK, the Financial Conduct Authority is deciding on a new sustainable classification and labelling system for investment products. In the EU, the Sustainable Finance Disclosures Regulation is strengthening investor protection. The US Securities and Exchange Commission has issued a proposal on standardising funds’ ESG disclosures. The International Financial Reporting Standards Foundation has started work to provide the equivalent of global financial reporting standards for ESG.

In part, it is the increasing strictness of reporting rules that is prompting the flurry of greenwashing scandals, as oversight bodies shine a light on casual abuses that went unnoticed and unpunished before.

While regulation is catching up with the market, there is much further to go. Many of the most cogent criticisms of ESG are that it lacks accountability and measurability. But there is already a tried and tested approach to address this — impact investing. To bring the necessary rigour to ESG investing in the future, impact investing standards need to become the norm.

Impact investment is investment made with the intention to generate positive, measurable social and environmental impact alongside a financial return. Where ESG is often passive — avoiding something — impact is proactive, intentionally seeking to deliver a positive benefit.

Applying this approach means an investment’s intended impact must be considered and stated. Since that impact must be measured, investors can hold those promising to deliver positive benefits, whether companies or asset managers, to account for how they deliver against their commitments.

Impact is delivered both by investors and by the companies in which they invest. Investors, including retail savers, can contribute through their investing behaviour — what they choose to invest in — and how they engage with investee companies — shareholder engagement.

Enterprises can deliver positive impacts. But both investor and enterprise impact needs to be intentional and measured, for it to be authentic and genuinely accountable.

The impact investing market in the UK is already worth £58bn, as our research showed in the first exercise to size the market. Retail investors can access the market via funds such as the Schroders Big Society Capital Social Impact Trust.

Journalists love to carp. I know — I was one. But amid the scepticism, it is worth acknowledging the firms which do live up to their ESG commitments. Five thousand businesses in 83 countries and 156 industries are Certified B Corporations, meeting rigorous social and environmental standards.

Impact investing acknowledges the shortcomings of ESG and has structured its approach to specifically address them. We know that we are not there yet. But we also know that people, including individual investors, want ESG to have real meaning. Research with 6,000 of them by the UK government in 2019 showed that two-thirds wanted their money to do good for people and the planet as well as deliver a financial return.

I believe that impact investment is the future of all investment and that, ultimately, all companies will have to report and be held accountable for their positive and negative impacts. Addressing the climate crisis is everybody’s responsibility, and if it is not addressed in an equitable way it won’t be solved. We are already nearly too late to do so. If we don’t all assume this responsibility, there won’t be much of a world for any of us — or future generations — to live in.