ESG investing needs more than a rebrand (2024)

If you want to solve climate change, you’ve got to build a lot of stuff: wind farms, grid interconnects, new electrified forms of manufacturing, lots of mines and factories to produce critical minerals, and so on. Of course, this costs lots of money — trillions of dollars — which looks pretty daunting. Fortunately, we have environmental, social, and governance (ESG) investing, in which socially conscious Investment funds direct their portfolios toward companies doing more ESG stuff, as measured by ESG ratings, which now have the money to make all those investments; planet saved, good job! And ideally, because these funds are investing in companies engaging in sustainability and doing good governance, they’ll make more money in the long term. Sounds great, but there are a few flies in the ointment, though, which are 1) ESG investing doesn’t work to improve those outcomes, 2) everyone hates it, and 3) it doesn’t even make money. 2023 was a rough year for big ESG funds: The S&P ESG index ended the year down, while the broader S&P 500 ended the year up.

This underperformance has led to a lot of opinions on what’s next for ESG. Bloomberg ran an article entitled “How to Fix ‘ESG’ by Changing Its Name,” which reports on a paper by professor Alex Edmans, who proposes renaming ESG to, uh, “rational sustainability.” Look, I’m deeply sympathetic to any argument critiquing ESG investing, but Alex really misses the mark here. I’m going to run through a few of the arguments he makes, not (just) to critique them but hopefully to define the contours of what I’d like for ESG investing going forward.

• Renaming ESG as “rational sustainability” will depoliticize sustainability: It’s true that ESG has become a political issue; we called out growing anti-ESG legislation last year and expected that this backlash could continue. However, Alex’s argument that just calling it sustainability will get everyone to agree because it focuses on “sustainable, long-term value, which is relevant to all job functions and political beliefs” is endearingly naïve and deeply misunderstands the issue. The sustainable transition will create, destroy, and transfer a huge amount of wealth and power (as oil reserves get less valuable, electric vehicles replace gasoline-based cars, etc.); transfer at this scale is an inherently political issue. And not just because big policy levers are being pulled to make it happen: Even if governments were not acting at all, sustainability would still be political. If there are any such things as “depoliticized” issues, sustainability is certainly not one, even if you call it rational.
• Rational sustainability centers evidence and analysis: Alex argues that ESG investing is often irrational, as is the backlash against ESG; renaming ESG “rational sustainability” will recenter hard-nosed logic in decision-making. Beyond the questionable assumption that renaming will change behavior, unfortunately, the bad behavior is often highly rational. What makes more sense is doing a huge amount of work to figure out which companies are truly sustainable and investing in them or maybe just renaming your fund “ESG” and collecting inflows? If you own billions of dollars of fossil fuel assets, preventing sustainable investing is in your rational self-interest. Even outside of these obvious issues, sustainability involves a lot of judgement calls: For example, when calculating the cost of carbon emissions, do you use the impact on the U.S. (lower) or on the world (significantly higher)? For a U.S. company, that’s fundamentally a question of how much you value the lives of people living outside the U.S. — a moral question, not an analytical one.
• Rational sustainability focuses on long-term value: According to Alex, “The goal of sustainability is to create long-term value”; he highlights not just financial returns and sustainability but also “the need to consider any factor that creates sustainable value, even if it does not fall under an ESG label – such as productivity, innovation and culture.” Again, this fundamentally misunderstands the problem: The issue is that structurally, financial value (and especially short-term financial value) is prioritized in ways that make it impossible to balance against long-term sustainability goals. If your company runs of out money, you go bankrupt, but nothing nearly so dire happens if you miss your decarbonization targets. Executives are compensated in large part on stock price, which is highly responsive to immediate financial results — not even long-term cash flows, let alone long-term non-financial metrics. Companies routinely destroy these other values (culture, productivity) while chasing such financial incentives.

The flaws with ESG investing are not going to be fixed by one silver bullet, let alone one as frivolous as renaming it. However, there are a few things we can do to improve it:

• Unpack E, S, and G. While there are some very interesting philosophical links between a company’s environmental, social, and governance performance, these ratings should really not be grouped together. It just confounds any analysis of company performance, an issue which is compounded by the terrible quality of data on these issues. As such, change two is:
• Mandate better reporting, especially from private companies. Even among the most progressive companies, there’s a wide range of sustainability reporting schemes; this lack of standardization makes any kind of comparison difficult. Standardized reporting can help make ESG scores more reliable — but, importantly, this standardization and disclosure requirement needs to be extended to private companies as well. The general rationale for reduced financial disclosure for private companies is that the public at large can’t invest in them, and thus, the kind of transparency needed to prevent financial malfeasance isn’t really necessary. This obviously doesn’t hold true for sustainability issues — carbon emissions don’t contribute any less to climate change just because a company is private. An inconsistent regime will just drive public companies to sell emitting assets to private companies, making emissions harder to track. In addition, a comprehensive reporting scheme is required for the third change:
• Enhance penalties and rewards for sustainability. This is very basic, yet very important. In most of the world, the price of carbon emissions (and other sustainability issues) paid by companies is much lower than the true cost. Ramping up the cost of continuing to emit for the emitters is essential, ideally through policy actions that put prices on carbon, though companies are getting ahead of the curve by adopting internal prices. These costs are already set to be borne by the world in the form of climate-driven weather events, disruptions, and more — we need to shift those costs to the activities that generate the emissions.

The biggest thing we have to do is throw out the assumption that the existing frameworks of business management, investment, and regulation — which generally work for businesses — make sense for sustainability or social issues. Those frameworks solved the problems they were aimed at (i.e., public markets work pretty well, big companies tend to be managed to produce shareholder returns) but they also significantly enabled the climate crisis. Sustainable approaches to business and regulation will need to be different, but not just in name only.