As sustainable investing became mainstream in the past decade, its practices have evolved and its influence has grown. But its purpose remains the same: change investment decision-making and corporate behaviour to generate environmentally and socially sustainable outcomes. These are ambitious objectives.
Today, it is de rigueur to point out shortcomings of sustainable investing. This phenomenon reflects that the field is maturing – and high expectations as it seeks to address complex challenges like climate change. Sustainable investing alone cannot be expected to solve such problems, however, it can play a catalytic role.
To get an unbiased (by me) view of these criticisms, I asked Claude.ai, a generative AI, about the “primary criticisms of ESG investing”. The top four are:
Subjectivity of rating criteria
Lack of standardisation
These criticisms will not be new to practitioners, but I thought it would be instructive to provide insights into these issues.
For the past 30 years, the performance of sustainable funds relative to their conventional peers has been the subject of hundreds of academic and practitioner studies.
Evidence based on fund performance, articles and meta studies show no evidence of systematic underperformance by sustainable funds and some evidence that they have provided performance benefits.
According to Morningstar research, sustainable funds consistently underperformed for the first time in many years in 2022, primarily due to structural biases favouring technology and underweighting energy in a market where the former strongly underperformed and the latter strongly outperformed. However, three-, five- and 10-year performance favoured investors in sustainable funds over those in conventional peer groups. So, 2022 appears to be the exception that proves the rule.
The good news for ETF issuers and investors is that passive sustainability funds tend to outperform active ones.
Yet as evidenced by the AI responses, the perception of underperformance persists. Perhaps it is reinforced by recency bias, but it means investors would benefit from ongoing education explaining that they should be able to at least achieve long-term, risk-adjusted performance in line with the market across a diversified portfolio.
Subjectivity of rating criteria
This concern stems from the qualitative nature of some sustainability issues and the prevalence of proprietary ESG rating frameworks.
While some sustainability issues lend themselves to quantitative analysis, others are distinctly qualitative. This is unavoidable when analysing ESG issues. The task of rating agencies and analysts is to develop ways to systematically transform qualitative information into quantitative metrics.
In the absence of established standards and data sources, ESG rating agencies developed proprietary frameworks starting in the 1990s.
The field evolved organically as there were no accepted models for evaluating sustainability issues at companies. Proprietary analytical approaches solved the need for rating models while also providing competitive differentiation. Without question, the field has benefitted – and will continue to benefit – from a multiplicity of approaches.
As sustainable investing became more popular, investors have appropriately come to expect greater transparency about rating models, their assumptions and the data they use. As this market moves into a more advanced stage, regulators are acting to ensure that expectation is met.
Greenwashing – intentionally misleading or exaggerated claims about green or sustainable practices – can come from companies or fund managers. We are adjusting to new regulatory regimes, so it is not surprising that high-profile greenwashing cases have surfaced as markets move away from voluntary disclosure and standards.
Selective disclosure of ESG information from companies may overstate positive and underreport negative information. This may skew ratings that use the information.
Greenwashing by companies is being addressed by regulatory rules for disclosure. The other type of greenwashing may come from fund managers who exaggerate their how extensively they incorporate ESG analysis into their investment process or use fund names that may mislead investors.
Greenwashing related to funds warrants regulatory guidance to ensure that investors’ interests are protected. Now that greenwashing is on the agenda and rules are being established, it is less likely to be a widespread problem going forward.
Fund managers are keenly aware of the new regulations as well as the reputational and financial costs of greenwashing.
All key stakeholders have a role to play to ensure greenwashing recedes as a concern, and it is incumbent on industry and regulators to align investor expectations with what can realistically be accomplished through sustainable investments.
Lack of standardisation
Investors need decision-useful, material information to make informed decisions. Since sustainable investing was not widely practised until recent decades, the field had to develop its own standards and practices. As it has matured and grown in importance, the need for greater standardisation has become a priority.
Investors have recognised the need to establish standards for sustainability-related data reporting since the founding of the Global Reporting Initiative (GRI) more than 25 years ago. Over the ensuing years, other standard-setting organisations like the Sustainable Accounting Standards Board (SASB) have been set up to meet the need for consistent reporting of material climate and sustainability-related data.
Founded in 2021, the International Sustainability Standards Board (ISSB) builds on the work of other initiatives to enable “companies and investors to standardise on a single, global baseline of sustainability disclosures for capital markets”. Its credibility stems from the fact that it was established by the IFRS Foundation, which set up the International Accounting Standards Board (IASB) in 2001.
Defining and implementing sustainability reporting standards will take time, but it is worth remembering that it took almost 70 years to enact global accounting standards. Investors should appreciate that standardisation is being addressed, though it’s a work in progress.
So, what can generative AI tell us about ESG investing? The sentiments it reflects define an agenda for fund sponsors, advisers, ESG service providers, regulators and standard setters. These criticisms have led to new oversight and standardisation, signs of a maturing field as it prepares to move forward. Sustainable investing developed without a clear blueprint but it is here to stay.
Hopefully, the list is different when we ask the AI again in a few years.
Thomas Kuh is head of ESG strategy at Morningstar Indexes
This article was first published in ESG Unlocked: Is it time to draw the curtain on 'ESG'?, an ETF Stream report. To read the full report, click here.