ESG Funds and the Question of Sustainability Impact

Climate change is perhaps the most crucial contemporary challenge for societies and businesses worldwide. Tackling it requires vast financial resources. Reflecting this issue, the 2015 Paris Agreement states that mitigating climate change requires ‘making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.’ In a recently published article, we investigate ESG funds—the most prominent financial instrument of sustainable finance—and unpack their sustainability impact, that is, whether and how they actually contribute towards a green transition.

ESG stands for integrating environmental, social and governance aspects in the capital allocation strategy of investment funds. In essence, most ESG funds take conventional mutual funds as their baseline and then alter the capital allocation according to environmental, social and governance factors. ESG funds buy equity or debt securities that have been issued in the past (what is called the secondary markets). The fact that ESG funds are not active on the primary markets, where new capital is raised through the issuance of shares or bonds means that ESG funds are not able to directly achieve ‘additionality,’ a term which captures capital flows to ‘green’ or ‘sustainable’ projects that would otherwise not have been financed.

Historically, ESG funds, and the ESG ratings and indices on which they are based, have been developed by private firms that sought to create profitable and easily scalable products for end-investors. This exclusive focus on end-investors is reflected in the fact that the ESG ratings of companies, on which ESG funds are based, do not seek to capture a corporation’s sustainability impact on the environment and society. In fact, they gauge the opposite: the potential impact of environmental, social and governance factors on the corporation and its shareholders, as this article argues conclusively. This approach is called single materiality risk measurement. Double materiality, on the other hand, also takes into account how the company affects society and the environment. ESG, as currently practised, functions almost exclusively as a single materiality risk management tool for end-investors.

In principle, there are two main transmission mechanisms through which ESG funds could potentially create sustainability impact, which can be defined as when ESG funds have significant positive effects on companies in their portfolio. Put differently, sustainability impact is a change in the business practices of firms and real-world outcomes caused by ESG funds.

The first mechanism is shareholder engagement. Here, investors either use their proxy voting rights at annual general meetings or pursue private engagements with the management of the portfolio companies. Research has shown that funds are indeed able to create significant impact via shareholder engagement. However, the vast majority of ESG funds do not precisely define their shareholder engagement strategy and thus end-investors are not able to know if this mechanism is being used.

The second potential mechanism for the sustainability impact of ESG funds is their capital allocation. In our recently published paper, we have provided a novel market analysis of ESG funds and their capital allocation. We distinguish between ‘Broad ESG’ (or ‘ESG integration’) funds, ‘Light Green’ funds and ‘Dark Green’ ESG funds. In their capital allocation strategy, most ‘Broad ESG’ funds only deviate marginally from conventional funds (and the benchmark stock indices which they track). On the one hand, this makes these funds prone to greenwashing as recent regulatory shake-ups have demonstrated. On the other hand, this means that the likelihood of them creating sustainability impact is extremely low as they still invest billions into fossil fuel stocks and other decidedly non-sustainable investments.

‘Light Green’ and ‘Dark Green’ ESG funds do not track their respective benchmark stock indices as closely and thus the plausibility that they are able to create a sustainability impact via their capital allocation is much higher. However, in our dataset of all index-tracking ESG funds among the 500 largest recorded on the Bloomberg Terminal, 88% are Broad ESG funds while Light Green and Dark Green funds only had market shares of 7% and 5%, respectively.

Another key finding of our research is that one single company dominates the development and provision of ESG indices—the financial metrics that define what counts as ESG for their respective funds: MSCI has an astonishing market share of 57% in ESG indices within our dataset, while the largest competitors S&P Dow Jones Indices and FTSE Russell (part of LSE Group) only have about 12% each. Importantly, in an age of passive investing, index providers have become important gatekeepers in global capital markets, essentially steering capital through their index methodologies. Through its very high market share, MSCI likely sets de facto private market standards of what is generally accepted as ‘sustainable’ investing.

A study on the ‘social origins of ESG’ is very instructive in this regard. Eccles, Lee and Strohle argue that in 2010 MSCI decided to adopt the financial ‘value-oriented’ (single materiality) ESG methodology of one firm it had acquired and largely abandoned the ‘values-driven’ (double materiality) ESG approach of another then recently bought ESG company. Importantly, the former methodology was much more compatible with financial metrics and the development of highly scalable products such as ESG indices. This, however, paved the way for the proliferation of ESG funds with little to no sustainability impact.

Building on these findings, our research suggests two potential ways for regulators to enhance the sustainability impact of ESG funds (and reduce obvious litigation risks that arise from greenwashing). First, regulators should develop credible minimum standards for all ESG funds concerning their proxy voting behaviour and private engagements. Second, the vague category of Broad ESG funds should be made much more precise, including clear criteria on how their capital allocation deviates from conventional funds.

If we are to use financial markets for a green transition, they need to be regulated in ways that facilitate sustainable investment outcomes. Without clear standards for ESG, marked greenwashing concerns are likely to create a lose-lose situation for investors, asset managers, and, above all, the environment.

Jan Fichtner is a Senior Researcher at the SuFi Project at the University of Witten/Herdecke, Germany.

Robin Jaspert is a PhD student at the Graduate College ‘Standards of Governance’ at Goethe University Frankfurt.

Johannes Petry is the principal investigator of the StateCapFinance project at Goethe University Frankfurt, and a CSGR research fellow at the University of Warwick.