Yrjo Koskinen is the BMO Professor of Sustainable and Transition Finance at the University of Calgary’s Haskayne School of Business.
I was shocked to read that the U.S. Senate recently voted to overturn a Labour Department rule allowing retirement plans to take into account environmental, social and governance (ESG) issues when making investment decisions. My initial reaction was bewilderment and anger. The rule allows pension plans to consider ESG factors as long as they are in the best financial interest of plan beneficiaries. No rational person should object to something that sensible. I was especially disappointed at Senator Mitt Romney, Republican of Utah, who, as a former successful private equity manager, should know better.
Yet there is a kernel of truth in Republican critique. It reflects widespread backlash against a movement that seems to be increasingly controversial, despite fuelling good returns over the past few years.
However, these critics are barking up the wrong tree. ESG is not the problem. It’s the behaviour of those who push such investments, the fund managers, that is the problem.
I have been an investor for more than 35 years. I have yet to meet the alleged “woke” investment manager the Republicans complain about, who prioritizes ideology and sidelines money-making. But I have witnessed plenty of greed and dishonesty among the fund managers who try to capitalize on the ESG movement. What we really need is stiff penalties against self-serving and misleading financial marketing; for example, rampant greenwashing and inflated claims of superior returns for ESG funds.
Too often ESG funds have higher management fees eating up net returns for pension beneficiaries. While such funds have experienced good stock returns since the ESG investment boom started, the party is over now. Most likely returns going forward will be disappointing, but this has nothing to do with ESG “wokeness.” It is simply due to too much money chasing too few good deals.
For too long investment managers have been getting away with claiming that ESG investments have superior returns over normal investments. This kind of blanket statement is always misleading. Good past performance is never a guarantee of future performance – that is the nature of financial markets. When investors realize that ESG investments have had superior returns, they bid up prices so much that the positive risk-adjusted returns disappear. In fact, so much money has flown to ESG assets that their prices may well be too high.
We need vigilant enforcement and stiff penalties against fraudulent claims, so fund managers will stop repeating exaggerated claims about superior returns for ESG investments. We also need strict enforcement against greenwashing, so fund managers cannot overstate the greenness of their portfolios. Finally, we also need informed investors and pension trustees who refuse to pay the exorbitant fees that are too often associated with ESG funds.
ESG or sustainable and responsible finance has nothing to do with wokeness; that is a gross misunderstanding of what ESG tries to achieve. The objective of ESG is to manage long-term risks better and take advantage of future opportunities.
We should start thinking abut ESG as a business issue, not political football. The best thing that could happen to ESG issues is that everybody starts thinking of them as an ordinary investment in intangible assets, such as R&D.
The same rules that apply to R&D should apply to ESG. For most companies and investors, it should be the familiar net present value rule: Invest if the present value of benefits exceeds costs. For social-justice warriors, there are always impact funds and benefit corporations that aim to make the world a better place, but at the expense of smaller financial rewards.