The backlash against ESG-washing is a sign that responsible finance is maturing

• As ESG has become mainstream, it has encountered a backlash for not delivering on a range of outcomes promised across responsible finance
• Even as this backlash against ESG greenwashing grows, the institutional foundations for a better future of responsible finance are being built
• ESG has become too complex to expect it to achieve every desired impact; each approach should be evaluated based on its own intended outcomes

Much ink has been spilled on critiques of ESG investing. Some question whether or not it creates an impact. Others how to properly contextualize issuers who are targeting ESG and green finance markets while at the same time providing an opaque perspective on their climate ambition. There are serious questions about how to aggregate ESG information in a way that doesn’t lose more information in the process of aggregation than it gains by providing comparability across issuers or investments.

Amidst efforts to create formal and binding standards for disclosure, these issues are becoming increasingly more important to confront. One important element of the European Union’s Corporate Sustainability Reporting Directive (CSRD) is a climate standard prototype being developed by the European Financial Reporting Advisory Group (EFRAG). Reading through the project documents recently released highlights the complexity that lurks beneath the surface of ‘ESG’ as the monolith it is sometimes treated as.

Materials released by EFRAG explaining the thinking behind proposals under development for a standard show how complex it will be. Efforts need to focus on harmonizing topical disclosure across all companies. Once that’s achieved, it needs to be evaluated as to whether it is portable enough between countries (or through the global supply chains of countries in a single region).

Even if the disclosures can be created in a format that is followed by a critical mass of companies, the challenge then migrates to frameworks such as the Sustainable Financial Reporting Directive (SFRD) to clearly transmit information about how ESG is used across the investment value chains from asset owners to consultants to asset managers and to promote understanding among ultimate beneficiaries.

All that information can never be distilled all the way down to a single score, but the maturing of ESG as a concept is in part recognizing that it doesn’t have to be. In the same way that there is no single, definitive way to identify whether a stock is ‘cheap’ or ‘overvalued’ except in hindsight, ESG will grow to be embedded within or overlaid on as varied a range of analytical approaches.

The answers to questions like ‘does ESG create impact?’ or ‘is ESG greenwashing?’ will move into the same realm of questions like ‘are stocks cheap?’ They can be prompts for entertaining discussion, easily conducted without understanding whether they lead to people talking past one another. There will be much richer sources of evaluation within the broad spectrum of ‘ESG’ relating to issues that may be unrelated other that possibly having an impact on financial performance. These dividing lines provide much more ground for discussion.

To the extent that various ESG issues are correlated with or have a relatively near-term causal linkage to financial outcomes, they’ll be identified and factored into financial markets. The direction that financial markets are heading on ESG leaves little doubt that the details on different financially material ESG issues will be increasingly defined. Some of that will be created by top-down pressure from investors, and their interests may not always align with the interests of their investees or other stakeholders.

There are two more intractable questions that face ESG which cannot be solved technocratically just by developing better reporting standards or more sophisticated analytical tools. First, the question comes between balancing environmental and social outcomes that are not of financial materiality to investors, and second, issues like climate change that are financially material but are too broad to be addressed bilaterally through analysis and engagement by investors working alone.

The first issue is how to deal with environmental and social outcomes that don’t have a material impact for investors, but do have a tangible impact for people. This is somewhat at the heart of the question imprecisely asked ‘whether ESG creates impact’. The lack of precision is about whether a particular use of ESG is designed to have impact in the first place. Most ESG integration is focused on picking up financial signals from the way environmental and social expectations are changing; it is not pursuing those changes.

This distinction is raising some concern. A report from the OECD to the G20 this week acknowledges the challenge: “These competing dynamics and challenges associated with ESG rating and investing could compromise market integrity, erode investor confidence, and mask the extent of environmental and climate-related impacts of investment decisions”. Part of the solution to the data issues will follow from the financial signals that investors are pursuing and that regulators are supporting with policies such as CSRD for data quality, and labeling rules and disclosures like SFDR and the FCA’s Guiding Principles for ESG funds.

As a result, instead of asking ‘whether ESG creates impact’ when evaluating new regulations or looking at specific approaches to ESG, it will be more productive to focus on three more specific questions:

• Are ESG approaches prioritizing the appropriate balance of financially material issues?
• If ESG is claimed to be creating environmental or social impacts that are not financially material for investors, how well can these outcomes be clearly defined and does it have any independent assurance?
• Are company-level ESG approaches consistent with systemic challenges such as climate change, and are relevant metrics for those systemic issues defined? For example, do company actions lag or lead their country’s NDCs or Net Zero ambition, and global net zero pathways, and what is the response in the face of misalignment? For climate as an example, what thresholds will investors set to divest, engage, or provide transition finance?

These are harder questions to answer, and even the most comprehensive regulatory frameworks on ESG don’t answer them to the satisfaction of everyone. However, adding specificity to define what we mean with ESG and what we expect will provide a more productive dialogue even where standards and data are lacking.

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