In 2022, Environmental, Social, and Corporate Governance (ESG) accounted for 65 percent of all new inflows in exchange traded funds in Europe. Investments in the US are also projected to grow—PricewaterhouseCoopers (PwC) observes that more than eight out of ten institutional investors plan to increase their allocations to ESG in coming years. ESG assets under management are expected to reach US$33 trillion by 2026, making up over 20 percent of all assets under management globally.
The dramatic rise of ESG investment has prompted resistance on both sides of the political aisle. Republican Congressman Andy Barr and Florida Governor and Presidential hopeful Ron DeSantis are part of an escalating right-wing backlash against “wokeness” on Wall Street. Last year, DeSantis implemented a ban on ESG considerations by Florida’s state pension fund. In January, Congressman Andy Barr, Chair of the House Financial Services Subcommittee on Financial Institutions and Monetary Policy, commented:
“We want to promote the depoliticization of our capital markets. In order for our country to be economically competitive we need our financial system to provide equal access to capital to all kinds of businesses.”
Across the country, over fifty anti-ESG bills have been introduced in the last two years. Last year, nineteen attorneys-general in red states accused BlackRock of sacrificing returns to an activist agenda on climate. The comptroller of Texas also published a list of financial institutions which it said were “boycotting” energy companies and thereby undermining the Lone Star state’s economic interests. As well as BlackRock, the comptroller listed Credit Suisse, BNP Paribas, UBS, Nordea, and Danske Bank. BlackRock responded to the criticisms:
“Elected and appointed public officials have a duty to act in the best interests of the people they serve. Politicizing state pension funds, restricting access to investments, and impacting the financial returns of retirees, is not consistent with that duty. Texans deserve access to the full range of asset managers, and investment opportunities that can help them meet their retirement goals.”
The political heat is coming from many directions. New ESG greenwashing scandals are making headlines on an almost daily basis, shaking market confidence. Fast fashion label Boohoo had been highly rated in ESG metrics, due to its UK-centered supply chain. However, in the early part of the pandemic, the Leicester factories it sourced from, were exposed by UK labour campaigners and media for relying on modern slavery. Stocks in Indian conglomerate Adani, which invests in highly contested coal mines and has been accused of corporate misconduct by activist short sellers Hindenburg Research, were found in over 500 ESG-labeled funds. In mid-2022, Deutsche Bank was raided by Frankfurt police, who were looking for evidence that one of its related companies had sold “financial products as ‘greener’ or ‘more sustainable’ than they actually were.”
For their part, investors have resisted the so-called politicization of finance, in turn casting themselves as objective profit maximizers. BlackRock—the world’s largest asset manager and primary target of the right-wing backlash—has defended ESG as a prudent risk management strategy. It insists that ESG is simply “the practice of incorporating financially material ESG data or information into our firmwide processes with the objective of enhancing risk-adjusted returns of our clients’ portfolios.”
And yet, many of the precepts of the sustainable investing movement have been thrown into question. Beneath the smoke and mirrors of US politics, a central proposition of ESG is being contested: namely, that investors can simultaneously do good (support sustainability) and do well (achieve profitability). If an environment of low interest rates and inflated tech stock prices could sustain this idea in some quarters, today’s economic conditions are far less forgiving.
Underpinning the rise of ESG investment is the assumption that expanding the definition of investor risk—by taking environmental, social, and governance factors into account—will generate positive social outcomes. This conflation of investor and public interest is the outcome of developments in the structure of the global political economy. With the growth of institutional investors (especially pension funds) in the late twentieth century, large financial companies have stakes across entire markets.
Capital markets research by the Organization for Economic Co-operation and Development (OECD) shows that institutional investors own over 70 percent of all listed equities in the US. A handful of asset managers, led by the Big Three (BlackRock, Vanguard, and State Street) control enormous amounts of equities trading, often on behalf of institutional investors. BlackRock manages nearly US$10 trillion in investments, Vanguard US$8 trillion, and State Street US$4 trillion. Combined, these firms manage the equivalent of more than half of the combined value of all shares for companies in the S&P 500. In the words of Brett Christophers, asset managers “own the world.”
Given the gargantuan breadth of institutional investor and asset manager portfolios, their returns are said to depend upon the health of the economy as a whole. Management scholars James Hawley and Andrew Williams have described these kinds of investors and managers as “universal owners” who have a stake in most industries and major firms across the market.1 This has encouraged some financiers to adopt a position akin to those of public regulators, purporting to manage systemic risks to the economy. Hiro Mizuno, formerly Chief Investment Officer for Japan’s Government Pension Investment Fund (GPIF), states the case clearly: “As a universal owner, instead of trying to beat the market, our responsibility at GPIF is to make capital markets more sustainable.”
Institutional investors have been encouraged to take up this quasi-regulatory role by international financial and intergovernmental organizations such as the United Nations (UN), the OECD, and the International Monetary Fund (IMF). The UN Principles for Responsible Investment (UNPRI) and the United Nations Environmental Program Finance Initiative (UNEP FI), which popularized the concept of ESG risk, have for nearly two decades done advocacy and research regarding a “modern” approach to fiduciary duty. The UNPRI and UNEP FI have made an increasingly assertive case that fiduciary duty not only permits, but requires, investors to manage financially material ESG risks.
The expansion of the field of risk management has raised questions about how to square an emerging “stakeholder capitalism” with the fiduciary duty of investors to maximize shareholder value. In the early 2000s, Michael Jensen developed a theory of “enlightened shareholder maximization” that answered this question by narrowing the definition of stakeholders to only those posing a financially material risk.2 While the broader definition of stakeholder included “any group or individual who can affect or is affected by the achievement of an organization’s purpose,” Jensen redefined the term as only those “individuals or groups who can substantially affect the welfare of the firm.”
What Jensen’s specification makes clear is that rather than seeking to reduce the risk of business activity to the environment or human rights, ESG seeks to manage financially material risks to investors. ESG managers ask, in the words of green finance researcher Adrienne Buller, “not what your portfolio can do for the climate crisis, but what the climate crisis will do to your portfolio.”3
The search for a standard
In response to controversies, securities regulators have sought to better define ESG frameworks as a standardized risk management strategy. They trace the problem to the proliferation of competing ESG frameworks advancing ratings that are inconsistent and even contradictory—as Tesla aptly demonstrates. Divergences between ESG ratings enable investors to pick and choose those that suit them, in a process of “green regulatory arbitrage.”4
A range of government and private sector initiatives have aimed to standardize ESG frameworks, through processes that mirror earlier efforts to standardize corporate accounting and financial reporting. The Social Accounting Standards Board (SASB) was formed in 2011 as the ESG-equivalent to the International Accounting Standards Board. In 2021, the SASB merged with the International Integrated Reporting Council to create the Value Reporting Foundation, which has since merged with the International Financial Reporting Standards Foundation (IFRS Foundation), the umbrella organization for mainstream corporate accounting and financial reporting.
Similarly, in 2022, the European Union implemented the Sustainable Finance Disclosure Regulation (SFDR), which defines “sustainable investments” and sets standards for how investment products are promoted. The American SEC has also acknowledged investors’ need for more easily comparable, reliable, and consistent information about ESG, in proposing some new draft rules for disclosure. And the UK government’s Financial Conduct Authority (FCA) is undertaking a consultation process to review sustainability labels, disclosure, and marketing for financial products. These rules, which have been heavily contested, come with financial consequences. The classification of natural gas and nuclear power was a major subject of debate within the EU; the implementation of SFDR led to sustainability labels being removed from funds worth €175 billion.
Because they assume a unity between asset managers and the public, these initiatives understand risk to be a concrete, measurable entity. The reality is far more complex—risk is a malleable construct, with varied impacts across communities. The crucial question behind risk measurement, then, is: for whom? The existing policies, public and private, focus on the financial implications of ESG risks to investors at the expense of those posed by finance to other “stakeholders.” The IFRS Foundation stipulates that its standards “will result in a high-quality, comprehensive global baseline of sustainability disclosures focused on the needs of investors and the financial markets.” The SEC proposal centres investors’ financial interests by permitting them to define their own approach to ESG. The UK FCA proposes SASB standards as a potential measure of investors’ ESG credibility, which is likely to re-inscribe the overriding concern with financial materiality. The exception to this is the EU sustainable finance taxonomy, which introduced the notion of “double materiality,” requiring disclosure of the social and environmental impacts of firms, alongside potential financial impacts to firms. But the Directive’s overall emphasis on risk inevitably privileges financial risk as the common metric of standardization. Underpinning these efforts is the belief that an objective, scientific approach to valuation and risk management is possible, given the right market information and accounting framework.
The political limits of risk
The ESG framework is thus weakened by the observation that risks are unevenly distributed. Moreover, financial risk cannot be scientifically measured because it is shaped by politics. It is widely understood in markets that the biggest financial risk of climate change is not the “physical risks” of extreme drought and rising sea levels, but “transition risk” created by future political responses. Valuing an asset through this prism requires making political judgements about factors such as the stringency of future emissions targets and the power that climate movements have to pressure governments to act. The “fat tail” of climate risk— those outlier, but not impossible, pathways in climate models—includes not only abrupt tipping points, but also the possibility of radical decarbonization, or indeed the possibility that conservative movements against climate action gain further traction.
Strategies of fossil fuel divestment movements are instructive because they reveal dynamism in the political construction of climate risk. Divestment activists are clear that their goals are less about the direct financial impact of divestment, and more about making fossil fuel investment a risky proposition through stigmatization, so that warnings of “stranded assets” become a self-fulfilling prophecy. Tactics such as climate litigation, for example, aim to make climate considerations a financially material risk. The success or failure of divestment can be measured through risk metrics, such as spreads on the cost of capital for coal, or rising insurance premiums.
The upshot is that financial risk is now a field of politics in its own right. Climate and other politics are increasingly being directed there through investment frameworks. What is novel about the current moment is that the political right, for all their appeals to the depoliticization of finance, are actively participating in the politics of financial risk. The right-wing backlash against ESG has created financial and quantifiable losses for funds, albeit representing only a fraction of their total funds under management. Several major finance companies have even declared that the politicking around ESG is becoming a material risk in itself.
On the other end, the fossil fuel divestment movement shows there is some scope to move risk and influence the allocation of capital. But ultimately the political possibilities of ESG are bounded by what is deemed to be financially material. As Tariq Fancy, former Chief of Sustainable Investing at BlackRock, put it, ESG “managers are focused on protecting their investment portfolios from potential damages done by a worsening climate rather than helping prevent that damage from occurring in the first place.”
Actually reducing the occurrence, rather than simply managing the consequences, of climate risks, is necessary because we are not all exposed to risk in the same ways, nor to the same degree. Rather than searching for standardized measurements and regulations, we ought to recognize the important distinction between managing financially material ESG risks for capital and managing the impact of ESG risks for everyone else. Climate risks that are financially non-material to investors are material to the communities and workers at the frontiers of climate change. But these are currently beyond the limits of ESG integration.
Hawley, James.P. and Williams, Andrew.T., The Rise of Fiduciary Capitalism: How Institutional Investors Can Make Corporate America More Democratic. Philadelphia: University of Pennsylvania Press, 2020.↩
Jenson, Michael.C., “Value Maximization, Stakeholder Theory, and the Corporate Objective Function,” Business Ethics Quarterly, Vol. 12, No. 2, 2002.↩
Buller, Adrienne.,The Value of a Whale: On the Illusions of Green Capitalism, Manchester: Manchester University Press, 2022.↩
Gabor, Daniela. “The Wall Street Consensus,” Development and change Vol. 52, No. 3. 2021.↩