The ESG Paradox

The departure of Donald Trump from the political stage has left a void of sorts in the flow of lurid and dramatic media. But this is a void that the financial industry seems keen to fill. Since January we have witnessed a crypto mania, Reddit craze, and the blow up of two investment funds (Greensill in Europe and Archegos on Wall St), to mention a few spectaculars.

This comes at a time when one of the most significant trends in the financial services industry is the rise of ESG (Environment, Social and Governance) investing, whose ostensible aim is to channel capital towards companies that are environmentally friendly, socially responsible and good governance.  The investor reaction to the Deliveroo initial public offering in London and the coming into force of the EU’s SFDR regime suggest that ESG focused investing is becoming more meaningful.

However, there is still an intrinsic contradiction in the behaviour of parts of the financial services industry and their efforts to sell trillions of euros in ESG products to investors and clients. Without being overly cynical, this incongruity is driven by incentives – the attraction of ESG as a cottage industry career path, and as one where as far as exchange traded funds are concerned for example, fees are higher than for plain vanilla products.

There is also a data problem. The ‘E’ part of ESG is a relatively data rich area and one where a firm’s climate impact is increasingly straightforward to capture. The quality of corporate social responsibility and governance are harder to capture, and much of the data collected by research firms that measure ESG comes directly from the companies being scrutinized and therefore susceptible to ‘greenwashing’.

While some new ESG ratings companies such as Equileap are trying to rectify this (from the point of view of gender equality) there are other vulnerabilities in the investor practice of ESG, most notably in investor voting on issues like pay and governance, which across the board is mild-mannered at best, and is not activist enough.

One overlooked aspect of ESG is that it is highly coloured by regional and national cultures. American corporates are more focused on the ‘S’ part of ESG, Europeans it seems focus on the ‘E’ part while the ‘G’ element is most important to emerging market investors. In general, corporate performance on ESG criteria is clustered in progressive countries – the Netherlands, Nordics and New Zealand for instance.

Against that backdrop, we need to ask whether there are ways to gauge what financial services firms are sincere when selling us ESG and ‘Impact’ funds, and generally preaching that they are ‘doing God’s work’. There are maybe three rules of thumb here.

The first, echoing Harry Truman’s desire for a ‘one handed economist’ is that the ‘left hand’ and the ‘right hand’ of a financial institution must be philosophically ‘joined up’ in the sense of being consistent in the ethics of what they do. Too many banks or asset managers have one division that pronounce the sanctity of their ESG or Impact efforts, and another that runs banking deals in extractive industries, pumps over priced investment funds or over-allocates to flawed enterprises (Wirecard was an example). 

Secondly, efforts to boost a financial institutions’ social responsibility need to permeate an entire institution, and its customers. There is little point in banks (one of the least female friendly industries) responding to gender equality by adding women to its board if issues like pay equality, childcare and sexual harassment are not fully addressed through organisations. Equally, there is a good deal of survey evidence to show that banks do a poor job of addressing the financial needs of women as customers.

The third area to examine is regulation and central banking. Since especially the financial crisis regulators have acquired a reputation for arriving late at the scene of banking accidents. Arguably one mistake they have made is to focus on disciplining corporate entities, in terms of fines, rather than individual bankers. A change in the burden of accountability towards irresponsible individuals would likely curb risk taking.

Related to this is the vogue on the part of central banks to try to solve the ‘E’ and ‘S’ parts of the ESG problem set. Whilst at the Fed, Janet Yellen nobly made reducing longterm unemployment a policy focus. In Europe, the ECB now talks about its role in spurring the green economy. While it is good to see central banks ‘caring’, the great danger is that the more active they become in say trying to change society, the more generous they become in monetary policy, and eventually, the more inflation and banking accidents we endure.

Have a great week ahead,


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