This article first appeared in The Edge Malaysia Weekly on December 26, 2022 - January 1, 2023

In 2022, environmental, social and governance (ESG) became the hottest phrase in the corporate world. But as the momentum of adoption accelerates, questions about whether ESG can achieve its true purpose have also emerged.

Activists, investors and consumers are taking companies and governments to task over ESG targets or policies that seem more like a marketing gimmick.

BlackRock Inc, a huge proponent of sustainable investing, was called out for “hypocrisy” by activist investor Bluebell Capital because it remains a major shareholder in fossil fuel companies and this inconsistent ESG strategy “alienated clients and attracted an undesired level of negative publicity”.

In the US, an “anti-ESG” movement has taken root, with prominent Republican-led states pulling their funds from asset managers that practise sustainable investing. The leaders claim that asset managers are ignoring their fiduciary duty by emphasising these strategies.

What do these developments mean for the ESG movement? Will it still be relevant despite these challenges?

The interviewees that ESG spoke to are optimistic that it will remain on the agenda. The scrutiny is like a rite of passage so that the necessary safeguards can be put in place to ensure ESG is not used for greenwashing.

“I’m happy that those who are greenwashing are being called out. It shows that impact is not something that’s just a nice narrative you put in a report. It’s something you must put into practice, which can be difficult,” says Margie Ong, partner at global sustainability firm Environmental Resources Management (M) Sdn Bhd (ERM). She has been in the sustainability field for almost a decade.

Ong says ESG is here to stay. “At the end of the day, the underlying factors are not going away. Climate change is not going to solve itself. Global injustice is not going to address itself. Whether we call it ESG or something else, environmental and social impact needs to be achieved through different sectors, which all have a role to play.”

If people truly understand what scientists are projecting to occur as climate change worsens, they will see the urgency to act, much as they did in response to Covid-19, Ong believes.

“I would say that we are not moving fast enough if you believe in the science. But is it worth the effort of getting every person to be a ‘convert?’ Can we just set the right market conditions so everyone, whether or not [you believe] the planet is on its way to destruction, has to comply? That might be more realistic.”

That sense of urgency is observed in some parts of the world, as it has driven activists and investors to pose hard questions to those who claim to be ESG compliant.

“Governments are under pressure because the courts are supporting the activists. For instance, the UK government lost a case recently because their [climate policies] weren’t good enough,” says Eugene Wong, CEO of Sustainable Finance Institute Asia (SFIA).

However, the anti-ESG movement in the US is deeply politicised, Wong and Ong observe. This cause has been largely pushed by the Republican Party, whose members mostly reject the science of climate change.

While those dynamics may be absent elsewhere, the opposition to ESG is not something to ignore, warns Wong. “In other parts of the world, we’re not going to see it as a political play but as an injustice play.”

The pace of ESG adoption across the world is uneven. It is unfair if the same standards are imposed on all countries, regardless of their level of development. “This is the danger of the Carbon Border Adjustment Mechanism (CBAM),” opines Wong. The CBAM is the European Union’s policy to impose a carbon price on imported goods.

“It’s not sufficiently recognising efforts to be better. It’s punishing people. Advocates say if you’re not strict, nothing is going to happen. But in the same vein, if you push people before they are ready, you will get a rebellion,” he says.

“If you want people on board, you must make it possible for them to get on board. When we do the taxonomy, we always say that we must be inclusive and understand the different starting points. We must have an orderly transition that does not cause dislocations, whether it’s economic or social.”

Wong is involved in developing the Asean Taxonomy for Sustainable Finance, which classifies sustainable economic activities in the region.

According to Bloomberg, the 10 largest ESG funds by assets posted double-digit losses this year, with eight of them underperforming the S&P 500. However, this, along with the few US states’ insistence on pulling money from ESG funds due to lacklustre returns, may not paint the full picture of ESG fund returns. But it does raise questions about the strategies these funds employ.

According to several analyses, the underperformance of ESG funds over the past year has been largely attributed to its overexposure to technology stocks. Another hypothesis was that ESG funds avoided fossil fuel companies in the energy sector, which presented outsized gains earlier this year.

This was partly debunked by Jon Hale, director of sustainability research for the Americas at Sustainalytics, who wrote in September that the energy exposure of sustainable funds is only slightly below that of conventional funds. The main factor driving the sustainable funds’ performance was their tilt towards growth and tech stocks, which gave these funds good returns in the past few years.

That’s why sustainable funds still win in the long term, according to data from the third quarter of 2022.

The Morningstar US Sustainability Index averaged an 8.7% return per year in the last five years, which is equal to that of the Morningstar US Market Index. Meanwhile, the Morningstar US Sustainability Leaders Index outperformed the latter by three percentage points a year.

Hale suggests that investors also consider value stocks, which can be found in sectors with higher ESG risks. Instead of investing only in companies that have low ESG risks, they can also invest in companies doing a better job at managing their ESG risks, which would broaden the scope beyond just the tech sector.

Another factor to consider is the wide array of “ESG-oriented funds”, says Ou Yong Xuan Sheng, green bonds and ESG analyst for Asia-Pacific at BNP Paribas Asset Management. Some funds use a best-in-class strategy, which invests in the best ESG stocks across industries; thematic funds invest in themes like renewable energy; and exclusionary funds avoid certain sectors. The performance of these funds and indices, which use different strategies, varies.

He gives the example of the MSCI ACWI Index, which is down 17.18% year to date (as at Dec 14). The MSCI ACWI ESG Universal Index was down 17.26%, the MSCI ACWI ESG Focus Index was down 17.77%, and the MSCI Multiple Factor ESG Target Index was down 16.14%.

“It’s hard to say that the ESG variants of the ACWI are largely worse off than the [parent index] ACWI, and we have at least one factor-based index that performed better than it. In any case, I think sustainable investing or investing with some form of ESG consideration will continue forward with positive momentum. Investors, policymakers and other market participants largely recognise it is here to stay,” says Ou Yong.

In Malaysia, digital investment manager StashAway’s responsible investing portfolio performed between -2.9% and -6.9% this year, which is roughly in line with conventional portfolios of equal risk, says country manager Wong Wai Ken, who still believes that the ESG trend is well underway.

“While ESG is an investing proxy for doing good, investors should realise that it is more of a factor in determining capital allocation.”

Businesses sometimes give the feedback that adopting ESG is a burden on top of what they already have to do in the wake of Covid-19.

“I tend to agree more than disagree with them sometimes. I do not urgently work to convert every business I speak to. What I seek is the acknowledgement and understanding of what is coming their way from a business perspective,” says Ong.

She has encountered many board members and senior management who are personally interested in driving ESG. However, they do not have the resources.

“This is where I tend to agree with them. Every quarter, they are asked to produce financial reports. They are rarely asked about ESG issues and are still held to strict financial targets. It is hard to make longer-term investments unless they have a board that is really bought in,” says Ong.

The response that BNP Paribas Asset Management has received from engaging with Malaysian companies is more positive. Liu Minyue, investment specialist for Asia, global emerging markets equities and greater China equities at the firm, observes that Malaysian companies have been very open to discussions about ESG.

It is now very common for the asset management firm’s investors to ask portfolio companies questions about ESG. “Before this, they only asked if you have considered these factors. Nowadays, they dig out what data source you use, which data point you checked and how you are engaging with companies,” she says.

“A lot of companies we engage with are positive. We never penalise them if they say they don’t have a very structured ESG policy.”

Instead, the firm helps them along the journey. “We give them advice on what global investors would look for, which data points to focus on and how they can improve,” Liu says.

For the ESG movement to truly be effective, it requires checks and balances from investors and other entities to examine the disclosures by companies to ensure they are doing as they say.

Bluebell Capital’s pressure on BlackRock is a good example, as is the increasing number of lawsuits brought against companies and governments for setting unrealistic targets or publishing misleading information.

“From my personal view, ESG ratings at the moment, due to the lack of a better structure, are very gamified. But it is the best that has evolved until now. You can have companies taking the right actions but not disclosing them properly or you can have companies that might not be taking the right actions but are disclosing extremely well or overly enthusiastically,” says Ong.

Some in the industry say that it is a work in progress. Right now, the focus is on driving better disclosure of ESG matters, so there is transparency and comparability of data.

“With time and the standardisation [of reporting] that will come, it will eliminate some of these [problems]. But let’s not expect the rating agencies to be the ones to do that. Similar to financial accounting, there has to be checks and balances put in place by the entire market, whether it’s auditors or external and internal assurances,” says Ong.

It is important to note that many funds and research houses do not solely rely on ESG ratings to make investment decisions. Some have in-house teams to do their own analysis.

“The way we use engagement also helps us prevent greenwashing because when we understand the company, we can see whether the data is relevant to what they do,” says Liu. She emphasises that there must also be engagement between companies and the government. This is to ensure that new policies are aligned with business direction.

Several jurisdictions are working on taxonomies and regulations to clarify what can be considered sustainable and what should be reported under ESG. These activities will pick up pace in the next year, say the interviewees.

“I call it cleansing, where we become very clear about what qualifies as green, ESG and sustainable. Asean has already come up with sustainability-linked bond standards and sustainable and responsible fund standards, so you cannot mislabel funds [as sustainable],” says SFIA’s Wong.

There will also be a shift in focus to social issues, says Ong. “S started with corporate social responsibility (CSR). CSR might have been one of the casualties of the ESG movement, as there is less focus on it now, but I think that needs to increase. What does it mean to provide fair wages and equal opportunities? How does that help the business?

“There will be new technologies and revenue streams created as a result of this transition. That would be exciting to watch,” she adds.

Another big theme to watch is a just transition, says Wong, where countries at different levels of development will form their own standards and companies that are transitioning are given recognition.

“I think we also need to do more on adaptation [to climate change]. We’re kind of past the limit [of halting climate change]. We can see a lot of climate refugees in some countries already, so we need to prepare for the fact that we’re not going to meet our targets,” says Wong.

As for investors, Ou Yong thinks that there will be more interest in thematic products. “ESG integration is great because it helps us identify good companies but I think in the next couple of years, investors will want to allocate capital towards solutions that address a specific problem, like mitigating social inequality or preventing biodiversity collapse.”

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