ESG in Financial Services: From Enthusiasm to Scrutiny and the Path Forward

The integration of Environmental, Social, and Governance (ESG) considerations within the financial services industry—particularly among private equity firms, fund groups and asset managers—initially sparked widespread enthusiasm. This transformative approach enhanced the ability to assess risks and opportunities associated with ESG factors. Concurrently, Impact or ESG investing emerged as a strategic avenue for aligning investment portfolios with broader commitments to sustainability, ethical decision-making, and long-term value creation. According to Morningstar, “[s]ustainable funds have been around since at least the 1970s in the United States, but a switch flipped in 2019 when sustainable funds recorded their first annual inflows greater than $10 billion.”

While ESG as a framework provides a comprehensive method for evaluating potential risks and opportunities, impact investing represents a strategic approach aimed at generating positive social and environmental outcomes alongside financial returns. This rise in ESG-focused strategies and risk assessments reflects an increasing demand for incorporating environmental and social considerations into the decision-making process.

Political Backlash, Performance Challenges, and Stricter Regulations

However, the initial enthusiasm surrounding ESG in due diligence and as a strategy for investing has been tempered by significant challenges, many of which are rooted in political opposition, compounded by performance issues and the difficulty of verifying tangible results. A major obstacle has been the politicization of ESG, particularly in the United States. Lawmakers have criticized ESG principles, arguing that they often conflict with financial objectives and personal freedoms. This backlash has led to shifts in corporate strategies, including a trend, known as “green hushing,” where companies downplay their ESG commitments to avoid political and public scrutiny. Many states have banned the use of ESG as a pecuniary factor for making investment decisions within their retirement and pension funds, amidst concerns that many of the environmental voting practices directly conflict with the industries and revenue streams critical to the state’s economy.

The performance of ESG funds has also raised concerns among investors. Many ESG portfolios underperformed in 2022, primarily due to a lack of exposure to the energy sector, which saw substantial gains during this period. Although ESG funds experienced a slight recovery in 2023, particularly in sectors with overweight exposure to clean technology, the overall performance lagged behind conventional funds. The underperformance and state restrictions contributed to significant outflows from ESG funds, with $40 billion withdrawn from ESG funds globally in 2023, as investors began to question their financial viability.

Adding to these challenges, the U.S. Securities and Exchange Commission (SEC) intensified its scrutiny of the reported claims of ESG funds. The SEC has focused on ensuring that funds provide accurate and substantiated representations of their ESG credentials, as evidenced by a notable $4 million fine imposed on Goldman Sachs Asset Management for inflating the environmental benefits of its investment products. This regulatory action underscores the SEC’s commitment to enforcing stricter standards and enhancing transparency within the sustainable investment industry.

Scrutiny of Verifiability and Greenwashing Concerns

Another critical issue that has faced the ESG movement for several years is the lack of verifiable results, as the vague and inconsistent application of ESG standards has led to widespread accusations of “greenwashing.” Greenwashing occurs when funds are labeled and marketed as sustainable while overstating their actual environmental and social impacts. This has eroded trust among investors, who are increasingly skeptical about the actual benefits of ESG investments. Legal actions have been taken against companies accused of greenwashing, and legislation in several U.S. states now aims to prevent public funds from hiring asset managers who consider ESG metrics.

The scrutiny intensifies when considering the differences between public and private funds. Public funds, or those registered and traded in public markets, are subject to the SEC’s “Names Rule,” which mandates that at least 80 percent of a fund’s assets align with the investment focus suggested by its name, including terms like “ESG.” The SEC noted that evolving investor expectations around terms such as “sustainable,” “green,” or “socially responsible” “compound the possibility of investor confusion and potential ‘greenwashing’ in fund names.”

To address these concerns, the “Names Rule” under the Investment Company Act of 1940 was amended in 2023, aiming to modernize and strengthen investor protections for products like ESG focused funds. The amendment essentially expanded the 80 percent investment policy requirement to any fund name with “particular characteristics,” including terms like “growth,” “thematic,” “value,” and “ESG.”  Previously, this policy applied to funds with names that indicated a focus on specific types of investment, geography, or industry. “The premise is that when investors see a fund’s name, they should have a good idea of what to expect,” Commissioner Hester Pierce said. Although the SEC did not provide a precise definition of “particular characteristics,” it emphasized the importance of a “meaningful nexus” between the investments and the focus suggested by the fund’s name.

Simultaneously, the SEC is looking into how large asset managers wield their voting power, especially when it comes to supporting ESG related shareholder proposals. Critics argue that these firms, by supporting or opposing certain proposals, may not always prioritize shareholder returns, raising concerns about whether their actions align with fiduciary responsibilities.

In contrast, private funds, which operate outside of these public market regulations, encounter different expectations. While not subject to the Names Rule, there is interest among both regulators and investors in the private fund space regarding the integration of ESG factors into the investment screening and committee evaluation processes. There is curiosity about the extent to which ESG considerations influence the holdings of the fund. Regulators and investors are asking questions related to whether the funds are signatories to the United Nations Principles for Responsible Investment (UNPRI) and whether ESG integration is prominently featured on their websites and marketing materials.

This heightened scrutiny reflects a broader demand for transparency and accountability across both public and private investment spaces. As the market evolves, it is crucial for fund managers to communicate their ESG strategies and the real impact of their investments clearly, whether they operate in the public or private domains.

Path Forward: Resilience and Regulatory Progress

Despite these challenges, Europe and the UK continue to reinforce the underlying principles of ESG where investors and regulators believe in the importance of sustainability for long-term value creation. Regulators are making efforts to address greenwashing, and fund managers are refining their approaches to create more consistent and impactful ESG funds.

Looking ahead, the continued momentum of ESG in the investment sector will depend on a combination of the following:

• Market Demand: Millennials and younger demographics have a strong sense of social responsibility and preference for ESG products and Impact investing.
• Regulation: Policy interventions, such as those by the SEC, the EU’s Sustainable Finance Disclosure Regulation and voluntary commitments to initiatives including signing the Principles for Responsible Investment (https://www.unpri.org/signatories ). The PRIs are focused primarily on integrating ESG issues into investment analysis and decision-making processes.
• Performance: The ability to deliver verifiable results while also meeting or exceeding expected returns.
• Risk Assessment: Effectively identifying and managing ESG related risks and opportunities.

With deep experience in ESG and Asset Management, Weaver is equipped to guide clients through the complex challenges of ESG investing. We offer tailored services to support your efforts, whether you need assistance in tracking and validating results, evaluating market risks—such as those related to climate change, social equity and fair labor practices—or preparing for evolving regulatory and financial reporting requirements.

Our experience includes developing robust processes for integrating ESG considerations into due diligence and translating ESG data analytics into meaningful KPIs that align with stakeholder expectations. By partnering with us, you can confidently navigate this evolving landscape, ensuring that your investments not only comply with regulatory standards but also contribute to long-term, sustainability-focused growth strategies.

For more information, contact us today. We’re here to help.

©2024