“The many reasons ESG is a loser” shouted an opinion piece in the Wall Street Journal this week.

I read the article with an eyebrow raised, but after reviewing the author’s evidence (as well as the underlying research he quoted and several additional sources), unfortunately, the author’s got a point.

This also means that we in compliance who run or assist in ESG programs have a problem.

In the movie I Give it a Year, the lead character is a branding expert whose new account is a chemical company. She quips that the client will want to add green and yellow font and slap a butterfly on the bottle to show his eco-credentials. The joke rings true on so many levels.

We’ve known for some time that the actions of companies claiming a focus on environmental, social, and governance (ESG) issues can run the gamut from complete commitment to total ethicswashing and greenwashing.

There’s now research about the performance of many ESG-related proclamations made by companies, as well as regulators starting to chase down false claims.

Here’s the bad news…

Companies in ESG Portfolios Have Worse Compliance Records

You read that right. Researchers at Colombia University and the London School of Economics compared the record of U.S. companies included in ESG fund portfolios compared to those that were not.

As analyzed in the Harvard Business Review, “They found that companies in the ESG portfolios had a worse compliance record for both labor and environmental rules. They also found that companies that added to ESG portfolios did not subsequently improve compliance with labor or environmental regulations.”

Bad Financials Can Lead to (questionable) ESG Proclamations

A recent paper co-authored by professors at the University of South Carolina and the University of Northern Iowa found that, perversely, when CEOs and managers underperform earning expectations set by analysis, they often publicly talk about their focus on ESG.

The professors stated that touting ESG and caring for stakeholders, “provides managers with a convenient excuse that reduces accountability for poor firm performance.”

Harvard Business Review author Sanjai Bhagat noted that, in contrast, “when [the company] exceeded earnings expectations, they made few, if any, public statements related to ESG.”

In other words, as performance wanes, the focus on ESG may actually increase in response, but not because the focus on ESG is real. Responding to the research, the WSJ said, “When earnings are bad, companies cite their focus on ESG. When earnings are good, they drop ESG references.”

Proclamations Don’t Lead to Better Outcomes Either

The Harvard Business Review reported that a recent European Corporate Governance Institute paper compared the ESG scores of companies invested in by hundreds of institutional investors that signed the United Nation’s Principles of Responsible Investing (PRI) and thousands that did not.

The paper did not find any improvement in ESG scores of companies held by PRI signatory funds after their signing. And what’s worse, the financial returns were lower and the risks higher.

Following the Money can Create Prosecutorial Scrutiny

It’s no wonder that so many companies want to jump on the ESG bandwagon. Sure, there is the desire to do the right thing, but it can also be highly lucrative to claim ESG credentials when seeking capital.

Per the Harvard Business Review, there is currently $2.77 TRILLION in global sustainable fund assets, and those funds need to make investments. In the fourth quarter of 2021 alone, $143 billion in new capital went into ESG funds.

All that money attracts 41.

On May 31, German law enforcement officials raided the offices of Deutsche Bank on suspicion of the fraudulent advertising of sustainable investment funds leading to prospectus fraud.

The raid came after the former head of sustainability warned last year that the company had made misleading statements in its annual report. She was dismissed after only eight months.

The former employee commented publicly, “It is terrible when executives misuse this issue as a marketing tool.” The company denies allegations of greenwashing.

Back in America, it’s been reported that the SEC is investigating Goldman Sachs over its ESG funds, some of which have interesting criteria.

Per the WSJ, “Goldman says holdings in the U.S. Equity ESG Fund undergo an ESG analysis but reserves the right to invest in some companies without such a screening. It can also invest up to 20% of its net assets in stocks that deviate from its ESG standards.”

Hmmm…

That scrutiny is getting bigger, and not just on banks and investment funds. The SEC and European Regulators are producing new rules and obligations. These obligations will flow down through contractual requirements meant to ensure the flow of information from suppliers of all sizes.

Is ESG a Loser?

The provocative title in the WSJ opinion piece referred primarily to the fact that ESG funds tend to have higher fees associated with them than index tracker funds and that the performance of those funds has been weaker than standard index funds.

WSJ found that managed ESG funds cost five to fifteen times as much in fees when compared to an index fund.

So yes – investors may not make more money investing in ESG funds. But does that mean ESG is a losing idea for companies and compliance teams?

I think not.

In next week’s blog, we’ll explore what we can do with this challenging information and how we can protect our teams and companies in their ESG initiatives.

Stay tuned!