With Donald Trump returning to the White House, the ESG movement is bracing for a day of reckoning. At a minimum, it must find a more unifying and conclusively beneficial way forward.
In preparation for the debate, proponents and critics alike would benefit from remembering its origins. United Nations Secretary General Kofi Annan launched the U.N.’s Principles for Responsible Investment in 2005 to accelerate the attainment of the U.N.’s Sustainable Development Goals. ESG grew out of this U.N.-PRI initiative. Today, trillions of dollars are dedicated to ESG investment strategies, hundreds of ESG rules and regulations govern corporate behaviors, and more than 1,000 ESG shareholder resolutions have been voted upon. In fields as far-flung as asset allocation, shareholder governance, industrial practice, optimal portfolio construction and corporate behavioral theory, ESG’s influence has been profound — far more so than its originators ever imagined. But what incontestable financial, social and environmental progress has ESG wrought, where has it disappointed, and where should it go from here?
Where ESG has failed
While a handful of ESG funds have outperformed the broader market, as an overall investment and rating discipline, ESG has disappointed. According to Morningstar, 2022 was the worst year for ESG fund performance on record; the second worst year was 2023. ESG has not delivered on its comprehensive alpha-generating promise. In fact, rather than producing excess returns, tangible social and environmental progress and/or clear investment metrics, incontrovertible evidence shows most ESG funds have neither performed well nor produced much good.
According to asset management giant Vanguard Group, moreover, exclusionary ESG investment strategies show limited prospects for future improvement. There is a compelling explanation for this. Restricting one’s investment universe to companies presumed to be more virtuous precludes participation in many value-creation opportunities, including those which often occur when brown companies turn green. As for impact, too many ESG investment strategies are inherently contradictory. Starving brown companies of capital is the opposite way to transform them: They need more investment, not less.
The time has come for fund managers to offer more convincing proof that their numerous offerings of sustainable investment strategies will generate reliably superior returns and/or compensating societal advancements. In the absence of such proof, investors should continue to move away from ESG investment funds for — please pardon the pun — greener pastures. The case for greater ESG fund selectivity is particularly pressing among public pension plans: they more than others are under growing legislative scrutiny for potential violation of fiduciary laws. If one’s investment goal is to lower carbon emissions, reduce racial income disparities, or build more low-income housing, impact investing makes much more sense. If one’s investment goal is to generate excess returns while remaining mindful of ESG factors, strategies which overweight high-quality firms in every sector are much more promising than those which divest from whole industries.
Where ESG has succeeded
So where has ESG been an unqualified success? In propagating corporate regulations and multiplying non-financial corporate disclosures. In Europe, the Corporate Sustainability Reporting Directive and supporting European Sustainability Reporting Standards are now in place. Coupled with California’s three climate laws and the Securities and Exchange Commission’s recent (though stayed and all-but-certain to be abandoned) climate rule, a dizzying array of ESG regulatory rules have been implemented in multiple jurisdictions around the world.
Companies have adapted to this new environment by employing chief sustainability officers and compliance codes. As a complement to these efforts, the International Sustainability Standards Board is now laboring to establish high-quality, global baselines of sustainability disclosures. Ultimately, ISSB should be able to incorporate other market-led investor-focused reporting initiatives, including the Climate Disclosure Standards Board, the Task Force for Climate-related Financial Disclosures, the Value Reporting Foundation’s Integrated Reporting Framework and industry-based SASB standards, as well as the World Economic Forum’s Stakeholder Capitalism Metrics. In short, ambitious ESG regulatory frameworks have dramatically impacted corporate decision-making. No major firm today can ignore ESG precepts without inviting some regulatory scrutiny, shareholder ire or, more likely, both.
Of course, all this begs the question: Have ESG rules and regulations gone too far, impeding rather than promoting optimal societal outcomes? Some regulatory excesses are obvious. Elsewhere, a crucial, real-time experiment is unfolding before our eyes. Climate disclosure rules, employee rights and supply-chain restrictions are much more demanding in Europe and the U.S. than in Asia. All other things being equal, such rules tilt the competitiveness playing field toward less regulated firms. It’s highly unlikely consumers will favor more expensive products and services over time simply because they are regulatory compliant: Cost, quality and innovation always assert themselves over time. With acrimony high and growing in the U.S. and Europe, the political debate, which ultimately governs the regulatory agenda, is growing increasingly fraught as well. Something’s got to give.
A better way forward
Because of disappointing investment results, distortionary regulations, mounting social divisions, and a regime change in Washington, an overwhelming case can be made for overhauling the current ESG paradigm. Environmental, social and governance concerns were never intended to be forever prioritized over other societal goals, like economic growth: They were supposed to broadly advance human flourishing.
For ESG to succeed optimally, it must now evolve into something less politically explosive and more conclusively beneficial. Stated simply, values and value creation need to come into better alignment. As I have argued elsewhere, five tenets would generate more optimal outcomes:
- Free markets should be allowed to work.
- Evolving consumer, worker and societal sensitivities involving stakeholders should be respected.
- The principle of shareholder primacy should be strengthened.
- Evolving shareowner priorities about employees, suppliers and the environment should also be accepted.
- Cost-effective remediation strategies that mute capitalism’s negative externalities should be pursued.
On the last point, more farsighted, less-distortionary public policies and an active NGO sector will prove much more lasting and effective than undemocratic, bureaucratic business regulation.
How might these tenets work in practice? There is a broad social consensus that we must protect our land, air and waters while simultaneously promoting better living standards. This means, among other things, we should lower our carbon and land-use footprints wherever and however they simultaneously promote growth. Environmental progress that promotes economic growth unifies rather than divides. There is also a growing need to maintain social cohesion as living standards rise. Quality of life and income gaps between the haves and have-nots cannot grow disproportionately forever without undermining social contracts. ESG’s successor must promote greater social inclusivity or environmental sustainability in incontestable yet economically value-enhancing ways, such as Bolt Threads, which has bio-engineered high-performance materials like leather substitute Mylo and silicone elastomer substitute B-Silk, both of which have negligible ecological impact.
All of this requires a wholescale review of the application of ESG rules and regulations, and greater transparency and rigor in the adoption of ESG ratings and investment disciplines. More rigorous cost-benefit analysis must govern environmental and social regulations, and more verifiable impact must be proven in so-called sustainable investment strategies. Many asset owners are willing to sacrifice some investment return in exchange for true environmental and social progress — but all costs and benefits need to be rigorously measured and publicly disclosed. One metric aimed at eliminating “impact washing” and promoting transparency is the Impact Authenticity Score, a new rating methodology designed by the Impact Evaluation Lab and beta-tested with the Sorenson Impact Institute at the University of Utah.
The incoming Trump administration is certain to look askance at past ESG rules and demand more efficient, more effective outcomes. They are right to do so. Regulations that penalize sustainable economic growth, stoke inflation, and/or hamper improved living standards should be discarded. Ongoing reprioritization would prove healthy. The ESG movement would also benefit from greater mindfulness of the trade-offs it necessarily engenders, regardless of its intents. The words of St. Bernard of Clairvaux are no less true today than they were in 1150: l'enfer est plein de bonnes volontés ou désirs — Hell is full of good intentions and desires. It is possible to promote economic growth, social inclusivity and environmental sustainability simultaneously. Values can be value-enhancing. ESG’s successor should vigorously strive for such “do well, do good” outcomes.
Terrence Keeley is the author of SUSTAINABLE: Moving Beyond ESG to Impact Investing, and CEO of the Impact Evaluation Lab and 1PointSix LLC. He is based in New York. He was formerly managing director, head of the official institutions group and the BlackRock Academies at BlackRock. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.