Shortfalls of Environment, Social, and Governance Portfolios
| By Alexander Haidar |
Environmental, Social, and Governance (ESG) focused policies are intended to promote sustainable and socially responsible practices among businesses and organizations. These policies aim to achieve certain goals, such as reducing carbon emissions, promoting social equality, or increasing government transparency and accountability. While the rise of Environmental, Social, and Governance (ESG) investments in recent years has largely promoted sustainability and ethical practices in businesses, ESG securities and portfolios pose a greater unique risk to investors. In particular, the recent collapse of Silicon Valley Bank (SVB) has generated questions as to whether or not proper risk assessment went into the active management of ESG funds.
The idea of investing in policy-specific securities or portfolios is not new; Impax Asset Management Funds has been divesting from the fossil fuel, tobacco, weapons, and other industries for over 50 years through its Sustainable Allocation Fund. However, the 21st Century has brought in a new wave of wide-spread social unrest over climate change. Considering that roughly half of the carbon emissions since 1751 have been produced in the last 30 years, the real-world impacts of climate change have likewise accelerated peoples’ reaction to call on their governments to make meaningful changes.
Perhaps one of the most influential policies in recent years which has spurred larger participation in ESG markets was the 2015 Paris Climate Agreement. Adopted by over 190 countries in the United Nations Framework Convention on Climate Change, it aimed to limit global warming to well below 2°C above pre-industrial levels through a series of cooperative policies and regulations on carbon emissions. This agreement prompted investors around the world to fund companies that support this goal, essentially incentivizing the monetary commodification of carbon emissions through financial markets. In Europe, this led to the establishment of a cap-and-trade system of carbon credits whereby firms bid on emissions allowances. This top-down approach essentially forces firms to assume a monetary assessment of the social impact of their emissions, thereby incentivizing less carbon-polluting industries.
In the United States, the results of the Paris Climate Agreement have manifested in the private sector through the apparent demand in the market for companies which promote sustainability. According to a working paper published by researchers at Harvard Business School, the number of firms in the S&P 500 which chose to publish ESG reports had increased from 35% in 2010 to 86% by 2021. The United States has pledged and recommitted as of August 2022 to its Nationally Determined Contributions (NDC’s) to reduce Greenhouse gas emissions by 50% of 2005 levels by 2030, with a net zero target of 2050. In an analysis of the impact of policies and actions in the United States by the independent Climate Action Tracker, the Inflation Reduction Act was noted as the “most ambitious and potentially impactful climate policy in US history” considering its reliance on large-scale government investment in green industries. While this is a short-term solution to spur investment and growth in primarily sustainable sectors, it naturally lacks the full scope to respond to worldwide climate change.
Large-scale investment into certain areas in the economy such as solar, wind, and electric vehicles and battery storage aims to generate a technological competition in the private sector for the best, most cost-effective sustainable solutions. Unfortunately, this means that relatively young and very risky technologies and markets can receive exposure to large amounts of capital investment. Since ESG portfolios are looking to access the growth potential of new technologies, it is not surprising that many invested heavily in one of a handful of institutions like SVB which bankrolls many tech start-ups. Among the investors most exposed were the Cromwell Tran Sustainable Focus Fund (held 4.39% of portfolio in SVB) and Morgan Stanley Institutional Fund Global Concentrated Portfolio Class R6 (held 4.09% of portfolio in SVB), according to data from Morningstar. Since environmentally sustainable portfolios naturally are limited in terms of their diversification opportunities, the sector as a whole becomes more susceptible to the unique risk of each individual investment.
One of the market risks associated with ESG investments is their elasticity to policy changes. As the three sectors which comprise ESG portfolios are often related in terms of fiscal policy, these investments tend to be more volatile based on potential changes in political leadership. This issue has recently come to the forefront of American politics as the U.S. The Department of Labor’s (DOL) 2021 decision, supported by President Biden, encouraged but not required firms to account for ESG factors in retirement portfolios rather than aiming for maximum possible returns. This faced serious backlash in Congress, where both chambers passed legislation to block this rule. This legislation, supported by the GOP and a few moderate Democrats, claimed that incentivizing ESG investment via retirement funds would jeopardize returns on individuals’ retirement plans. This was likewise opposed by the White House, with President Biden issuing the first veto of his Presidency in March, 2023. Biden’s veto is unlikely to be overruled by Congress as a ⅔ majority would be almost impossible to obtain in either chamber. Nevertheless, representatives from mostly republican states have begun to propose state bills counteracting ESG investment, with 25 states’ attorney generals also filing lawsuits against the DOL for “overstepping its statutory authority.” Either way, as both parties begin to look toward the 2024 Elections, it is clear that ESG investment policy will become subject to more political contention, increasing the markets potential volatility.
ESG investments are gaining popularity, driven by top-down policies such as the Paris Agreement, the Inflation Reduction Act or Cap-and-Trade. However, these investments pose new types of fiscal risks to investors which need to be taken into account when assessing total portfolio risk. The lack of standardization and transparency in ESG data, the potential for underperformance, the political nature of ESG criteria, and the potential conflict between ESG objectives and financial performance are all important factors investors should consider when investing in ESG portfolios/bonds. While ESG investments have the growth potential to promote sustainability and ethical practices, investors should recognize individual sectors’ youth and future political volatility as fundamental risks to the market itself.