ESG investors are hitting the road. Don’t blame them. The investing standards are broken and need fixing

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The three letters that were supposed to put capitalism on a sustainable trajectory – ESG – have failed to do so. Emissions continue to rise despite the trillions of dollars ploughed into environmental, social and governance funds over the decades. Scandals relating to the last two letters in the formula abound, and ESG progress overall is hard to measure and easy to manipulate. ESG investing is in trouble, deservedly so, and needs a radical overhaul.

Investors seem to have realized that there is less to ESG than meets the eye. At best, its value to society and to portfolios is overstated; at worst, it’s a con job dressed up in a green package. Research released this week by Barclays says a net US$40-billion has been withdrawn from ESG equity funds so far this year – the first year the flows have gone in reverse. April alone saw a record net US$14-billion exodus.

The figures do not say the end is nigh for the ESG beast. They do suggest that ESG is not immune from bubbles and that the feel-good magic is disappearing. If the ESG investing reversal continues, watch out. According to Bloomberg Intelligence, global ESG assets surpassed US$30-trillion in 2022; Europe’s, at US$14-trillion, represent almost half the total. More unravelling may yet come.

ESG has been around for decades and really took off after the landmark 2015 Paris climate agreement, when 195 countries agreed to limit global warming to two degrees Celsius above preindustrial levels – and preferably 1.5 degrees. ESG investing has not prevented those goals from being surpassed, though the investing method may have slowed the rise somewhat.

Europe’s Copernicus Climate Change Service this week reported that average temperatures for the past 12 months had climbed 1.63 degrees above preindustrial levels. In late May, temperatures in New Delhi reached 52.3 C (126.1 F), a national record high. Alarmed by the figures, United Nations Secretary-General António Guterres said the world needs “an exit ramp off the highway to climate hell.”

The rising temperatures do not mean that ESG investing, overall, has been a fraud, though it certainly has been overhyped, to the point that some funds have been guilty of greenwashing. The Deutsche Bank-owned asset manager DWS, which was accused by regulators on both sides of the Atlantic of marketing funds that were less green than advertised, comes to mind.

ESG needs a radical overhaul because the category is too broad, too nebulous and almost impossible to measure – the letters represent too many targets. ESG needs to be simplified and made easier to quantify.

Take Tesla, the world’s most valuable maker of electric vehicles (though, with the rise of China’s BYD, no longer the biggest). Despite the cars’ zero-emission status, the S&P 500 two years ago punted the company from its ESG index. Why? S&P was highly critical of Tesla’s workplace and governance standards, including alleged harassment and discrimination at its factory in Fremont, Calif. Meanwhile, S&P kept ExxonMobil, one of the world’s biggest privately owned emitters of greenhouse gases, in the index.

Something is wrong with this picture. Why do the S and G outweigh the E in this case and others? And how are the S and G measured? Their measurements seem subjective, whereas the E part can be measured by proven metrics such as carbon intensity, emissions output and progress on Scope 1, 2 and 3 emissions (the first is direct emissions; the latter two are indirect emissions).

Another problem is ESG greenwashing in corporate overhauls. Take the mining industry. For several years, big mining companies, including BHP, Anglo American and Canada’s Teck Resources, have been busy selling or spinning off their fossil-fuel assets, notably coal, to reduce their carbon footprints and pretty themselves up for ESG investors to make themselves less of a target for environmental regulators.

But these corporate clean-up acts do nothing to clean up the planet. The fossil fuels are simply burned by new owners, whose ESG credentials are often weaker than those of the sellers. Similarly, ESG funds love companies that mine critical metals such as copper, cobalt and lithium – essential elements for batteries and the transition to a low-carbon economy. But what if making batteries requires the eradication of forests to construct the mines, smelters, ports, roads and railways needed to produce, refine and export those metals?

There are no easy solutions to these questions, but let’s agree that each of the letters in ESG represents parameters that are far too broad to be measured accurately or fairly, to the point that the rankings lose their effectiveness. The immediate threat to life on Earth is excessive carbon emissions, which refuse to go down as the global population rises, industrialization is pursued and coal plants remain the power-generation tool of choice in developing countries.

So why not a simple “E” rating that measures a company’s emissions output? Easy to measure, hard to fudge – and capable of being understood by investors who have legitimately taken a cynical view of ESG.