Since the early noughties the integration of environmental, social and governance (ESG) factors into investment processes has grown from being a niche initiative to a global phenomenon. More recently, however, the term is facing a reckoning with critics arguing that it is too opaque and open to greenwashing

Words: Will Moffitt

The integration of environmental, social and governance (ESG) factors into investment processes has a long history, but the term was officially coined in 2004 during a period of frenetic global change when the rigid delineation between environmentalism and finance began to blur.

Kofi Annan, the then secretary-general of the UN, asked 50 global chief executives to support sustainability causes. To track progress the initiative suggested in a report that ESG metrics be monitored. Though radical at the time, the term is now ubiquitous in financial circles and a global phenomenon. By May 2021, ESG was mentioned in almost a fifth of earnings calls according to analysis by asset manager Pimco.

“ESG started off strictly as an investment term. It wasn’t really about impact, it was about risk management. What ESG risks are companies exposed to and how might that affect their valuation,” says Simon Oswald, senior manager within PwC’s Sustainability and Climate Change team. “It’s grown far beyond that now and it's become a catch all term for whatever people want it to mean.”

According to a recent survey by PwC, ESG funds will surge to nearly $34 trillion by 2026. As Oswald sees it, a desire to improve returns and respond to broader societal expectations around issues such as climate change have redefined the financial landscape. Key players such as Mark Carney, the former governor of the Bank of England, have been instrumental in shifting the issue from an ethical principle to a financial obligation. The end result is a belief within the investor community that ESG performance and financial returns, rather than conflicting, go hand in hand.

Simultaneously the great ‘ESG rush’ has been met with growing cynicism and opposition, with critics arguing that the ESG moniker is too opaque and vulnerable to greenwashing. The Deutsche Bank scandal, in particular, marked the first time that an asset manager has been raided in an ESG investigation.

Regulators such as the Financial Conduct Authority (FCA) have responded to these concerns by introducing proposals to clampdown on the labelling of ESG financial products. In October, the FCA said that firms will be forced to justify labels like ‘ESG’, ‘sustainability’ and ‘green’ against objective criteria.

For Oswald the fact that the term now “means all things to all people” is both its greatest strength and weakness. “The lack of a robust definition for ESG means that there’s a lack of consistent standards and a lack of transparency which means that labelling products as ESG has ballooned across the market.”

Some argue that the ESG moniker isn’t always useful. Hannah Leach, a partner at Houghton Street Ventures, a venture capital firm partnered with the London School of Economics, says that the term can be misleading and that existing ESG frameworks are ill suited and often irrelevant to nascent and fast-growing venture capital firms. To this end: Leach co-founded VentureESG in July 2021 to promote and help venture capital firms tailor and integrate ESG practices into their end-to-end processes. 

“We don’t really believe in the term ESG investing, we believe that every investment should take ESG factors into account,” Leach says, arguing that often people laser in on the E in ESG and forget the rest. At VentureESG the term extends far beyond climate and encompasses areas such as treatment of employees, good governance practices and inclusivity.

Hannah Leach, a partner at Houghton Street Ventures

“We’re saying to the VC funds that they have a responsibility to make sure that those businesses are being built in the right way, that those founders have the right kinds of attitudes and values,” Leach says. “We can provide the tools and resources to help them implement those values.”

While Oswald cites the clampdown by regulators such as the FCA as “welcome and probably needed”, he also sees the tightening of requirements as an added layer of red tape to an “alphabet soup of standards, reporting requirements and regimes”. “The last thing that investors in the UK want is to have to respond to multiple different regimes so there needs to be a degree of interoperability there.”

“Transparency is key and companies that do that best will be able to maximise return over and above their peers,” he adds. “I think that the very best companies will go over and above the FCA’s mandatory requirements and engage in a genuine dialogue with stakeholders.”