ESG considerations as part of the investment process can be dated all the way back to the 17th century when the then asset owners, mostly religious groups, excluded activities involving certain ethical concerns from their investment list. Such practice continued with recent examples seen in the 70s and 80s as investors divested from military arms suppliers at the height of the Vietnam War and later from South African companies in support of ending Apartheid. Today’s ESG investing, while following the same spirit, differentiates from its predecessor in at least three ways:

  • While social concerns mostly drove the early form of ESG investing, today’s ESG has three pillars: Environmental, Social, and Governance, with ‘E’ attracting the most attention (and scrutiny) due to rising climate change concerns.
  • Different from its earlier adoption, which was mostly voluntary-based, today’s ESG investing is much more policy/regulation-driven. The UN has been at the forefront of this, including coining the term ‘ESG’, along with IFC via the famous letter Who Cares Wins. Since the 2015 Paris Agreement, a slew of regulations have passed, most notably the EU green taxonomy, which enforces ESG compliance across sectors and has pushed private-sector ESG adoption to a whole different level.
  • Today’s ESG investing is more data-driven. Many companies with an ‘ESG strategy’ have developed comprehensive frameworks to collect data and measure ESG with granularity.

The ESG industry is growing. However, the improvement of ESG centers mostly around practice, especially in compliance and reporting, and has yet to prove its impact in addressing the underlying concerns. From a value-generation standpoint, most ESG investors have failed to deliver value to their clients, both in terms of economic value and ‘ESG’ value: The performance of ESG strategies has lagged market returns, and very few ESG strategies have convincingly proved their ‘ESG’ impacts.

So why are most ESG investors failing?

As mentioned, one thing that differentiates today’s ESG investing from its traditional form is the data-driven component resulting from regulatory push: there is an alphabetical soup of regulations across jurisdictions pushing companies to disclose ESG data and mandating investors to adopt such data. While this data-driven approach creates more transparency and probably more so a common language to discuss and measure progress, does this truly generate value from an ESG impact perspective? Can data ever reflect ESG progress, let alone ESG impact?

Data, at its best, documents historical changes and encapsulates the current state. Unless specifically coded, data won’t account for any of the chain reactions an action may lead to in the future, nor will it detect an inflection point when a new pattern emerges. ESG issues are complicated, usually with unforeseen systematic impacts and ever-evolving mechanisms. These defining characteristics of ESG happen to be the exact blind spots of data.

Most ESG data are backward-looking, and most ESG professionals recognize this. In fact, the largest ESG data vendors these days, maybe with the exception of Bloomberg, leverage ‘human judgment’ on top of quantitative metrics to fine-tune the data. Many investment firms adopt a similar practice in-house, which, as claimed, gives them a ‘competitive advantage’ in their ESG measurement and investing. This only trades off one problem for another. Now, we’re dealing with the subjectivity of human biases! How many people do you think can convincingly defend their ESG domain expertise and the ‘fine-tuning’ they make? Nearly none. I actually think Bloomberg has a point in not trying to pollute their ESG data with human inputs compared to its two main competitors, MSCI and S&P.

Contrasting the increasingly nuanced and innovative approaches of collecting ESG data and measuring impacts, the final step of integrating ESG practices into the investment process looks surprisingly similar to its original form: exclusion. While many companies aspire to take a more active approach, either through investing in ‘impact-driven’ companies or engaging with companies that are not ‘ESG responsible’, the actions taken in this direction are very minimal: most ‘impact-driven’ funds struggle to survive due to their lackluster economic performance; ‘active engagement’ keeps getting pushed off the business priority list because of its resource-intensive nature. As a result, ‘impact investing’ and ‘active engagement’, while growing, only form a fraction of ESG practices, and most ESG investing these days still happens through ‘divesting’.

Divesting, at scale, following some generic data rules, is ineffective at best and damaging at worst. It’s ineffective because capital will find its way. Just because you divest doesn’t mean everyone else will. While ESG investors are shying away from fossil fuel companies, hedge funds are filling the void and pouring money to buy those stocks at a lower price point. The ‘exclusion’ movements in the 70s and 80s were effective because they happened in conjunction with the social campaigns that were taking place. ‘Excluding’ alone won’t work unless it can somehow send a signal to the market.

And when it does, it may even be the wrong signal. Because many ESG investors follow generic rules to divest without thoroughly examining the business, many divested companies are doing good for our society in the long term. In the ‘E’ world, for example, a handful of companies are deemed as non-ESG because of their historically large carbon footprints. What the data don’t say is their effort in transitioning their business model and, more importantly, their roles in enabling net-zero technology and deployment. One notable signal many asset owners tend to follow comes from Norges Bank, which oversees the Norwegian Sovereign Fund. It regularly publishes a list of companies that are excluded from their investment universe. Because of its credibility and large AUM base, many asset owners and asset managers refer to this list and often shy away from companies enlisted to avoid unnecessary controversy. However, when you look at this list, it actually includes a number of companies that are driving net-zero transition in a meaningful way. Top of this list is AES, the company that I came to watch in 2022 and decided to join in 2024. Started as an Independent Power Producer in the 70s, the company has been retiring its brownfield assets in the past decade and is at the forefront of both deploying renewable energy as well as innovating on clean energy technologies. Yet, because of the small coal assets that still stand on its balance sheet, which are set to retire in 2025, the company remains ‘excluded’ by Norges Bank and sees its stock price battered.

There are two fundamental issues that make ESG investing challenging: the false precision of using data to reflect ESG issues and impact, and the challenge of deploying ‘active’ ESG strategy for value creation. While ESG is a laudable effort in driving public attention and scrutiny to the sustainable and responsible practice of business through disclosure and compliance, its value, at least in its current form, in generating financial returns as an investment strategy is limited.