After the ESG party

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Controversial in terms of its performance, credibility and political direction, sustainable finance is going through a growth crisis and is becoming clearer and more integrated into the landscape

In July, the Financial Times published a documentary entitled Who Killed the ESG Party?  The film prompts us to revisit the period when ESG experienced a huge boom, catalyzed by the signing of the Paris Climate Agreement (2015) and culminating through to the launch of the Glasgow Finance Alliance for Net Zero (2021). Subsequently, assets managed with environmental, social and governance (ESG) factors in mind have grown massively, investment products and specialist jobs have been created, and intense communication and marketing campaigns have been launched.

But then killjoys crashed the party: the warmongering politician, the whistleblower, the repentant manager, the opinion journalist. The tide has turned: the energy crisis following Russia's invasion of Ukraine, the underperformance of some green investments, greenwashing scandals, opposition from a section of the American right.

The decline thesis

Recent developments may indeed support the thesis of ESG’s decline. The S&P Global Clean Energy Index has dropped more than 50% since the start of 2021, while conventional indices have risen. Since the end of 2022, assets under management in U.S. sustainable funds have been decreasing, with a record outflow of $9 billion in the first quarter of 2024. Moreover, in 2024, the number of ESG resolutions approved by a majority U.S. shareholders fell, and large asset managers have been withdrawing from pro-climate shareholder coalitions.

However, there are positive signs that sustainable finance is gaining traction.  Published this month, a document from the European Central Bank reveals that banks are charging higher interest rates to companies with high greenhouse gas emissions (+0.14%) and to those lacking strategies to reduce their emissions (+0.2%).

Securities fraud

In late July, a Californian judge upheld a complaint against Wells Fargo for lying about its efforts to promote diversity, equity and inclusion (DE&I). The bank allegedly conducted job interviews with women and ethnic minorities solely to showcase its concern for diversity, even though the positions had already been awarded to white men.

The court decision was based on Wells Fargo’s voluminous documentation of its diversity policy, which the bank itself described as essential to its long-term success. This prompted a Bloomberg commentator to speak of securities fraud, allowing shareholders to seek compensation for the drop in Wells Fargo's share price following the revelation of the scandal.

In Great Britain, a court found the retailer Next guilty of wage discrimination against 3,500 female workers in late August, a case that, according to several commentators, has become ‘material’ for investors.

Lending further credence to resilience of sustainable finance, a report by the Institute for Energy Economics and Financial Analysis, based on Morningstar data, revealed that, on average, ESG funds generated higher returns than traditional funds in 2023. Similar studies have previously emphasized the resilience of ESG investments. In Europe, flows into sustainable funds remain positive.

Regulatory developments

On the regulatory front, changes are underway globally. For both large corporations and asset managers alike, the publication of ESG indicators is becoming a legal requirement. According to Eric Pedersen of Nordea Asset Management, this development “will continue to support investor aspirations in terms of sustainability”.

Who Killed the ESG Party? does seemingly carry negative connotations. Notwithstanding, the documentary ultimately points to a promising future for sustainable finance. For Nicolai Tangen, CEO of the Norwegian sovereign wealth fund, “If you are a long-term investor who cares about financial performance, you have to take climate risks into account. You need to consider board diversity, because companies with diverse boards generally perform better.”

The film also features HSBC alumnus Stuart Kirk, who observes, “ESG has been presented as both a risk management tool and a measure of corporate virtue, which is a source of misunderstanding; it's a fundamental problem that's still present in the industry.’ Kirk predicts that in the future, ESG integration will seamlessly interweave with the existing investment process, whereas funds aiming for positive impact will be explicitly cautioned with the label: ‘This goodness may affect your return.’

Sustainable finance has survived its youth, matured beyond its formative years and has transitioned from adolescence into adulthood, establishing its presence and influence within the financial sector. Today, sustainable finance has emerged as an indispensable tool for investors, serving their interests and values. ESG issues – such as climate change, diversity, and pay equity – are moral questions that will eventually acquire financial significance, a concept known as dynamic materiality. The evolution of sustainable finance is shaped by political, regulatory and legal contexts. Whether they focus on risk management, their values, or a combination of the two, we're betting that investors will be increasingly sensitive to ESG issues in the future.