ESG’s dirty secret

In 1976, Dame Anita Roddick had a novel business idea: could she make a profit, while also doing good?

The mother-of-two set up a cosmetics store, The Body Shop, in Brighton that year. Its products were sold in reusable bottles, made with ethically-sourced natural ingredients, and not tested on animals. It was an immediate hit with customers: by the 1980s, Roddick was opening a new store almost every couple of days.

Investors, too, bought into the company’s ethical brand. The Body Shop listed on the London Stock Exchange in 1984, later distributing annual reports to shareholders assuring them that “profits and principles can go hand in hand”. By 1992, its shares had increased almost fourfold, earning them the nickname “the shares that defy gravity”.

Then, after hitting a stock market peak in the early 1990s, the company was hit by scandal. Business Ethics, a US magazine, alleged it was built on a “shattered image”: The Body Shop’s claims about using natural ingredients, sourcing materials from developing nations, and donating profits to charity were all exaggerated. The Body Shop furiously denied the allegations, but the damage was done. Its shares dropped 15 per cent before the article was even published, as rumours of the magazine’s findings circulated and it emerged that the Federal Trade Commission had launched an investigation. One fund manager sold its entire 50,000 shareholding.

The stock’s downfall was as unique as its ascent: investors were not spooked by falling revenues or squeezed profit margins. They were concerned that The Body Shop was not as nice as it made out.

But Roddick’s empire was just the beginning of the story. Almost three decades later the ethical business movement is stronger than ever; aligning profits with principles no longer seems such a novel idea. In the last year alone, hundreds of the world’s biggest companies have rushed to declare their support for Black Lives Matter, launch diversity initiatives, and acknowledge their debt to workers and the planet.

In 2017, following a decade of ownership by cosmetics group L'Oréal, The Body Shop was bought by Natura (US:NTCO), a Brazilian company that seeks to “promote the well-being of people, animals and the planet”. Now the fourth-largest beauty conglomerate in the world, it owns four international cosmetics firms that all sell themselves on their socially-conscious branding. Its shares are up almost 300 per cent in the years since acquiring The Body Shop. 

Natura has been joined on that ascent by listed plant-based food producers, electric car manufacturers and myriad other companies across different sectors, as more investors pick shares not based on their financial valuations, but on perceptions of companies’ social and environmental responsibility.

Faced with this dramatic shift in investment attitudes, even the former bad boys of business are keen to burnish their ethical credentials. In recent years, the world’s leading fund managers and banks have started bundling shares in companies with good environmental, social and corporate governance (ESG) practices into their own investment products. As the shares held by these so-called ESG funds continue to rise, City firms are enticing investors with the win-win pitch that what’s best for the planet is now also best for your wallet. 

A lot of cash is now banking on this hypothesis. Last year, assets managed by ESG funds reached $1.7tn (£1.22tn), having soared 50 per cent since the end of 2019, according to data provider Morningstar. But as the history of The Body Shop shows, ESG investing comes with unpredictable risks, as well as rewards. Even now, it is not clear if investing with your heart is the best long-term decision for your money.

Is ESG a good investment?

On a Monday afternoon in the autumn of 2019, employees at BlackRock’s (US:BLK) London headquarters saw a startling display. The offices of the world’s largest fund manager were blockaded by climate protesters from Extinction Rebellion: some glued themselves to the glass doors, while others ate banknotes off dining plates. Long the enemies of Big Oil, environmental campaigners were now targeting a company they saw as the “number one investor in fossil fuels”.

That same year, BlackRock CEO Larry Fink was disturbed by a no less dramatic sight on a trip to Alaska, the annual destination for his summer jaunt with other finance leaders. Arriving in the normally tranquil wilderness of Lake Iliamna, he was shocked to find that smoke from nearby wildfires had filled the atmosphere, obscuring the sun. 

The alarming scene caused his mind to “click”, according to a recent article in the Financial Times. Nearly 40 years after Roddick, Fink realised that profits could be aligned with the destiny of the planet: the same destruction he now saw wreaking havoc on the climate would potentially hit asset prices too.

Since then, funds geared towards green companies have increasingly populated BlackRock’s multi-billion dollar universe of passive investment products. The firm now has more than one hundred index and exchange traded funds in its “sustainable” range, four of which have amassed more than $5bn in assets each. “Climate transition presents a historic investment opportunity,” Fink declared in January. 

Investors have been persuaded by this winning pitch, as ESG funds already show signs of outperforming the wider market. Last year, Morningstar found nearly 60 per cent of these funds had beaten their conventional peers over the past decade. 

But Fink’s statement can also be seen as a marketing pitch that his firm uses to sell products, and the recent success of ESG funds belies some of the more complex forces at play. The revolution in government policy that would turn the greenest companies into industry leaders is yet to happen, so much of the outperformance to date has little to do with an actual “climate transition”.

BlackRock’s ACS World ESG Equity Tracker Fund, one of its largest sustainable funds, outpaced the broader market last year while following an index of “low carbon” stocks: its top five holdings are Apple (US:AAPL), Microsoft (US:MSFT), Amazon (US:AMZN), Facebook (US:FB) and Google’s parent company, Alphabet (US:GOOGL). High-flying technology firms like these regularly sneak into “green” portfolios, but their growth has more to do with the tech boom than their carbon footprint.

The recent success of ESG products can also be partly explained by the sheer amount of money flowing into the market: the value of shares goes up because people are buying them, not necessarily because of a company’s financial performance. And investors have been buying a lot of ESG stocks. 

Even after their recent correction, shares in one of the most popular, Tesla (US:TSLA), are up fivefold in the past 12 months, leaving the electric carmaker trading on a mind-boggling valuation of 109 times 2022 earnings. Beyond Meat (US:BYND), another vanguard of the green business movement, is up 71 per cent over the same period – never mind that the plant-based food producer is still loss-making. Collectively, the 50 most popular ESG stocks trade at a 33 per cent premium to the wider market, according to research published by Bank of America (BofA) in January.

Investors are already valuing ESG companies as if they are industry leaders, when in reality many remain small players in their respective sectors. Today, electric cars don’t come close to sales of oil-guzzling motors. Although vegan food is becoming more popular in western countries, its market share globally remains minuscule, with meat consumption continuing to grow across Asia.

But, despite their optimistic valuations, the money keeps flowing into ESG stocks. Fund managers are only stoking the demand, launching dozens of new products each month as they look to profit from the frenzy. In the last quarter alone, a record 196 ESG funds entered the market, according to Morningstar. PwC has estimated assets in these investment products will outnumber those in conventional funds by 2025. 

As share prices grow ever more detached from current earnings – as well as realistic expectations of future earnings – some warn that the market is becoming dangerously overheated.

Peter Bisztyga, an analyst at BofA, says researchers at the bank “have been big bulls on the whole renewables theme”. But this year they were forced to downgrade their view on two of the biggest players, after shares in utilities firms EDP Renovaveis (PT:EDPR) and Ørsted (DK:ORSTED) both rallied more than 40 per cent in just a few months.

“We were scratching our heads a bit, going: ‘What the hell is going on here? That stock is going absolutely insane,’” says Bisztyga. “We have been a big fan of Ørsted. But I just couldn’t keep it on a buy.”

After some head-scratching, the analysts put their finger on the main culprit: a “clean energy” ETF, which held the two stocks as some of its top-weighted companies. Inflows into this fund had increased fourfold to almost $2bn in the fourth quarter, as incoming US President Joe Biden pledged to ramp up green investment, spurring a flurry of excitement about renewables. But the researchers warned that those inflows meant share prices no longer reflected their assessment of companies’ fundamental value, adding there was now a “bubble” in some of the most expensive stocks.

The firm selling the clean energy fund driving this market distortion? Fink’s BlackRock.

Is ESG actually doing good?

Like a lot of people, Simon Youel has been saving money during lockdown, so he decided to try his hand at investing. But unlike those who piled their savings into Tesla and other hot stocks, he invested in precious metals, as a “hedge against the stock market”.

Asked whether he was tempted by the ESG funds that have also surged in popularity, he admits buying silver and gold was “probably not very ESG”. But, he adds, “the stock market is for making money, it’s not about helping the environment”.

Youel is head of policy and advocacy at Positive Money, a not-for-profit group that campaigns for “a more fair, sustainable and democratic economy”. Given his career choice, he admits maybe he should be investing differently. “But I don’t see many good options,” he says, pointing to the prevalence of “greenwashing” in the market. ESG investments “are being sold as the panacea: ‘This could be the solution.’ But I don’t think it will be”.

Amid signs of a market bubble, doubts about the financial benefits of ESG are being murmured across the world of investing. But Youel’s scepticism raises a more counter-intuitive question: is ESG investing even that good for the planet?

Just a cursory look through the holdings of top ESG funds raises doubts about how responsible these products really are. The technology sector may be less carbon intensive than Big Oil, but Big Tech firms have faced their fair share of competition, workers’ rights and privacy scandals. Can their prominence in ESG funds really be justified?

Ethics are subjective, to an extent, but critics say many investment products are wilfully misleading. During the final three months of 2020, Morningstar said at least 219 funds rebranded by adding terms like “sustainable”, “ESG” or “green” to their names. Some may have genuinely revamped their investment strategy, but concerns about misleading marketing are rife. In December, think-tank Common Wealth found a third of low-carbon funds sold in the UK were invested in oil and gas companies. 

Earlier in the year, after Boohoo (BOO) was hit with reports of dire working conditions in its supply chain, it emerged that 20 funds that purportedly aimed to invest sustainably had been invested in the fast-fashion retailer. Before German payments company Wirecard disclosed a multiyear fraud in June, ESG ETFs sold by BlackRock and Vanguard were both invested in the firm. Boohoo’s shares lost nearly half of their value in the days after the allegations were made; Wirecard filed for insolvency.  

Two of the biggest business scandals of the year proved poor social and governance standards do have a material impact on shareholders. But they also showed ESG investing may not be smart enough to avoid the risks.

Many of the ESG products invested in Boohoo and Wirecard were passive funds, which have exploded onto the market as the responsible investment mania meets the growing demand for cheap funds not run by human managers. These products tend to track indexes of stocks based on scores dictated by ESG ratings providers; one of the most popular providers, MSCI, had given a middling ESG score to Wirecard and awarded Boohoo its second-highest rating – ranking the retailer among the top 15 per cent of its peers. 

Critics say ratings providers assess companies through box-ticking exercises and obscure algorithms, so can overlook issues that are transparent to the human eye: Boohoo and Wirecard had been the subject of controversial reports long before last year’s scandals. But even active fund managers and individual stockpickers have to struggle with the limited data available from businesses themselves. 

Listed companies around the world are legally required to publish regular statements on their financial performance, with international guidelines dictating how income and profit are measured. But despite the huge amount of money being staked on companies’ ESG practices, reporting on these standards is patchy at best. Much like in The Body Shop’s golden days in the 1980s, investors are highly dependent on what companies choose to reveal about themselves.

The Reporting Exchange, an online platform, has identified at least 160 voluntary ESG reporting standards and 64 different standards-setters worldwide. There is growing pressure on these organisations to converge, and for regulators globally to write a single set of guidelines into law. But as Janine Guillot, CEO of one of the more popular standards-setters, the Sustainability Accounting Standards Board, told the Investors’ Chronicle last year: the evolution remains in its “chaos phase”.

Regulated ESG accounting should reduce the risks of greenwashing, but a universal standard could be years in the making. Even if more transparent data were available, Youel suggests he would still doubt the market’s ability to pick the best solutions for countering climate change.

The main issue with ESG investing, he says, is the disconnect between what people are investing in and what climate scientists say needs to happen. “I get sceptical when we see ESG investing in electric cars. Fundamentally that is not the solution. We cannot just switch all cars for electric cars.”

Despite paying more attention to companies’ environmental and social standards, ESG stockpickers and fund managers are still ultimately in pursuit of the bottom line: they buy shares in the nice companies that they think will generate the most income in the future. This, environmental economists say, is a counterproductive approach to saving the planet. The climate transition requires huge investments in projects that are often the least profitable, such as sustainable public transport. 

You cannot “have limitless growth on a planet with limited resources”, says Youel. “We need an approach that is not dependent on people only investing with the expectation of future returns.” 

Roddick once said as much, nearly two decades after making what she described as one of her “biggest mistakes”: listing The Body Shop on the LSE. “There’s a fascism attached to financial institutions, which only look at a very unimaginative bottom line,” she said. Today, ESG investors are placing more value on companies’ non-financial performance, but they haven’t lost their hunger for profits. By increasingly overvaluing their favourite stocks, they may also be overestimating how much more the bottom line for these companies can grow.