The State of ESG….Part II…Where is Here?

In Part I, we discussed the evolution of themes and concepts on Wall Street and how over time, with each new iteration, the original concept gets diluted and the goal obfuscated in favor of higher fees, middling returns, and little to no investing goal achievement. These cyclical evolutions within Wall Street, and the risks they create, are nothing new. We have seen this movie before.

In this installment, we talk about the current state of ESG investing. We’ll include what some major players are saying and doing amidst the evolving landscape. We’ll show many digging in their heels, “all in,” while refusing to acknowledge any flaws or shortcomings in thesis or process as they push harder into the headwinds. We also touch on how this is compounding macro and micro risks.

“Greenwashing,” is a major smudge on ESG investing. This involves promising green initiatives while delivering none of it. It seems ubiquitous with much of current ESG investing.

In February, Morningstar saw $1Trillion worth of funds stripped of the “ESG” label for greenwashing.

More recently, DWS (the retail investment arm of Deutsche Bank) was raided for “Greenwashing.” A whistleblower called them out. She was fired and others lost their jobs. This surfaced on May 31st. In June, DWS issued their next ETF, “Net zero pathways Paris-aligned.”

This ETF purports to be the epitome of “Greenwashing,” but consider the alternative. Consider all those buzzwords in the word salad. DWS was raided for “Greenwashing” and less than 1mo later issued a brand-new ETF, doing essentially the same thing. ESG malinvestment leads to misinformation. Is DWS is doubling down?

As provider of the ESG Orphans Index and developer of the ORFN ETF, we know about listing an Index and filing an ETF with the SEC. It takes time, capital, and regulatory knowledge along with subject matter experts such as legal counsel and marketing teams. DWS likely started the Paris-aligned ETF in motion in Q1. Yet even before news of the raid had surfaced, they were ready with their next ESG ETF. Talk about a cottage industry.

In Q2, we attended an ETF conference where a prominent investment manager said that they had 60 ESG analysts. SIXTY!! That explains the high fees. It also underscores the depth and breadth of the ESG industry. To our further amazement, this manager then said they were forming their own ESG ratings’ platform on top of the current ESG ratings’ platform.

In our research, we dissected the ESG ratings’ agencies, and found many have different ratings for “E,” “S,” and “G,” for the same companies. MIT called ESG, “aggregate confusion.” Our research confirmed this. We found a lack of consistency across the ratings’ system. Recall our Part I discussion of Amazon (carbon footprint) and Mondelez (junk food/obesity & diabetes) and their big weightings in ESG funds. KO/PEP score high in “G” w diversity and equity, but fail miserably in “E” when they produce plastic bottles filled with tap water by the millions and are major contributor to Type II diabetes and obesity. They are in a majority of ESG funds.

Despite these inconsistencies due to a vague ratings system, this prominent ESG fund issuer is creating their own rating system on top of the current one.

At another recent ETF conference, a different well-known investment manager with trillions in AUM, said the same thing: They are creating their own ratings’ system on top of the existing framework.

In sum, two well-known asset managers are riding the ESG wave, collecting big fees, and are creating their own ratings’ system on top of an already flawed one. They’re building a new ESG foundation on top of ESG sand. Essentially, investors could own ESG funds from both managers and hold completely different securities.

Recall the credit rating agencies contributions to the Global Financial Crisis on the back of bogus ratings. We have seen all of this before in a slightly different form. As the industry expands, so do the conflicts, especially when fees are involved. This further pushes the narrative from the objective voice meant to guide ESG investing. The ESG managers are “all-in” on ESG and have nowhere else to go but forward into the headwinds.

Where are we now in the cycle? We like to think of Gandhi’s famous quip: “First they ignore you, then they laugh at you, then they fight you, then you win.”

Seems we are somewhere between steps 2 and 3 and scurrying towards #3 at rapid speed. The only question now is, how long before we get to #4?

We are starting to see contra-ESG noise get louder in the investment community, the public domain, and the political arenas. We expect migrations of investment flows and a reversal of preceding trends to continue as time passes. We are just starting to see ESG flows staunch and head for the exits. In June, Bloomberg reported $2Bln in ESG fund outflows. This seems to be just starting. One glidepath we envision, is money flows out of alleged ESG stocks and into the exclusions, the “Orphans.”

Political news to this effect is starting to percolate. Recently the SCOTUS moved to limit the EPA’s regulatory powers towards corporations. (Note the discussion on future ESG implications.) The SEC recently tried to increase ESG corporate scrutiny. After the recent SCOTUS ruling towards the EPA, we find it likely that the SEC may have to dial back their ESG regulatory aims.

At Constrained Capital, we feel this political wind shift is just starting. Government largesse may suffer and it makes us wonder about further blue/red, globalization/anti-globalization shifts and the impact. We don’t have a political horse in the race. We are simply gauging potential outcomes that can further affect risk/reward in ESG investing. We are trying to identify drivers and end results.

Constraints on capital result in malinvestment and misallocation of capital. Consider what has happened in fossil fuel and nuclear energy due to the higher cost of capital imposed by ESG exclusion. The result: Putin seized opportunity and now controls much of the energy flow into the EU. He took full advantage of ESG constraints on capital. To add “fuel” to the fire, proponents of ESG are digging in their heels, doubling down, and acting “pot committed.” This continues to exacerbate the risks on a macro and micro level.

This 2nd installment of our 3-part series focused on “Where we are” in ESG.

Part 3 will discuss what to expect going forward and how to start thinking about investing with this insight and knowledge for the coming next steps in the ESG evolution.

For more up-to-date and live time ESG-related news, follow us on Twitter:
@ESGOrphan and @MarkNeuman18

Mark Neuman, CFA, CIO/Founder, Constrained Capital  917 658 9369