You’ve probably heard of ESG, and may know it as a form of investing and finance that involves considering material financial risks from environmental factors, social issues and questions of corporate governance. If you’re like most people, you’re probably not clear on the difference between ESG and socially responsible investing, impact investing and similar, sometimes overlapping approaches -- in part because ESG has come to means different things to different people. That vagueness has helped fuel rapid growth in recent years. But with that growth has also come increased scrutiny from regulators cracking down on banks and investment firms making exaggerated claims. In the US, ESG has also faced backlash both from conservatives who deride it as “woke capitalism” and from insiders who say it isn’t creating the kinds of real-world impacts it seemed to promise. 

Here’s a guide to the basics.  

1. What’s the big idea? 

The broadest umbrella term for the strategy of which ESG is a part is sustainable investing. Proponents say the goals of sustainable investing, which covers fund assets valued globally at $2.7 trillion by Morningstar Inc., are to achieve societal impact, align with personal values or manage risks. And make money along the way, of course. 

2. Where did ESG come from?

The acronym was coined in the mid 2000s. A British law firm wrote a report for the United Nations Environment Programme Finance Initiative in 2005 that argued that the use of ESG factors in financial analysis was compatible with investors’ fiduciary responsibilities. The idea was that incorporating ESG data would help protect investments by avoiding material financial risks from things such as climate change; worker disputes and humans rights issues in supply chains; and poor corporate governance and resulting litigation. As time has passed, the label has come to be slapped on investments that run the gamut from predictable things such as owning renewable-energy stocks to things you wouldn’t expect, like funds that track benchmark indexes containing oil companies or assets in autocratic nations such as Russia. 

Estimates vary depending on what people count as ESG. According to Bloomberg Intelligence, assets are set to climb to $50 trillion by 2025 from about $35 trillion now. They have grown from $30.7 trillion in 2018 and $22.8 trillion in 2016, according to the Global Sustainable Investment Association. 

The popularity of ESG has depended in part on a belief that it will play a positive role in making the world a better place. But critics say that such a warm-and-fuzzy feeling helps asset managers blur a key distinction -- that ESG is mainly about using data to identify risks that might undermine investment performance, or to find opportunities to make money. That’s a contrast to some other branches of sustainable investment that sometimes go further: 

• Ethical and Values-Based Investing: These are broad strategies that enable investors to shun or invest in companies that reflect their political, religious or philosophical beliefs and values. Its earliest practitioners were religious groups such as the Quakers who shunned investments in things like alcohol, weapons and gambling. Church-affiliated groups in Sweden began the first ethics-based mutual fund in 1965. The Pax World Fund began in the US in 1971.

• Socially Responsible Investing: Galvanized by anti-Vietnam War protests, consumer boycotts of napalm producers and efforts to end apartheid in South Africa, a group of investors in the 1980s and 90s sought to do good by not only avoiding companies that harm society but investing in those that are improving their business practices. They may also focus on companies that are engaged in clean-technology efforts.

• Impact Investing: While socially responsible investing tends to focus on publicly traded companies, impact investing centers on private projects. It’s a niche strategy where investors target specific outcomes that can be measured, such as the promotion of sustainable agriculture or companies that provide affordable housing.

• Systems-Level Investing: A nascent strategy that has yet to take off in a big way. As people increasingly point to the failure of ESG in catalyzing large, real-world impacts, they are looking at systems-level investing. This involves making decisions that take into account the entirety of one’s portfolio and how its elements intersect across all assets in the long term. An example would be climate change: A systems-level approach would examine how it affects entire portfolios, from shares in energy and insurance companies to sovereign bonds and foreign exchange. Systems-level investors are then meant to work with other investors to collectively push companies to improve their business practices by creating industry standards, sharing data with other investors and pressing for public policy changes.

5. What do critics think about ESG?

Some think the term has become so broad as to lose much of its meaning. Many point to the prevalence of greenwashing, which happens when companies exaggerate the environmental benefits of their actions. Even the man who coined the acronym has said the finance industry has sprinkled “ESG fairy dust” on products that don’t merit the label, and that there will be an industry shakeout in the coming years. Other criticisms focus on the way fund managers rely on ESG ratings that rank companies by how they are performing on ESG factors. There is a lot of inconsistency in those scores -- in some cases, companies are ranked by the risks that ESG factors pose to them rather than, say, the risks the companies pose to the environment and society. 

With the ESG label now widely used by money managers and bankers selling everything from mutual funds to complex derivatives, European and US regulators are clamping down on firms exaggerating their ESG bona fides. In May, German authorities raided the offices of Deutsche Bank AG’s fund unit amid allegations that it overstated its ESG capabilities to investors. The following month, it emerged that US regulators are looking into whether ESG funds sold by Goldman Sachs Group Inc.’s asset management group are in breach of ESG metrics promised in marketing materials.

The US Securities and Exchange Commission proposed a slate of new restrictions in May aimed at ensuring that ESG funds accurately describe their investments, and which may require some money managers to disclose the greenhouse gas emissions of companies they’re invested in. These proposed rules come off the back of new laws in Europe, the Sustainable Finance Disclosure Regulations, where investments have to be labeled under categories commonly referred to as “light green” and “dark green,” according to the priority placed on sustainability.

8. Does sustainable investing actually make a difference?

A cohort of ESG executives and academics have bemoaned the lack of far reaching and long-term impacts the strategy has had. Of course, sustainable investors have made some strides, such as pressing companies to reduce their plastics use, addressing workers rights and performing so-called civil rights audits. They have also succeeded in replacing directors on Exxon Mobil Corp.’s board to help the oil giant position itself towards cleaner fuels. Other proponents have said that had investors in U.K.’s Deliveroo Plc taken ESG issues into account, they could have avoided losses after the company faced a backlash over gig-economy exploitation and worker pay last year. Still, detractors say the idea that ESG investment alone is enough to address complex problems is being shown to be wrong and that more government intervention is needed to address societal issues such as living wage minimums and greenhouse gas emissions.

9. How do these approaches stack up in terms of investment returns?

Across three categories -- Europe-focused, US-focused and global — ESG large-cap equity funds have done better this year, on average, than their non-ESG counterparts. While they have lost money -- in line with the broad market selloff -- those losses are smaller. Globally, ESG funds are down 11.7% this year through June 10, compared with the 14.8% slump of the MSCI World Index. But there have been some early signs that investors are souring on ESG. They pulled a record $2 billion net from US equity exchange-traded funds in May, ending three years of inflows, according to Bloomberg Intelligence.

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