The strategy known as ESG (environmental, social and corporate governance) investing has grown by leaps and bounds – and landed in hot water.

Its focus on environmental factors, social issues and questions of corporate governance had always attracted people drawn to progressive causes. But in the US, that association with liberalism has triggered a backlash from Republican Party politicians, with efforts underway in about 20 states to rein in ESG.

At the same time, states led by Democratic Party officials have been pushing the other way, joined by activists who are quick to call out anything they see as ESG backsliding.

What is ESG?

It is a particular thread in the broader field known as sustainable investing. The original concept was that using ESG criteria would help protect investments by avoiding material financial risks from things such as climate change, worker disputes, human rights issues in supply chains and poor corporate governance and resulting litigation.

But as time passed and the field has grown – according to Bloomberg Intelligence, global ESG assets stand at about US$35 trillion – the label has come to be slapped not only on funds that invest in things like renewable energy stocks, but onto funds that track benchmark indexes containing oil companies or assets in autocratic nations such as Russia. 

What is the backlash against ESG?

Many Republican officials deride Wall Street’s ESG policies as “woke”, turning a term progressives coined to convey awareness of racism’s role in society into an insult akin to “politically correct”.

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When Donald Trump was president, the Department of Labor issued a rule saying managers with fiduciary responsibility for retirement funds should not base their decisions on anything other monetary considerations, a step that is being rolled back under President Joe Biden.

But most of the action has come at the state level, where Republican-controlled governments have banned state pension funds from using ESG criteria, or investing or doing business with entities they see as boycotting fossil fuel or gunmaking companies.

• In announcing investment restrictions, Florida Governor Ron DeSantis said that Wall Street firms were trying “to implement policies through the boardroom that Floridians reject at the ballot box”.

• In October, 19 state attorneys general announced an investigation into the six largest US banks for joining a United Nations coalition whose members pledge to align their financing with net-zero emission goals, saying they may be violating consumer protection laws.

• Republican-led Missouri and Louisiana pulled more than US$1.3 billion in state funds from BlackRock, the world’s largest asset manager and Wall Street’s biggest ESG champion.

• There are also likely to be hearings on ESG on Capitol Hill. Representative Patrick McHenry, the top Republican on the House Financial Services Committee, said the panel plans to probe the issue in 2023 if his party wins control of the chamber in the 2022 midterm elections.

What have ESG funds said in response?

Some have criticised the Republican measures as anti-free market, saying they amounted to barring funds from pursuing investors’ economic preferences because of conservative political support for oil and gas (O&G). Using ESG factors, they said, actually helps them meet their fiduciary duties.

A study co-written by a Federal Reserve economist concluded that a 2021 Texas law barring the state from doing business with banks it sees as boycotting O&G companies will raise its borrowing costs by hundreds of millions of dollars.

BlackRock has defended its policies, arguing that “taking a forward-looking position” generates better long-term returns. At the same time, it has played up the fact that it is one of the world’s biggest energy investors, with more than US$100 billion in Texas companies, and is ExxonMobil’s second-largest shareholder with a stake of more than 6 per cent. 

What pressure is ESG facing from progressives?

In a sign of how politically fraught the subject has become, BlackRock’s attempt to blunt Republican attacks led New York City Comptroller Brad Lander, a Democrat, to say he was “reassessing” the city’s business with the company.

Some progressives think the term ESG has become so broad as to lose much of its meaning. Many point to the prevalence of greenwashing, which is when companies exaggerate the environmental benefits of their actions.

Even the man who coined the acronym, Paul Clements-Hunt, who now runs an advisory firm called Blended Capital Group, said the finance industry has sprinkled “ESG fairy dust” on products that do not merit the label.

Greenwashing charges have led to tougher stances by regulators in the US, UK and in the EU, where funds will now have to label themselves as “dark” green, if ESG is the fund’s objective, or “light” green, if ESG is merely “promoted”.

Amid all these cross-currents, investors may be voting with their feet, if a sharp drop in the number of new ESG funds being rolled out is an indication.

What are ESG returns like?

Global ESG exchange-traded funds are slightly outperforming benchmark indexes this year, according to Bloomberg data. About 56 per cent of US sustainable funds beat rival category groups in the three years ending September, according to Morningstar. BLOOMBERG