Do institutional investors around the world ‘walk the [ESG] talk'?

By Professor Pedro Matos from Darden School of Business, author of “Do Responsible Investors Invest Responsibly?”

No matter how one refers to it — “ESG” (environmental, social and governance), “responsible” or “sustainable” investing — the world is paying increased attention to investment decisions that include non-financial factors not captured by traditional accounting methods.

Many investment managers signal their acceptance of ESG investment principles by signing pledges such as the Principles for Responsible Investing (PRI), the UN-supported global network of signatory institutions, which currently represent over $120 trillion (£99tn) in assets under management. The rapid growth of the PRI and other ESG initiatives have led many industry observers to project that ESG investing will become mainstream in the not-too-distant future. But, despite all its progress, ESG finds itself at a crossroads.

One issue it faces, for example, is what is commonly referred to as “greenwashing.” This cleverly labelled term describes cases in which institutional investors (mis)label products — perhaps a mutual fund claiming to incorporate ESG factors — while the bulk of its investments fail to actually incorporate ESG.

This issue recently came to the fore in 2022 when the US Securities and Exchange Commission fined firms such as BNY Mellon and Goldman Sachs Asset Management for various ESG-related misstatements. Additionally, the German regulator BaFin investigated DWS Group (formerly Deutsche Asset Management), which resulted in police raiding the firm’s offices to gather information.

An anti-ESG movement may be on the rise, particularly in the US, with an effort among a few states led by conservative legislators. As an example, Blackrock received a letter concerning the state pension plans, challenging its prominent use of ESG criteria in making its fund investments. The criticism was that Blackrock — the largest asset manager in the world — had a “fiduciary duty” to consider only financial returns in its decision-making, leading some state treasuries to announce asset withdrawals from the asset manager.

In light of this ongoing debate, questions arise regarding how institutional investors actually go about implementing ESG principles. Questions such as: For those institutional investors who commit publicly to invest responsibly, do they actually do so in practice? Furthermore, do these practices translate into desirable ESG portfolio outcomes? These are important questions to investigate, as after all, the goal of responsible investing — allocating capital toward companies that make the world more sustainable — is only possible if investors live up to these commitments.

I examined this question in a recent paper Do Responsible Investors Invest Responsibly? (which was featured in The Economist). Together with colleagues, we investigated equity portfolios around the world to compare PRI-signatory institutional investors versus their non-PRI signatory counterparts. We also examined a unique PRI reporting dataset that allowed them to classify signatories across three groups: full, partial, or no ESG incorporation. We were curious about whether PRI signatory institutions “walk the talk” in terms of integrating ESG into their equity portfolio holdings.

The study compared what PRI signatories reported doing (in terms of ESG incorporation disclosed in their annual PRI reporting) versus their actual portfolio ESG scores (that quantify the extent to which their portfolio holdings reflect their ESG pledges). In other words, how sustainable are the stocks included in a PRI institution’s portfolio as compared to their non-PRI peers?

In taking this approach, we revealed that responsible investors (PRI signatory institutions) in fact do invest more responsibly than non-PRI institutions. And finally, we concluded that globally, external to the US, signatories with even partial incorporation of ESG frameworks into their active equity holdings have better portfolio ESG scores than non-PRI signatories.

Our study also illuminated interesting ESG incorporation approaches around the world. For example, ESG “screening” strategies (i.e., favouring or excluding stocks based on ESG criteria) are more commonly used in Europe, while ESG “integration” strategies (i.e., the inclusion of ESG factors into financial analysis, portfolio construction and risk management) are more popular among institutions in the US and other parts of the world.

A TRANSATLANTIC DIVIDE

Our research also revealed that outside the US, investment firms generally walk the talk when it comes to following through on their responsible investing pledges. On the other hand, in the US, we observed a substantial disconnect: we did not find improved portfolio ESG scores for PRI signatories in the US, including for those firms that report full ESG incorporation. In fact, US investment firms that signed the PRI but then did no implementation of ESG factors actually had worse ESG portfolio scores on average than US investment firms that did not sign the pledge.

I have concerns that this could indicate pervasive greenwashing in the US and speculated that our findings could be driven by a combination of factors such as: higher commercial incentives to become a PRI signatory; the regulatory uncertainty as to whether ESG investing is consistent with “fiduciary duties” that binds asset managers; and a less mature market and hence less pressure for ESG implementation in the US.

MOVING FORWARD

Overall, our results highlight that, especially in the US, retail investors would be well-advised to do more than simply rely on the “PRI signatory” label alone. This means conducting additional due diligence when evaluating a potential investment manager.

I would advise investors to look beyond simple ESG credentials and attempt to assess the extent of alignment between their asset manager’s responsible investing commitments and their actions. This approach not only would benefit retail investors but could also perhaps enable a less politically charged discussion around ESG investing both in the US and abroad.

Professor Pedro Matos co-authored “Do Responsible Investors Invest Responsibly?” which appeared in the Review of Finance, with Rajna Gibson Brandon of the University of Geneva, Simon Glossner of the Federal Reserve Board, Philipp Krueger of the University of Geneva and Tom Steffen of Osmosis Investment Management.