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Investors seeking to align their portfolios with climate science can be forgiven for experiencing a sharp sense of cognitive dissonance. In some respects, it has never been easier to be a sustainable investor: they can register for a sustainable investing platform; consult stock-or issuer-specific scorecards addressing every conceivable climate and social issue; and choose from ESG (Environment, Social, and Governance) funds of every stripe. But among this wealth of options, confusion abounds.
If a fund’s name includes ESG, what does that convey to investors about the way the fund’s managers consider or integrate ESG factors? How can investors compare different ESG funds when fund managers employ proprietary methodologies to account for ESG factors? And how to make sense of the various flavors of sustainability ratings that underpin this industry?
The sustainable investor’s predicament closely parallels that of consumers in the organic food aisle three decades ago. Even as demand for organic food swelled in the 1990s, the term “organic” remained unregulated which made it difficult for consumers to discern precisely what that word meant from one label to the next.
The similarities between the organic food and ESG investing movements run deeper. Both are fueled by a desire to address environmental concerns, whether by choosing foods that avoid pesticides’ adverse impacts on land and water systems (organic foods) or by favoring companies with credible plans to reduce their greenhouse gas emissions in line with climate science (ESG investing). Both movements are underpinned by an intention to align matters core to one’s long-term well-being—food and life savings—with one’s closely held principles.
But, these two movements also underscore that the road leading from the niche to the mainstream can be very bumpy indeed. When the market responds to exponential demand—whether for organic fruit or ESG funds—the initial results are frequently messy. A bounty of targeted products may flood the market to meet demand, but transparent standards are much slower to follow. It is in this interim period when the messiness becomes all too apparent: competing frameworks and certifications; customer confusion about the attributes of what they’re eating or investing in; fraudulent labeling or greenwashing; and, fueled by this disorder, a backlash against the underlying goals of the movements themselves.
It is abundantly clear that ESG investing is in the thick of this messy stage. According to Blackrock, Institutional investors worldwide representing $25 trillion in assets expect to double their sustainable assets under management over the next five years, highlighting the high demand for ESG investments and its lurch to the mainstream. But funds that name-check ESG are not considering ESG factors in uniform ways, leaving some ESG-motivated investors confused and others making erroneous assumptions about the impact their dollars will have. Even investors willing to do their own research may find themselves outmatched by the ESG rating industry: there are six major providers of ESG ratings, each with its own unique methodology. In fact, researchers from MIT’s Sloan School of Business found very little correlation among competing ratings for the same company. The cumulative result? Claims of greenwashing and a backlash against the industry (as followers of Elon Musk’s Twitter account can attest).
True, we’re currently in a particularly muddled period but that in no way means that it’s a prelude to ESG investing’s decline. Rather, it signals that ESG investing has reached an inflection point, indicating that the movement is advancing toward greater consensus and standardization.
Anyone who followed the rise of the organic food movement in the 1990s will notice a pattern repeating itself. In response to demand for foods grown in line with ecologically-based practices, organic farmland in the U.S. more than doubled during that decade and organic food sales grew at an annual rate of more than 20%. But, much like ESG investors today, consumers in the 1990s suffered from information asymmetry because “organic” had no fixed definition. Rather, the term’s meaning depended on the specific regulations of the state where the products were grown or the requirements of one of the dozens of private and non-profit organizations that provided their own certifications. As a result, consumers had no assurance that organic strawberries grown in New Jersey adhered to the same standards as those from California. The organic movement also suffered its own backlash, with critics deriding it as elitist, expensive, and not necessarily good for the environment.
Given these parallels, the organic food movement provides a guidebook for ESG investing’s path to the mainstream.
While the U.S. Congress passed the Organic Foods Production Act in 1990 with the intent of setting national standards for organic food production and marketing, it wasn’t until a decade later that the U.S. Department of Agriculture finalized the rules for defining what is organic, and developed a certification program to ensure compliance. In the interim, messiness was the norm: competing standards created confusion over what’s behind an organic label or how to address processed foods with multiple ingredients, and there was little enforcement.
Today, this market is mature and organic products exist comfortably alongside conventional foods in supermarket aisles. Thanks to national certification standards, shoppers can easily distinguish between organic and conventional products. Of course, the mainstream doesn’t mean market-dominant: despite an average annual growth rate of 9.5% from 2011 to 2020, organic products only represent about 5% of retail food sales in the U.S. (although the figure is higher for fruits and vegetables.)
ESG investing products will likely settle in a similar place, albeit with some key distinctions. Whether through regulation, legislation, or converging standards, investors will eventually benefit from a clear definition of ESG to help them distinguish between that corner of the market and the rest of the investible universe.
But here’s where the analogy gets complicated: choosing between an ESG fund and a similar fund without that designation will never be as straightforward as deciding between organic milk and a conventional carton.
After all, ESG is a much broader (and less binary) term than organic, encompassing environmental goals (GHG emission reductions, promotion of climate solutions); social impacts (reducing economic inequality, promoting racial and gender equity); and governance best practices (effective board oversight; comprehensive risk management), each with their own specific metrics. Still, the ESG label will come to mean something precise: the consideration of identified E, S, or G factors to meaningfully inform an investment thesis, security selection, and expected impacts.
Regulations are already being developed along these lines. In May 2022, the U.S. Securities and Exchange Commission proposed disclosure rules for funds that make ESG-related claims. The intent of this proposed rule is to create consistent standards for ESG disclosure so that investors can more easily compare ESG claims across funds.
Still, we should expect grey areas to persist, much as they continue to do in the food industry. Even today, consumers may struggle to define what a “USDA Organic” label encompasses (no synthetic pesticides and fertilizers; crop rotation; no genetic engineering) and what it doesn’t (locally grown; grass-fed; humanely raised). Moreover, supermarket shelves are full of products marketed as “natural,” a loosely regulated term that is commonly conflated with organic. It is perhaps inevitable that similarly fuzzy terms (like “sustainable”) will continue to be used in the investing sector.
These limitations aside, the only way to bring order to the ESG investing market is for a precise taxonomy to take hold and provide all market participants with a common understanding and set of expectations.
The organic food movement’s trajectory from a marginal and fractured corner of the U.S. food system to a mainstay of supermarket shelves underscores the mainstreaming effect of uniform, rules-based systems, and provides a useful roadmap for ESG investing in these rocky times.
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