The Upside of ESG Backlash

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Aaron White, vice president of sustainable investments at CIBC Asset Management.

In the last several months, we have seen an increase in the backlash against ESG, both in media and from regulators and governments around the world, but particularly in the United States. In the U.S., several state governments instituted legislation aimed at targeting ESG and how it is used by institutional investors. This was led by Florida and Texas and has been joined by over 31 total states having introduced some form of anti-ESG legislation.

In Florida, Ron DeSantis spearheaded legislation that focused on limiting staff to consider only financial factors in their decision making. In Texas, the focus was on calling out investment managers that spurn energy companies, which may prevent them from managing any state capital. The key theme here was to politicize the ESG space by creating confusion as to the intent of various forms of ESG investing and to lump all approaches into one category.

This calls for a reaction to the politicization of ESG by redefining what ESG is and how investors are considering material non-financial risks in their assessment of companies. By getting back to basics and recognizing the bulk of ESG is intended to make better financial decisions, the industry can push back against the perception that ESG is solely about affecting change, regardless of the impact to the financial and investment returns.

Some jurisdictions continue to move forward with their approach to ESG, regardless of the media attention, recognizing the benefit to stakeholders of considering all material factors within the investment process. And some, including California’s largest state plans, proceeding with their ambition to net zero by 2050. An acknowledgement that climate is a real investment risk and the largest asset owners globally play an important role in facilitating a climate transition to both the benefit of society and their investors.

We’ve also seen a move by regulators towards enforcement action with regards to greenwashing. Enforcement, up until this point, has been focused on investment managers that are making unsubstantiated claims as it relates to their ESG work. Key examples being cases where the manager changed the objective of an existing fund and did not have any ESG objectives prior and kept the track record within various databases. Another investment manager that claimed in their materials that all holdings in the fund had proprietary ESG assessments, and an audit revealed that it did not.

The key theme here being that regulators are looking for transparency on both the ESG objectives and processes that a manager will employ, and that there is evidence that the manager is adhering to those statements. Most of these enforcement actions have taken place in the U.S. and the E.U., but the CSA and the OSC have made it very clear that they will be looking for the same type of authenticity in communications and actions here in Canada. We can expect the release of more explicit guidelines in 2023, helping managers understand their regulatory responsibility.

For advisors, it’s very important to understand and document a client’s objectives, including those that are ESG or non-financial. Our recommendation is to redefine the KYC process following some of the guidelines that IIROC released earlier this year indicating that you should consider whether a client wants to invest alongside their values or invest with any ESG objectives in mind. It’s really important to understand the methodology of the investment solutioning that you’re offering to meet these objectives and to be able to clearly communicate and report to clients on this.

Investors, on the other hand, should look to managers and how they disclose around their approach to ESG risks embedded both within the organization and the processes that they employ. And, should seek managers that are transparent about the solutions they offer and how they deliver on the stated outcomes or intent of the specific investment solution.

Overall, the ESG community is receiving backlash from every angle: investors, companies, regulators, red states or blue states in the U.S. And while ESG is truly about better identifying risks and opportunities, it has been co-opted by people who use it as a marketing tool. The reclassification of ESG funds without meaningful changes in holdings has increased fund flows and sounded alarms for both regulators and investors.

As the market evolves, it will naturally expose greenwashers and investors will receive increased transparency and be able to make more informed decisions. The backlash will inevitably be good for ESG as the increased scrutiny creates better alignment on the stated outcomes and objectives of how we invest.