Humble Beginnings

ESG constitutes an investment approach, increasingly popular within the financial industry, whereby funds and other investment vehicles incorporate measures of companies’ environmental, social, and governance impact into their investment decisions. The antecedents of ESGs can be traced back to religiously inspired investing practices, like Quaker funds that refrain from investing in gambling or alcohol, or the divestment campaigns organized by the anti-apartheid movement.

Divestment has been widely popular in campaigns for human rights as well as in the antiwar, LGBTQ, and environmental movements. Its effectiveness has been widely debated, both in academia and in social movements. Most empirical research identifies some impact, but no drastic changes, and many on the Left have rejected divestment as a market-based approach to inherently political conflicts.

The contemporary trillion-dollar ESG industry bears little resemblance to these humble, idealistic beginnings, however. Early on, small firms like the London-based Ethical Investment Research and Information Services Ltd. (EIRIS), founded in the 1980s, conducted research for institutional investors keen to shape their investment practices in line with their morals; faith-based institutions and charities were among the principal clients. Research facilitating socially responsible investment began in earnest in the United States in 1988. KLD Research & Analytics was among the so-called first movers in that market, a small agency devoted to its task of pushing the private sector toward sustainability and equity.

Over time, these idealistic, less market-oriented firms were acquired by larger companies, the industry developed, and piece by piece they merged into large ESG fund conglomerates. The earlier, ostensibly ethical values–based approaches for measuring companies’ ESG performance were gradually replaced by financial worth–based assessments — which were much more useful for the financial industry.

Estimates of the ESG industry’s size vary widely, mostly due to a lack of coherent regulation or definition, and the current state of affairs in the sector has been described as the “Wild West.” Despite this confusion, analysts and scholars widely agree that the ESG sector has constantly grown in size and influence since its humble beginnings. This growing importance results from ESG’s steering capacity: every time a new investment practice is established in the financial industry, billions of dollars move according to the new criteria — shifting investments to different companies, changing corporate behavior, and impacting societies more broadly.

The power to define such investment criteria is highly contested. So who actually decides what constitutes an ESG?

The New Distribution of Financial Market Power

The organization of the investment chain has undergone extensive changes in the last decade. For practically as long as financial markets have existed, it was common practice to actively bet on a limited number of companies that fund managers believed would outperform the market.

Since the global financial crisis of 2007–9, however, we have witnessed a massive shift toward what is known as “passive investment.” Passive investment styles do not select particular companies but merely track or replicate indices. These indices are metrics representing particular markets, such as the S&P 500 or the MSCI Emerging Markets Index. The great advantage of passive investing is that it minimizes risks and reduces costs, and asset managers such as BlackRock, State Street, or Vanguard are famous for implementing index-based investment styles at a massive scale and generating huge profits.

While these changes might sound like technical adjustments with little importance, they have triggered a far-reaching shift in the balance of decision-making power within the financial industry. Asset managers’ choice for or against a particular index, as well as the assumptions and evaluations underlying the construction of indices, have much more influence than the assessments of any individual fund manager.

With the growing tide of passive investment, even actively managed funds are moving closer to indices, a phenomenon known as “benchmark hugging,” because their performance is assessed in comparison to indices. Effectively, there are three index providers whose judgements really matter: MSCI, S&P Dow Jones Indices, and FTSE Russell. They are massively influential, as any change in their assessments of which companies or countries constitute a particular index translate directly into changed investment decisions.

The overall pattern of this oligopolistic distribution of power is replicated in the ESG industry. While most of the investments carried out under the banner of ESG are still actively managed, a noteworthy drive toward passive investment is underway. Overall, 88.1 percent of all investors in the ESG sector either use indices as a core part of their strategy or to assess their performance in comparison to them. Of the five hundred largest ESG funds in the world, 28.2 percent passively follow an index. BlackRock alone manages 45.5 percent of these funds — only a handful of other asset managers can claim relevant market shares.

While this market concentration is astounding, it pales in comparison to the market for index provision. This is the part of the market where index providers, such as MSCI, compete for the asset managers’ use of the indices they offer. Here, 93.6 percent of passive assets under management follow ESG indices provided by just five index providers, with MSCI alone. accounting for 67.9 percent. If we want to understand how the ESG market really functions, then, we need to scrutinize the criteria constructed and applied by the index providers, and above all MSCI.

Empty Standards, Empty Promises

MSCI and other index providers essentially define what counts as an ESG fund. But not all of their ESG indices are the same. In our research, we propose a threefold categorization of indices in order to assess their potential impact. We distinguish between what we call “broad ESG,” “light green,” and “dark green” indices.

Crucially, none of these three categories enforce any sort of mechanism for exerting direct influence on corporations’ business practices, like voting behavior at annual meetings or private engagements with management. So ESG funds exclusively rely on their decision-making power over the allocation of capital to shape corporate business practices. The first category of “broad ESG” mimics regular indices and barely excludes extractive industries, fossil fuels, or arms producers. The exclusion mechanisms are not very precise; it very often is the case, for instance, that companies like Total or Lockheed Martin are included in broad ESG funds because they achieve a slightly better ESG rating in comparison to other fossil fuel or arms producers.

Light green indices apply somewhat stricter criteria and quite credibly exclude companies whose practices are deemed unacceptable regarding their environmental or social impact. Only dark green indices actively channel capital toward the transformation of the economy, by applying relatively tough exclusion and decarbonizing criteria and favoring investment into sectors producing the necessary means for an energy transition (such as solar panels).

But of the $189.9 billion guided by passive investment structures in our dataset, merely $9.3 billion follow dark green indices, or about 4.9 percent of assets under management. The bulk of that money, $167.2 billion (88 percent), follows indices that we categorize as broad ESG. So the metrics guiding most global ESG investment differ only very slightly from business-as-usual.

These findings have major political implications. First, the smear campaign launched to cultivate fear regarding the allegedly far-ranging impacts of ESG funds is the product of an ideologically motivated political project. In stark contrast to the strong impact the Right claims ESG funds have on the economy, we do not observe meaningful material effects. Only very minor segments of the private sector substantially differ from regular investment practices.

This lack of deviation from regular market practices shows that we cannot expect the free market to rapidly decarbonize the economy or direct capital into the green transition we so urgently need. While this might be common sense on parts of the Left, high-ranking politicians and renowned economists repeatedly express high expectations regarding the steering capacity of private financial markets. Increased public regulation, such as the Securities and Exchanges Commission’s climate disclosure rules — the final publication of which, however, has been postponed over and over again — could potentially bring some change in this regard. If regulators live up to their stated ambitions, they could enforce strict exclusion criteria and actively steer capital into business sectors producing clean energy. Our research, however, suggests that regulation will most likely follow the script provided by the financial industry and further increase the market power of index providers.

ESG funds are neither particularly “woke” nor a threat to capitalism; we need to think beyond private finance in the fight against climate change. If the private sector is unable or unwilling to enact the kinds of changes to production needed to respond to the climate crisis, then the public sector will have to. As economist Daniela Gabor put it, “Private finance won’t decarbonise our economies — but the ‘big green state’ can”.