Over the past few years, the ESG movement gained a broad following across corporate America, with a proliferation of related management and investment strategies to advance ESG priorities.

But in the past year, the ESG movement risked stalling, amid scrutiny revealing the insincerity of managerial proponents and a declining level of both returns and enthusiasm among funds and individuals alike.

What accounts for the rise and stall of ESG and what might we expect in the next three years?

Since launching the ESG movement in 2004, the United Nations (UN) promoted incontestable aspirations such as to end poverty, hunger and war and to promote sustainable living — defined as using only those resources that are necessary to meet current needs and thereby preserve resources to meet the needs of future generations. 

The UN articulated related management and investment principles that came to coalesce around equally virtuous ideas in three categories: environmental, spanning from mitigating climate change to fighting water scarcity; social, encompassing customer satisfaction and assuring fair labor standards; and governance, assuring board leadership to advance such goals.

The UN persuaded many managers and investors to follow, especially in Europe but also in the United States. For instance, companies began to create more ecological production and packaging methods, improved employee training and workplace safety, and appointed sustainability officers. 

Among investors, many incorporated a company's ESG commitments into traditional investment analysis, believing that would improve returns; others prioritize social impact as much as financial returns; and some exclude certain businesses they simply regard as un-ESG, such as those involved with alcohol, gambling, guns, oil or tobacco.

Over the next decade, ESG's appeal gradually widened in the United States into a movement due to several factors. For one, the concept of sustainability and the UN's other virtuous concepts are inherently appealing. The movement was amplified by massive index funds that found ESG a good way to compete in a market where it's not possible to compete on price or returns. 

From 2019, the ESG movement intensified in the United States due to other powerful social movements such as #MeToo and Black Lives Matter, whose participants seek remedies for grievances of the sort ESG seemed to offer. This intensification was reinforced by an eroding trust in American government (worsened by the pandemic) that led Americans to look to the private sector for solutions to economic and social problems.

As such forces gathered strength from Europe to America, theyenticed development of a cottage industry in ESG that grew so vast to become a self-sustaining power, commonly called the “ESG ecosystem.” Millions earn their living through ESG, from framework developers, standard-setters and dozens of big data providers to broad coalitions, professional service firms, money managers and an army of nongovernmental organizations.

During the COVID pandemic, investment dollars began to be allocated to companies ranking high for ESG consciousness, starting in the first quarter of 2020. Investment inflows to ESG funds were greatest among European investors but included a large segment in the United States. Those in the ESG ecosystem responded to the demand by increasingly stating specific expectations and priorities, and many investors and companies alike followed suit.

Interest in ESG investing closely followed the arc of the pandemic: net investment inflows to ESG funds peaked in the first quarter of 2021, flattened throughout 2021 and declined sharply from the first quarter of 2022, according to Morningstar data. An inflection point occurred in the first quarter of 2023, with a net investment outflow from ESG funds. Net outflows continued in subsequent quarters.

Survey evidence confirms what the net investment outflows reflect: most individual investors have always prioritized financial returns over environmental benefits. That preference has been consistently held by older investors. Among younger investors, who once leaned toward ESG investing, their enthusiasm has “fallen precipitously,” according to a late 2023 survey by researchers at Stanford University.

The reversal of funds flows and attitudes coincides with rising concern that the ESG movement has begun to follow rigid uniform messaging with mandated behaviors, some with ideological tones. Many frictions have appeared: between those who favor spontaneous coordination through markets over mandates; between sides in a revival of long-simmering debates over corporate purpose — shareholder primacy versus stakeholder theory; and between critics and defenders of capitalism. 

Several factors deepened these frictions. Academic literature increasingly questions the promised value of ESG investing or managing. For instance, a 2022 meta review of all the studies — 1,400 of them — found that “the financial performance of ESG investing has on average been indistinguishable from conventional investing.”

Complaints arose that asset managers in corporate balloting vote their personal interests rather than client interests. Reforms seek to pass through the vote to the ultimate investor rather than continuing to have asset managers decide.

The pièce de résistance: the exposure of greenwashing or pinkwashing, vaguely defined colloquial terms referring to allegations of false or fraudulent assertions of ESG fidelity. That has created regulatory, litigation and reputational risk for global banks, major companies and large asset managers for claims about sustainability practices, hypocrisy and misstatements.

With the gap widening between ESG's original aspirational virtues and recent practical realities, a political divide emerged. Dozens of Republican-led states are regulating against using ESG in investment and management while Democrat-led states do the opposite. At the federal level, both the Department of Labor and the SEC took sharply different approaches from the Trump administration and that of President Biden.

On the front lines — in shareholder proposals during proxy season — record levels of progressive social proposals were put on the ballots in 2022 and 2023. Many of these addressed topics well beyond anything the UN had dreamt of, from demands that companies perform internal audits of civil rights and racial equity to demands that they discuss how they protect employee access to abortion services. Support for such proposals fell dramatically. At the same time, there have been a rising number of conservative proposals — also garnering little support. Shareholders may be saying “enough” to the politicization of business.

Revealing further fissures are the proliferation of divergent ESG standards. Multiple authorities promulgate disclosure and directives on a bewildering array of topics using different methods and measures. Diverse regulations have been published by governments in Brazil, California, Europe, Hong Kong and the United Kingdom while attempted harmonizations have been both strenuous and of limited effect, including decades-long efforts by the Task Force on Climate-related Financial Disclosures and more recent ones on a broader array of topics from the Sustainability Accounting Standards Board.

As ESG proliferated in reach and variety, more counterpoints and criticisms readily appeared, revealing deepening trade-offs and conflicts between different ESG goals and constituents, the potential for unintended consequences and negative externalities of ESG interventions, and the ethical and moral dilemmas of ESG decision-making and evaluation. Proponents have been compelled to devote increasing time and attention to a whole new set of challenges, diminishing resources available for advocacy or proselytization.

Where to from here? The ESG movement remains forceful but faces strong headwinds that continued oversteps will intensify. That would not only stall forward momentum but reverse past achievements. Opponents must likewise remain measured in their critiques, lest they damage their credibility. They would do well to keep up the pressure, harness the tailwinds and fight to a draw.

Over the coming year, the political pendulum will be back in play, amid the Presidential campaign and election. In an ideal political environment, candidates would reduce the heat as well, pulling constituents to the center. There is certainly plenty of common ground across corporate America and everyone would benefit if it could find national leadership that searched for it. Few may bet on that sanguine equilibrium, however, leaving ESG a well-intended battleground backfire.

Originally published by Directors & Boards.

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