The real impact of the ESG backlash

In 2020, BlackRock chief executive Larry Fink put the world’s largest money manager squarely behind the cause of purpose-driven investing.

“Climate change is different” from other financial challenges, he wrote in his closely watched annual letter to corporate chief executives. Fink promised “a fundamental reshaping of finance” that would put “sustainability at the centre of our investment approach”.

Corporate America and investors quickly followed suit, scrambling to sign up to net zero carbon plans and launching funds that included environmental, social and governance (ESG) factors in their investment decisions.

Three years later, BlackRock is still betting big on the transition to a lower-carbon economy, but the $9.1tn money manager’s emphasis when it talks about sustainability and social issues has changed.

Last month, when BlackRock put $550mn into one of the world’s largest carbon capture projects in Texas, Fink focused on moneymaking potential rather than its contribution to the planet’s welfare. Describing it as “an incredible investment opportunity”, he also highlighted BlackRock’s decision to continue to work with big energy companies.

The shift comes after a two-year stretch during which US Republican politicians have relentlessly pounded big banks and investment managers for being “too woke” or “hostile” to fossil fuel.

Red-state treasurers blacklisted big financial groups including BlackRock, Goldman Sachs, State Street and Wells Fargo. Some state legislatures, including Florida, Kansas and Idaho, have passed laws that ban or limit the consideration of ESG.

The anti-ESG backlash has captured public attention and opened up a transatlantic rift. While EU investors boast of their efforts to reach net zero greenhouse gas emissions as quickly as possible, many of their US counterparts are dodging the subject or saying they must defer to client wishes.

The real-world impact is hard to assess. On the one hand, green infrastructure and transition investment funds continue to rake in cash. Anti-ESG legislation has been beaten back in a number of red-state legislatures, and relatively little money has been moved away from blacklisted institutions. The vast majority of investors and fund managers incorporate climate and social risk factors into their decisions even if they don’t call it ESG.

“More of the largest institutional investors in the world are more interested in what we have to say today than they were three years ago,” says David Blood, who founded sustainable investing specialist Generation Investment Management with former US vice-president Al Gore nearly two decades ago.

But there is also clear evidence of scepticism about the way sustainable investing has been marketed and carried out. Investor support for environmental and social shareholder proposals has fallen sharply; the flow of US money into ESG-labelled funds has slowed after poor performance; prominent financial groups including Allianz, Lloyd’s of London and Vanguard have pulled out of net zero alliances; and JPMorgan Chase has redefined its climate goals to move away from that benchmark. Even supporters of sustainable investing warn of “greenwashing”, in which money managers overstate the environmental impact of their investments.

The backlash raises the question of how much longer funds advertising themselves as ESG will be on the menu for investors. Fink himself said in June he no longer used the term as it had become “weaponised”.

Part of the problem is that ESG funds often try to address too many factors at once, says Brad Lander, who runs New York City’s $248bn in pension funds, leading to “a loss of clarity and strategic attention to what any of it means”.

“I understand if you’re a smaller investor, the idea of a fund that you feel good having your money in is nice,” adds Lander, who has publicly committed to long-term sustainability. “But inevitably, [such a fund] isn’t going to be that strategic.”

Red-state resistance

Conservative resentment about green investment built up in the US over several years, but finally boiled over in late 2021.

The precipitating moment came in May 2021 when start-up hedge fund Engine No 1 won three board seats at ExxonMobil by arguing that the energy giant needed to do more to diversify away from oil and gas.

BlackRock, which holds nearly 7 per cent of Exxon shares through its massive index fund business, backed the campaign, arguing the oil major was not doing enough to protect its shareholders from “the impact of climate risk”.

Red-state politicians, scenting an opportunity to mobilise voters over fears for domestic jobs, focused their ire on Fink, because of his prior full-throated support for “stakeholder capitalism”, in which chief executives claimed to be helping society, employees and the environment as well as making money.

In September 2021, former biotech executive — and future presidential candidate — Vivek Ramaswamy singled him out during a talk to the influential conservative network the Federalist Society.

Asset managers were overstepping their role by telling corporate leaders “we want you, executive, to be advancing and using your corporate platform to advance a particular social agenda”, Ramaswamy said. “That’s not actually the investors saying it, that is Larry Fink.”

Months later, he launched activist fund shop Strive Asset Management, promising it would use its shareholder clout to lobby against corporate ESG agendas.

The Exxon vote also galvanised the efforts of Republican politicians in Texas and other oil and coal-producing states who were already moving to punish banks and investment companies for signing up to net zero pledges. In January 2022, West Virginia treasurer Riley Moore, who manages the US state’s cash and financial dealings, became the first red-state official to pull money out of BlackRock.

Texas drew up the first boycott list that summer, targeting financial firms it considered hostile to fossil fuel, and held legislative hearings that pilloried both State Street and BlackRock. By the end of 2022, red states had announced plans to pull more than $3bn out of BlackRock funds.

“Larry Fink has done nothing over the past year but try to divert people’s attention from him getting caught politicising pension money,” says Dale Folwell, North Carolina’s treasurer, who has called for the chief executive to be sacked — but has declined to pull his state’s money out of BlackRock, citing its attractive low fees.

The anti-ESG movement has had a major impact in the arena of proxy voting. In the past two years, asset managers have become much more wary about supporting activist shareholder proposals to take specific action on environmental and social issues such as diversity audits or eschewing investment in fossil fuel.

Average support for liberal proposals in these areas has plummeted from 33 per cent in 2021 to 22 per cent this year, with the biggest drop related to climate-related questions, according to the Sustainable Investments Institute.

The change has been particularly visible at BlackRock itself.

Though Fink’s earlier letters had urged chief executives to focus on purpose rather than just profits, BlackRock is now much more wary of shareholder efforts to force companies to do more on climate and diversity.

The money manager backed just 7 per cent of environmental and social proposals at companies’ annual meetings in 2023 proxy season, down from 47 per cent two years earlier.

It said in its annual report on shareholder voting that many of this year’s proposals were too prescriptive or pointless, and cited a US Securities and Exchange Commission policy change that has allowed more ESG proposals to get on proxy ballots.

That is not to say that BlackRock and its peers have turned conservative — proposals that oppose diversity and inclusion efforts or seek to ban companies from paying for employee abortions did substantially worse, receiving, on average, support from less than 3 per cent of all shareholders.

Rather, it reflects a trend among big US index fund managers: where they once sought to pressure companies to take action, they now are distancing themselves from having to take positions on these issues when they can.

BlackRock, Vanguard and State Street have come under particular fire because their funds collectively control about 20 per cent of most large US companies. They have all launched programmes to let their clients decide how their shares are voted.

ESG was born in a bullish environment and now we are in the opposite. The cost of capital is going up and many green things are inflationary

The managers now let investors choose among approaches ranging from “vote with management” to prioritise Catholic values or ESG. State Street last week made its version available to holders of $1.7tn in assets, and institutional BlackRock clients controlling more than $585bn have taken control of their own votes. Fink has said the change will “transform the relationship between asset owners and companies.”

Folwell, the North Carolina treasurer, has said his office has taken over proxy voting from BlackRock for its funds with the firm, and New York City already voted its own shares.

Others say the emphasis on the role of the investment firms in proxy voting was misplaced to begin with.

“There was an outsized belief in the influence of investors, so I am not sure [proxy voting] makes as much of a difference as people think,” says Sarah Williamson, chief executive of Focusing Capital on the Long Term, a non-profit group. “There has been a little bit of a greater recognition that unless [the shareholder proposal] is directly attributable to the return and the mandate, that it’s the client’s choice.”

US money managers have also pulled back significantly when it comes to advertising and talking about ESG, especially after Texas and other red states used membership in Net Zero Asset Managers, an initiative launched in December 2020 to support global climate goals of limiting warming to 1.5C by 2050, as evidence of hostility to fossil fuel.

Some have scrubbed references to net zero from their websites and 30 per cent of US asset managers told a recent Cerulli survey they were going to be more guarded about sharing their ESG-related activities in marketing materials, prospectuses and other formal investment documents. Some 57 per cent of retail advisers said they were not discussing ESG with clients, up from 44 per cent last year.

When pressed on the issue, asset managers in the US now emphasise that they are service providers. Clients, they say, should be free to choose from investments that run the gamut from impact funds that explicitly seek to improve diversity or cut carbon emissions to sector funds that focus on traditional energy companies.

Though Fink warned in 2020 that the asset manager would “continue to hold exposures to the hydrocarbon economy”, in recent years he has hit back explicitly at rightwing and leftwing critics who want the group to take a stand on climate issues.

“There are many people with opinions about how we should manage our clients’ money,” he wrote in this year’s annual letter. “But the money doesn’t belong to these people. It’s not ours either. It belongs to our clients, and our responsibility and our duty is to them.”

Performance first

Public furore aside, the direct impact of the backlash against ESG has been more limited.

Overall, BlackRock’s funds continue to see net inflows that dwarf the $3bn in red-state withdrawals: nearly $500bn since the start of 2022.

The anti-woke manager Strive has seen funds under management grow rapidly, but at $1bn, it remains a minnow in a sea of trillion-dollar whales. Since Ramaswamy stepped down from active management to focus on his US presidential bid, the firm has dialled down its “anti-woke” rhetoric in favour of an emphasis on purely financial returns.

Eighteen states have adopted some kind of anti-ESG legislation. Some of the laws ban “discrimination” against companies that sell fossil fuel and guns, others order state pension funds not to consider environmental and social factors while investing.

But in 19 states, such laws were proposed but did not pass. Four have adopted pro-ESG laws, according to the K&L Gates law firm. In the Midwestern state of Nebraska, community bankers who objected to having their hands tied when doing business helped doom the legislation.

In some cases, when anti-ESG and boycott laws passed, public pension fund trustees baulked at being forced to move money, saying it would violate their fiduciary duty to put investors first.

Oklahoma’s state pension board voted nine to one against a proposal from treasurer Todd Russ to fire BlackRock and State Street, and state pensioners have sued to prevent Russ from overriding them, alleging that divestiture could cost at least $10mn. Kentucky’s state pension funds this year also opted not to divest, despite anti-ESG legislation.

Liberal-leaning states, meanwhile, are racing in the other direction, while justifying their decision on financial grounds. Calpers, the largest US public pension fund, last month pledged to double its low-carbon assets to $100bn. “We believe by investing in that strategy we can achieve outperformance,” says Peter Cashion, Calper’s managing investment director for sustainable investing. “We believe by 2030 we will be able to reduce the carbon intensity of the [Calpers] portfolio by 50 per cent.”

Moreover, the reticence found in some parts of the US is not mirrored in other markets. In the EU, where nine in 10 people support ambitious net zero and renewable energy goals, financial groups such as Axa and BNP Paribas have publicly promised to shun new fossil fuel projects.

“If you’re a US wealth adviser sitting in a regional office somewhere, probably the last question you want to ask somebody is, ‘What is your view on sustainability?’, because that is a very sensitive area,” says Peter Harrison, chief executive of Schroders, a big UK asset manager with a substantial US arm. “That issue is quite different elsewhere in the world. In fact, in the UK, we’ve got an obligation to ask people what their views are.”

‘A provable story’

The bigger problems for ESG-themed investing may not be politics, but recent poor performance and weakening demand.

Such funds historically have been overexposed to tech because of its relatively low carbon footprint. They also benefited from the enthusiasm for the energy transition at a time when oil and gas prices were low.

But higher interest rates have driven down the valuations of growth companies, while Russia’s invasion of Ukraine and turmoil in the Middle East have driven up profits at the fossil fuel companies that such funds typically avoid.

“ESG was born in a bullish environment and now we are in the opposite. The cost of capital is going up and many green things are inflationary,” says one top sustainability banker.

In the past year, investors have pulled more than $14bn from US sustainable funds, including $2.7bn in the quarter to the end of September, according to Morningstar. A single BlackRock fund accounted for $2.1bn of the third-quarter outflows.

Sustainable funds shrank 0.85 per cent in the third quarter, while the industry overall was flat. The story is similar at family offices, which cater to the wealthiest US investors: just 45 per cent of them told a Morgan Stanley survey that ESG has any impact on investment strategy, down from 56 per cent two years ago.

At the same time, ESG bond issuance has slowed from a record $4tn in 2021 and is on pace for more like $3tn this year, while the price premium over ordinary debt has shrunk, according to research house Capital Economics.

The likely result, industry leaders say, is that funds will have to be much more explicit about what they mean when they say they offer ESG investing.

For some, that means being more quantitative about the links between sustainability measures and higher financial returns. “The heightened focus on having a provable story around ESG and being able to demonstrate quantitatively that you do what you say you’re going to do is a good thing,” says David Hunt, chief executive of asset manager PGIM. “ESG with integrity.”

For others, it means dropping the term completely. A $95.2bn Massachusetts state pension fund voted last week to change the name of its ESG Committee to the Stewardship and Sustainability Committee.

One prominent bond fund manager argues that it “makes no sense” to try to impose one universal do-gooder framework on all clients because each of them hold different values. His prediction? “ESG will be dead in five years.”

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