‘ESG’ may be popular but it could hurt your retirement portfolio

A craze is sweeping the professional investment world and it is called “ESG.” The acronym stands for “environmental, social and governance,” new criteria used by some funds to rule out certain publicly-traded companies from investments. The popularity of ESG is becoming prevalent among ERISA-managed private pension funds, but the Department of Labor has proposed regulations to keep your retirement funds from sacrificing returns because of this trend. The regulation is much-needed.   

Those who run pension funds, private and public, have a fiduciary duty. They must seek the best returns for the worker and retiree. However, when they commit to ESG, they are not doing that, because they are excluding potentially good investments twice. 

First, ESG funds exclude equities that decide not to participate in the various ESG-reporting requests that are used by funds and third-party boards to judge the equities and determine if they meet the standards. Second, they exclude more equities that have reported based on amorphous standards, which are not always explained. This limiting factor deteriorates investing strategy by decreasing the ability to diversify and by excising good investments from the pool.

Take the E (environment) part of ESG, for example. When looking at the energy sector, it is clear that ESG can be chosen only if financial outcome is not the priority. Some companies do not provide information used to gauge ESG compliance and others fail to qualify because they do not meet amorphous standards. The end result is a smaller set of possibilities. When a fund discounts the possibility of investing in a good portion of publicly-traded companies, it hampers its ability to diversify. 

A study by Wayne Winegarden at the Pacific Research Institute found that ESG waste and clean tech funds lack diversification. These funds averaged 48.65 percent of their portfolios committed to just the top 10 equities in each fund. One waste and clean tech fund committed an astounding 64 percent to its top 10 equities. That is an inordinate amount and creates the potential for outsized losses. 

A significant contributing factor to this lack of diversification is that the set of ESG-qualifying stocks is too small. The choices for the fund managers are insufficient. To qualify as an ESG stock for any given fund, a company must provide information beyond its normal legal requirements for disclosure and then, with that information, meet amorphous ESG standards. 

Moreover, it might surprise many ESG investors that much of the funding and work for some of the most promising new “green tech” energy technology comes from legacy energy firms that may not match ESG criteria. There are a variety of fields in which researchers are working to achieve breakthroughs significant enough to minimize the environmental impact from fuels and power generation. These include battery storage technology, carbon capture, fuel efficiency and emissions of engines, biofuels, small modular nuclear reactors, tide power and fusion power. Other technologies can be improved still, including solar panels and wind turbines.

Legacy energy companies invest hundreds of millions of dollars — sometimes billions of dollars — in research and development in areas such as carbon capture, biofuels, battery technology and even solar and wind energy. For example, ExxonMobil has invested $10 billion in lower emissions solutions since 2000; it invested $300 million in carbon capture between 2010 and 2019; and is currently working on a joint project with Princeton University to improve battery technology. BP operates nine wind power sites in the United States, and invests in biofuel and solar power development in the U.S. and elsewhere. Despite the incredible amount of capital and expertise these companies invest in developing clean energy solutions, they do not appear on many — if any — ESG lists. This is because these firms either chose not to submit the requested information or because these legacy energy firms don’t meet nebulous ESG standards.

As a result, ESG firms and investors are missing out on investing in potentially transformative technologies that can help the environment. More importantly for the financial health of workers and retirees, they are missing out on the potential windfall that breakthroughs will bring. Pension funds have a long-term focus to provide for workers in their retirement. That focus should not be distracted by criteria that put financial success at risk.

Ellen R. Wald, Ph.D., is a senior fellow at the Atlantic Council’s Global Energy Center and the president of Transversal Consulting, a global energy and geopolitics consultancy. She is the author of “Saudi, Inc.,” a history of Aramco and how the Saudi royal family controls this multitrillion-dollar enterprise. Follow her on Twitter @EnergzdEconomy.