EXPLAINER: ESG investing and the debate surrounding it

Here's the latest sign ESG investing is now mainstream after starting as a niche corner of Wall Street: It's become the target of Republican politicians and billionaire Elon Musk amid the nation's cultural schism.

To use an ESG approach is to consider a company's performance on environmental and other measures before deciding whether to invest in it. The ESG industry says it helps highlight companies that may be riskier than traditional investing guidelines alone would suggest. It could also help investors find better opportunities.

ESG has become popular across a wide range of investors, from smaller-pocketed regular people to pension funds responsible for the retirements of millions of workers. ESG investments overall have amassed enough monetary might to buy all of the stock of the most valuable U.S. company, Apple, seven times over.

To critics, meanwhile, ESG is just the latest example of the world trying to get “woke.”

Here’s a look at what ESG is and how big it’s become:

WHAT IS ESG?

It's an acronym, with each of the letters describing an additional lens that some investors use to decide whether a particular stock or bond looks like a good buy.

Before risking their money, both traditional and ESG investors look at how much revenue a company is bringing in, how much profit it's making and what the prospects are for the future.

ESG investors then layer on a few more specific considerations.

WHAT IS E?

Environment. It can pay to avoid companies with poor records on the environment, the thinking goes, because they may be at greater risk of big fines from regulators. Or their businesses could be at particular risk of getting upended by future government attempts to protect the environment.

Such risks may not be exposed by traditional investment analysis, which could lead to too-high stock prices, ESG advocates say.

On the flip side, measuring a company's environmental awareness could also unearth companies that could be better positioned for the future. Companies that care about climate change may be better prepared for its repercussions, whether that means potential flooding damage at factory sites or the risks of increased wildfires.

WHAT IS S?

Social. This is a wide-ranging category that focuses on a company's relationships with people, both within it and outside.

Investors measuring a company's social impact often look at whether pay is fair and working conditions are good through the rank and file, for example, because that can lead to better retention of employees, lower turnover costs and ultimately better profits.

Others consider a company's record on data protection and privacy, where lax protocols could lead to leaks that drive customers away.

Increasingly, companies are also getting called upon to take positions on big social issues, such as abortion or the Black Lives Matter movement. Some ESG investors encourage this, saying companies' employees and customers want to hear it.

Not every ESG investor considers all these factors, but they all get lumped in together under the “S” umbrella.

WHAT IS G?

Governance, which essentially means the company is running itself well.

That includes tying executives' pay to the company's performance, whether that's defined by the stock price, profits or something else, and having strong, independent directors on the board to act as a powerful check on CEOs.

Some ESG investors are also pushing companies for more diversity on their boards and in their executive suites. That's to help them look more like their employees and their customers, which can lead to better decision-making and a better understanding of stakeholders.

HOW BIG A DEAL IS ESG?

Investors using ESG criteria in their analysis controlled $16.6 trillion in U.S.-domiciled assets at the start of 2020, according to the most recent count by US SIF, a trade group representing the sustainable and responsible investing industry. That means ESG accounted for nearly $1 of every $3 in all U.S. assets under professional management.

It was also up 43% over just two years, from $11.6 trillion in 2018.

With stock and bond markets tumbling so far this year, the flow of dollars into ESG funds has slowed. U.S. sustainable funds attracted a net $10.6 billion in the first three months of 2022, down 26% from the prior quarter, according to Morningstar. But that still outperformed the overall U.S. fund industry, which saw flows slump by 65%.

IS IT JUST MILLENNIALS DOING IT?

No, the vast majority of money in ESG investments comes from huge investors like endowments at universities and foundations, pension funds and other big institutional investors. They accounted for 72% of all ESG investments, according to US SIF.

WHAT IMPACT IS IT HAVING?

ESG investors are pushing for more engagement with companies, discussing their concerns about the environment, social issues and governance. They're also casting their votes at annual shareholder meetings with ESG issues more in mind.

Last year a relatively small fund known as Engine No. 1 shocked corporate America after it convinced some of Wall Street's biggest investment firms to approve its proposal to replace three directors on Exxon Mobil's board, citing a decarbonizing world. Investors have also pushed Royal Caribbean Cruises to document how much food waste it produces and Starbucks to no longer pay long-term performance awards in cash rather than stock.

It’s all an evolution from the industry’s early days, when “socially responsible” investing was quite simplistic. Early funds would just promise not to own stocks of tobacco companies, gun makers, or other companies seen as distasteful.

AND THE BACKLASH?

Some politicians have denounced ESG as a politicization of investing.

Some in the business world also have been particularly critical of rating agencies that try to boil complex issues down to simple ESG scores.

“ESG is a scam. It has been weaponized by phony social justice warriors,” Tesla CEO Elon Musk tweeted earlier this week.

That tweet, along with a meme equating ESG scores to “how compliant your business is with the leftist agenda,” came a couple of weeks after Tesla got kicked out of the S&P 500 ESG index. The index tries to hold only companies with better ESG scores within each industry, while holding similar amounts of energy stocks, tech stocks and other sectors as the broader S&P 500 index.

So, Exxon Mobil could remain in the S&P 500 ESG index, even if it’s pulling fossil fuels from the ground to burn, because it rates better than peer energy companies. Tesla, meanwhile, got the boot partly because of ESG issues unrelated to the environment. S&P Dow Jones Indices cited Tesla’s potential for controversial incidents, highlighting past claims of racial discrimination at the company and its handling of the investigation into deaths linked to its vehicles equipped with its autopilot autonomous driving system.

ARE THOSE THE ONLY CONTROVERSIES?

No. Any boom brings in opportunists, and regulators have warned of some potentially misleading statements.

That could include firms claiming to be ESG-driven but owning shares in companies with low ESG scores. It’s reminiscent of how products along supermarket aisles get accused of “greenwashing,” or pitching their wares as “green” even if they’re not.

Part of that could be how big the ESG industry has become, with some players taking a lighter touch.

Some funds pledge not to own stocks of any companies seen as dangerous, for example. Others will try to own only companies that get the highest ratings from scorekeepers on ESG issues. Still others try to buy only companies that score the best within their specific industry, even if the score is very low overall.

Such nuance can make for confusion among investors trying to find the right ESG fund for them.

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AP Writer Sam Metz contributed from Salt Lake City.