Once upon a time, if a company wasn’t selling nicotine-infused land mines or using child labor to mine thermal coal, someone would find a justification to stick it in an ESG fund.

Now, however, with climate watersheds no longer on the never-never, regulators and asset owners alike are increasing their scrutiny of companies and those charged with investing in them. In June, it was reported that 168 asset managers and financial institutions, with more than $17tn in combined assets, had signed up to a campaign by the Carbon Disclosure Project (CDP) to ensure adequate disclosure on climate change, deforestation, and water usage by companies. The CDP has further identified those companies it says are failing to adequately disclose information to shareholders on climate change. Prominent among these are ESG fund favorite stocks Amazon, Facebook, and Tesla.

Large Cap, Little Excuse

Meanwhile, other ESG fund staples Microsoft and Alphabet are resisting greater disclosures on ESG issues in key US regulatory filings. This is surprising, not only because these companies are ESG staples, but because disclosure is generally more of an issue lower down the cap scale, as smaller companies find the increasingly granular reporting requirements burdensome. What needs to be reported on will not vary so much, big or small, but larger companies will have the resources and scale to do this. A larger company will, by definition, benefit from economies of scale. And these companies are the largest.

Tech giants’ reticence goes against the direction of travel, whereby standard mandatory reporting increasingly includes environmental and social impact metrics, as shown by the rollout of the Sustainable Financial Disclosure Regulation (SFDR) in Europe and the increasing traction of the Taskforce on Climate-related Financial Disclosure (TCFD). This will likely continue, as societies approach—or go sailing past—environmental tipping points. For example, the CDP believes that the S&P 500 and FTSE 100 are on a temperature pathway of 3°C or above pre-industrial global temperature averages. No major G7 stock index is currently on a 2°C or the 1.5°C pathway, as targeted by the Paris Agreement, believes the organization.

Heavy Weights

Back, then, to big tech and ESG disclosure foot-dragging. What are the implications for ESG funds? Amazon, Facebook, Tesla, Microsoft, and Alphabet have a combined weight of about 17.5% of the S&P 500 index.

Table 1: S&P 500 Weightings of Microsoft, Amazon, Alphabet, Facebook, and Tesla

Source: Refinitiv Eikon, 22 June 2021

The 10 biggest US equity fund share classes labeled as ESG or sustainable have a combined AUM of almost $50bn. Looking at just the top 10 holdings, these funds have an average weighting of 16.4% to these five stocks (so, about one percentage point under index weight). However, two of the 10 have more than 20% of their portfolios in these five—one more than 24%. This represents nearly $8bn within the top 10 holdings of the 10 largest US equity funds, labeled as ‘ESG’ or ‘sustainable’.

It’s not just an issue for active funds, as passive funds that weigh according to ESG factors have a similar profile. For example, Xtrackers S&P 500 ESG ETF (SNPE) has 21.59% of its portfolio in four of these stocks—with no Tesla—while iShares ESG Screened S&P 500 ETF (XVV) has 18.32%.

In the early days of ESG, investors were happy enough to limit their fossil fuel exposures to a given percentage below their benchmarks. So, avoiding oil, gas, and coal while having overweighted to tech—which, almost by definition, has a lower carbon footprint—was enough to tick the ESG box.

There’s nothing wrong with this approach if, as an investor, your goal is to avoid financial loss due to, for example, stranded assets. Now, however, regulatory and investor pressure is raising the bar. Investors increasingly want to align their portfolios with the Paris Agreement or with select UN Sustainable Development Goals, of which there are 17.

In this still-emerging world, greater disclosure is required, and investors and regulators alike are looking to determine specific goals, such as carbon neutrality for companies and portfolios by specific dates. Investing in a tech company because it has a lower carbon footprint than a mining company no longer suffices for many. Sustainable investing is shifting up a gear—but will the big funds keep pace?