Soaring compliance costs will swamp the benefits of ESG and sustainable investing unless regulators and investors embrace technology-based solutions.
According to PWC, ESG-focused institutional investment will grow by 84% to US$33.9 trillion in 2026, representing 21.5% of assets under management. Little wonder sustainable investing is the key strategic growth driver for most investment firms.
As with all good tragedies, this silver cloud has a dark lining: rising compliance costs. 35% of asset managers in the PWC survey said that ESG compliance costs had risen 10-20% since 2020. In Asia, where ESG funds are expected to triple by 2026, costs are rising even faster.
Costs are rising because the regulatory environment is inconsistent across regions and becoming increasingly complex; the rules for disclosure and reporting are becoming more arduous; and greenwashing penalties are increasingly severe. As one manager says in the link, “ESG is becoming an “infrastructure capability as opposed to a standalone investment strategy”.
A deeper reason for increased regulation is that greenwashing is rife. Greenwashing is the act of conveying a false impression about the sustainability of a organization’s activities.
In the PWC survey, for example, more than 80% of respondents complained that “mislabeling is prevalent” in the asset management industry.
More than 80% of respondents complained that “mislabeling is prevalent” in the asset management industry.
Herein lies the rub: 76% of managers in the same PWC survey said that re-labelling of existing products as ESG-oriented was their “immediate priority.” We suspect the difference between mislabeling and re-labelling is not great.
The practice of economic agents seeking to influence government regulation, known as regulatory capture, is long and storied. Examples abound, ranging from the guilds of medieval Europe to the US railroad barons of the late 19th century.
Typically, the goal of industry-led calls for regulation has been either to limit competition or to mask ill-doings.
Fraudsters crave legitimacy
Contrary to the popular belief fraudsters do not lurk in dark places. Evidence suggests that fraudsters crave legitimacy and love dealing with regulators.
Prior to its collapse, for example, Enron was among the highest profile companies of its era and deeply associated with regulators.
Before his demise, Bernie Madoff was closer to US financial industry regulators than any other participant on Wall Street. He was highly trusted by regulators and thus avoided scrutiny. Some regulators displaced by the collapse of the World Trade Center actually shared his office for a time. His close association with the SEC and lawmakers in Congress gave him great legitimacy with investors.
Sam Bankman-Fried is innocent until proven guilty, but prior to the collapse of FTX he was definitely the face of cryptocurrency. He was actively engaged in developing a regulatory framework for crypto, donating an incredible US$40 million to congressional candidates for the 2022 mid-term elections. Madoff gave only US$1 million throughout his long career.
Regulatory capture is an old game. Whether a captor wishes to limit competition or engage in illegal activities, the goal is the same – make the regulatory process as complex as possible. This deters competition and makes detection difficult.
Thomas Sowell once said, “You will never understand bureaucracies until you understand that for bureaucrats procedure is everything and outcomes are nothing.” This assessment is unfair but it emphasizes the point that regulation tends to be more focused on process than on outcomes.
The entire ESG regulatory framework is focused on demonstration of process, measurement and reporting. It rests on the presumption that economic agents will be open and honest in their reporting.
Agents engaged in fraud are not deterred by excruciating paperwork.
The only problem is that agents engaged in fraud are not honest. Agents engaged in fraud are not deterred by excruciating paperwork and procedures. Numbers are easy when you make them up and procedure typically hides more than it exposes.
In the current ESG regulatory structure there is little focus on detection, little focus on innovation, but much focus on process. We find this approach perplexing. With intelligent use of AI, and many other forms of technology, transparently.AI and other innovators have the means to assess the risk that companies might not be acting as they should.
With technology, aberrant companies are in plain sight. There is no need for complex procedures and reporting across the whole investment industry. Unless regulators and investors embrace market-based technology solutions, we fear the soaring compliance costs of sustainable investing will swamp the benefits.