ESG investment and green washing

Given the complex interlocking issues surrounding sustainability, combined with a ‘green rush’ of funds moving into the space, it is inevitable that there will be questions raised about the quality and transparency of some of the products that are labelled ‘green’ or ‘ESG’. Concerns have also been raised about the quality of the ready-made ESG ratings provided by some consultants and ratings companies.

In a study by InfluenceMap¹, some 71% of the 593 ESG funds studied failed a test to determine whether or not they were aligned with the Paris Agreement global targets. Worryingly, 55% of the 130 specifically ‘climate-themed’ funds reviewed also landed negative Paris Alignment scores.

Several allegedly sustainable funds continued to hold fossil fuel production value chain companies, including some funds labelled ‘fossil fuel restricted.’ Overall, the study criticised the lack of consistency and poor transparency of many ESG and climate-themed funds and noted a very large variation of impact among these instruments.

Another study from École des Hautes Etudes Commerciales du Nord (EDHEC) has found that climate data points represent at most 12% of determinants of portfolio stock weights in an average climate fund². For example, nine of the 10 largest holdings in the $22.5 billion iShares ESG Aware MSCI USA ETF (Ticker: ESGU@US) are the same as the biggest-weighted companies that make up the S&P 500.

Simplicity cannot replace complexity

As well as controversy about the integrity of the investments contained within ESG funds, there have also been questions raised about the quality of ESG rankings; services which examine individual companies and provide numerical ratings for sustainability performance.

In July 2021, the International Organization of Securities Commissions (IOSCO) found little clarity, alignment or transparency in methodologies for rating of ESG funds³. IOSCO also noted potential conflict of interest where consulting companies provided ESG services to companies but also produced ratings or data products incorporating the same companies.

Sustainability analysis is at least as complex as financial analysis, especially as it must take account of social, political, regulatory and scientific factors that rebound upon each other. There is clearly room for improved definitions and metrics, but it is a myth often promoted by raters and some fund managers that there exists a universal and decision-ready rating of sustainability fitness.

Furthermore, however good the metrics, there will always be shoddy merchandise on the market. This creates opportunity for investment managers to pick a dodgy green fund and pass on the dubious claims about its environmental credentials to their own customers.

ESG ratings are a means to an end -- less climate risk, improved reputation, happier workers, and reassured customers. Analysts would, or course, like objective data points they can slot into a spreadsheet without much personal effort or risk. That can signal laziness; something akin to the opposite of social awareness -- perhaps seeking an easy algorithm for morality.

How ESG metrics can influence public policies

One of the most important and relatively straightforward sustainability indicators concerns greenhouse gas emissions. Clearer standards for GHG emissions calculations in a fund results from the work of the scientific and research groups and alliances such as GHG Protocol, CDP, IPCC, PACTA and PCAF⁴. These in turn are applied by reputable sustainability consultants and ratings agencies.

While good progress is being made on trustworthy measurement of GHG emissions, a standard rating for overall sustainability performance of a company is less attainable. A meaningful measure of total environmental, social and governance performance that applies fairly across different business sectors, different sizes of company, in different countries and geographies remains a challenge.

At a deeper level, some have questioned the effectiveness of voluntary sustainability investment initiatives as an answer to the threat of climate change, regardless of whether the quality or the rankings can be improved.

In a surprising article in August 2021, Tariq Fancy, former Chief Investment Ocer for Sustainable Investing at BlackRock, suggested ESG funds can be a ‘deadly distraction’ from a real focus on systemic action on the part of governments⁵.His denouncement may, however, be overstating the case.

It is true that industry-led ESG and climate investment can only build on firm policy initiatives from governments and multilateral efforts to solve environmental and social problems. However, green investment can not only show us what’s effective, what’s profitable and what’s measurable, it can also have some collective power to influence government policies in a positive direction.

For example, when net zero strategies become a mainstream metric for ESG funds, companies will be awakened to the fact that emission factors (e.g. the level of carbon emissions per kwh of electricity consumed) are largely determined by government policies (e.g. mandatory targets of renewables for power utilities). This will put pressure on governments to adopt high-ambition policies if they wish to attract more ESG-themed investments in their own country or city.

New professionals for an ESG era

Most of those who point out the weaknesses of ESG funds and ratings suggest some measures to improve the situation, such as more transparency, mandatory disclosure of conflict of interest and better alignment of taxonomy. As such, they accept that sustainable investment is vital to our future and to combat climate change. This points to the need for more sophisticated analyses and higher demands on data integrity -- the opposite of the current “green-rush” into investments claiming ESG credentials.

Genuine professionalism begins when a professional knows where their expertise ends. When an ESG-themed fund is dominated by finance professionals who spend their careers refining financial returns, it is hard for investors to have much confidence that the full spectrum of ESG factors or climate scenarios are assessed with the required degree of social awareness and environmental knowledge.

Perhaps it’s time for regulators to require a different breed of raters and fund managers for sustainable investments -- qualified sustainability professionals who can live up to the complexity of the new ESG era.

¹ InfluenceMap. 2021. “Climate Funds: Are They Paris Aligned?” https://influencemap.org/report/Climate-Funds-Are-They-Paris-Aligned-3eb83347267949847084306dae01c7b0

² EDHEC. August 2021. “Doing Good or Feeling Good? Detecting Greenwashing in Climate Investing.” Reported in: Quinson, Tim. 2021. “How Wall Street is Gaming ESG Scores.” Bloomberg Green, 8 September 2021. https://www.edhec.edu/en/edhec-scientific-beta-research-chair-advanced-esg-and-climate-investing

³ International Organisation of Securities Commissions (IOSCO). 2021. “Environmental, Social and Governance (ESG) Ratings and Data Products Providers. Consultation Report.” July 2021 https://www.iosco.org/library/pubdocs/pdf/IOSCOPD681.pdf

⁴ CDP formerly known as Carbon Disclosure Project; IPCC, the Intergovernmental Panel on Climate Change reviews climate science for Paris Agreement signatories; PACTA - the Paris Agreement Capital Transition Assessment; and PCAF – Partnership for Carbon Accounting Financials.

⁵ Fancy, T. 2021. “Secret Diary of a Sustainable Investor” https://medium.com/@sosofancy/the-secret-diary-of-a-sustainable-investor-part-1-70b6987fa139