A series of high-profile greenwashing scandals rocked public trust in the concept. The speed with which index providers responded to Russia’s invasion of Ukraine prompted criticism about its efficacy. And the ensuing debate about weapons and fossil fuels in portfolios called into question its very definition.
Cynics have been quick to declare ESG dead but what we are seeing is the inevitable growing pains of a young market approaching maturity.
Despite these headwinds, client demand has remained resilient. According to Morningstar, global sustainable funds attracted $32.6bn inflows in Q2, a drop of 62% from Q1, admittedly, yet sustainable funds “still held up better than the broader market”.
In Europe, these figures are expected to grow on the back of the new MiFID II obligation requiring fund managers to take clients’ sustainability preferences into account.
As the worst effects of climate change are felt across the world, and an emerging generation of retail investors makes their values and preferences known, we expect more interest in products that meet sustainable objectives.
Demand is being matched by regulation. In May, the Securities and Exchange Commission (SEC) proposed changes to its ‘Names Rule’ for funds. SFDR has guided EU asset managers for some time.
Meanwhile, looming corporate disclosure standards promise to make it easier to build and sell sustainable funds, with recent consultations closing for the ISSB Climate and General Sustainability-Related disclosures and the EFRAG European Sustainability Reporting Standard – the latter of which will underpin the EU’s Corporate Sustainability Reporting Directive.
Asset managers must tread carefully
Nevertheless, fund providers are wary. Morningstar found just 45 funds were repurposed in Q2, the second-lowest number in three years. In private conversations, asset managers are expressing caution about lofty ESG claims at both corporate and fund level.
The risk aversion is understandable. For a long time, there were no rules mandating the contents of a sustainable fund. Recent investigations levelled at industry behemoths DWS, BNY Mellon and Goldman Sachs Asset Management, however, signal those days are over.
A multi-million dollar fine is not the only cause for concern. A year ago, there was less fluency around sustainable investing. A lot has changed.
Customers, journalists and third-party data providers are scrutinising portfolios independently. As a result, ETF issuers face mounting pressure to provide clarity about what, exactly, ‘sustainable’ means, and what it achieves, in any given fund.
For products hooked around a clear sustainability theme such as clean energy, this is a relatively straightforward task. For those with the dubious ‘ESG integration’ moniker, however, it becomes more complicated.
Unsurprising, then, that Article 8 funds – which promote environmental or social characteristics – have fallen out of favour among fund providers, whereas Article 9 funds – for which sustainability is a core objective – have not. The scope for Article 8 funds is too vague.
A framework for communicating products will help mitigate risk. So too the Corporate Sustainability Reporting Directive (CSRD), due in 2024, with which asset managers can, more confidently, build products that do what they say on the tin.
As pointed out by BNP Paribas, however, “the order of the regulations could have been better. If, first companies disclose their ESG data…asset managers could use them in the construction of [funds], and finally, distributors could assess investor preferences for sustainable investments”.
50 shades of greenwash
Still, some pitfalls are easy to avoid. Citing ‘consideration’ or ‘integration’, without reporting on how factors have been considered or integrated, is one. Insinuating that ESG measures outcomes, rather than risk to shareholder value, is another.
And selling as ‘sustainable’ any product that hugs a traditional index – albeit with a little technology overweight – is an open invitation for accusations.
In September 2021, we measured the relative holdings and impact of ESG and non-ESG funds, from a universe of 6,000 US-domiciled equity mutual funds and ETFs.
At a sector, industry and company level, the sustainable funds hardly deviated from their vanilla peers, despite a higher average fee.
In terms of impact, the sustainable fund group performed just two percentage points higher than the benchmark against the UN Sustainable Development Goals (SDGs).
The trouble with this particular brand of greenwashing is that it opens the floodgates to avoidable criticism, which can, in a worst-case scenario, be weaponised. MSCI’s “better portfolios for a better world” walked so that Elon Musk’s “ESG ratings make no sense” could drive.
Today, that little white lie — that ESG ratings, and the ESG indices they underpin, have a relationship with social and environmental outcomes — has been taken at face value by the GOP, and sustainable finance made the unlikely target of its campaign vitriol.
Pending improved clarification about corporate disclosures and product labels, calls to unbundle ‘ESG’ are gaining ground. What can be measured, can be managed, but it must be defined first. And ESG defies categorisation.
What sustainable finance does next
Each letter represents a distinct concept with disparate, sometimes conflicting, objectives.
Lumping them into a catchall acronym obscures inevitable trade-offs, particularly between environmental, social and economic development objectives. There is rarely anything as simple as a ‘good’ or ‘bad’ investment.
In our latest report, we reveal the 10 highest positive and negative contributing funds relative to each SDG. Notably, every one of the 10 highest negative contributors relative to SDG 13 (climate action) is, also, among the top 100 leaders relative to SDG 4 (quality education), SDG 7 (affordable and clean energy), SDG 8 (decent work and economic growth), and SDG 9 (industry, innovation and infrastructure).
The devil is in the detail and the detail is buried in ESG scores. Companies may be incentivised to counterbalance weakness on one metric with an (entirely) unrelated initiative. That, alone, is a greenwash risk for any fund claiming ‘sustainability’. It compounds if a fund fails to communicate which issue among the E, S, and G takes priority, as well as how it is measured and managed.
Working at the intersection of finance and machine learning, we often hear the phrase “if you cannot explain it to your six-year-old, then you do not understand it”. Perhaps sustainable finance needs a similar guiding principle. If you cannot explain to a non-financially literate observer why a sustainable fund is sustainable, the problem may be the explanation – or the product.
Patrick Wood Uribe is CEO of Util
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.