The problems of “ESG investing” labels

This “ESG Clarity” article by Matt Orsagh of the CFA Institute is a good reminder of the greenwashing problems for funds:

The ESG investing landscape right now is remarkable.

According to a 2020 report, at the start of 2020, global sustainable investment reached $35.3trn in five major markets, a 15% increase from 2018. Sustainable investment assets under management made up a total of 35.9% of total assets under management, up from 33.4% in 2018.

Another recent report stated the total US-domiciled assets under management using sustainable investing strategies grew from $12trn at the start of 2018 to $17.1trn at the start of 2020.

Impressive numbers, yes? No, not really. They aren’t real.

“ESG investing” has become an accepted and widely-used term, but there is no agreed definition among investors. And there is very little standardisation behind what makes an ESG fund. Currently, if something is labelled or marketed as an ESG fund it is just that – a label. This is not going unnoticed – last year the former global chief investment officer for sustainable investing at BlackRock blew the whistle on alleged greenwashing of ESG funds across the industry.

A recent article in Bloomberg Businessweek examined the use of MSCI benchmarks to create most ESG funds and ETFs. Many investors would be surprised to find that these benchmarks do not measure the impact of a company on the world, but rather how ESG factors impact a company bottom line.

These ratings focus more on whether a company is simply complying with existing laws, regulations and disclosure best practices (which they get points for). The ratings do not assess whether a company is having a positive impact on the planet. For example, an MSCI rating will reflect whether a company has access to water for its operations but will likely not assess whether that company is a good steward of water resources.

ESG is a hot trend, so asset management firms can’t be blamed for cashing in. But ESG or sustainable labels on funds are often misleading. In reality, ESG funds often only have slight tilts to or from certain investments and vary little from benchmarks. Managers are incentivised to perform against benchmarks rather than to cut carbon, protect biodiversity or ensure good governance. That may change, but for now the safe way to operate as an ESG fund manager is to just slightly alter your portfolio to throw out one or two egregious environmental actors, while still hugging that benchmark. Funds can label themselves ESG, charge a higher fee, while being a closet index fund. There is no incentive to aggressively pursue an ESG mandate.

People buy ESG funds for myriad motives – among them climate mitigation, protection of biodiversity, to invest in water, forestry, social justice, human capital management, and dozens of other reasons. It is natural for investors to want to do some good with their investments, but they need to make sure they understand what that ESG label really means when buying an ESG fund. Individuals will all have different ideas of what makes an ESG investment, and the odds that the fund they are buying lines up with their perception of what ESG means are not good. Investors must do their homework and read prospectuses front to back.

People want to invest in ESG funds because they want to do something about climate or address the planetary boundaries. If one person chooses not to invest in a company with a poor water pollution track record, someone else will see those shares as a bargain and gladly invest.

All things considered, the bad news is that there is no consensus on what constitutes ESG investing. The good news is there is such a thing as ESG analysis. While it can be time consuming and intensive, there are rewards for those who undertake the comprehensive research required in ESG analysis. Someone with a good understanding of where the clean energy sector is headed, or the newest developments in battery technology, or who understands companies that will meet the world’s growing water needs will be ahead of the competition and could potentially reap big rewards for the expertise they develop.

The climate emergency we currently face demands action beyond investment in ESG funds. Our investment decisions alone will have less impact on the future of our planet than our actions as consumers and voters. Everything from what we eat to what we drive, how we travel to how we get our energy and how much energy we use has a direct impact on our planet. Our investment decisions do not.

Investing in a cleaner and better future can be done, but it takes a lot of work and is just one piece of a much larger puzzle. Instead of relying solely on the ESG marketing of a mutual fund company, investors should also be considering how they invest their money directly in everyday products they buy to make real, direct change.

Then consider this note from Bonnie-Lyn de Bartok to see how hard it can be to distinguish “ESG fund” from an “impact fund”:

Story Time: We were recently working with a fund manager who introduced an “ESG fund” that invests in “wind and solar”. They asked us to run some diagnostics on it. But wind and solar are not an ESG investment. They are mission-based investments.

Their mission is to reduce carbon by investing in alternative or renewable energy sources. It’s a very targeted platform. The fund could potentially be both Impact and ESG, but it would then require the company to go into the production of their material components and more and basically validate across the company’s entire operations to certify that they are environmentally, socially and governance compliant with regulations.

My example demonstrates how we are still somewhat in the early days compared to the broader market understanding of ESG vs Impact. It is something that we must remind ourselves, especially when many of us have been working in the sector.

As a backdrop, I am very interested in how the global recategorization of products will pan out going forward, especially with the recent announcements happening with US and European regulators that are cracking down on these classifications.