Environmental, social and governance (ESG) criteria have become an important tool for evaluating investment risks amid a growing regulatory push towards increasingly cost-effective clean energy.
Those risks include litigation, reputational harm and falling share prices arising when ‘sustainable’ funds fall short of their promises.
Research published by Morgan Stanley in 2018 indicated that 78% of investors identified risk management as “an important application for ESG data”. This is partly because ESG, unlike its predecessor corporate social responsibility (CSR), provides reporting frameworks for tracking compliance.
Consequently, funds invested in ESG assets are expected to exceed $50 trillion by 2025 – up from $22.8 trillion in 2016 to represent more than a third of total, global managed assets.
Nevertheless, there are understandable concerns that ESG is being abused by corporations and fund managers as a vehicle for greenwashing.
Greenwashing involves duping investors and environmentally conscious consumers with exaggerated, outright false or otherwise misleading marketing claims about the sustainability of a company’s products, services or operations.
Recent allegations of greenwashing include unfounded claims about the sustainability of clothing manufacture, tree-planting schemes that fail because of slapdash planting practices, and even the world’s twenty biggest ESG funds holding investments in fossil-fuel producers.
While greenwashing undoubtedly occurs outside of ESG contexts, critics of ESG frameworks have claimed their shortcomings make ESG a particularly useful vehicle for corporate deception.
These claims are not entirely without merit.
A relatively recent phenomenon, ESG can potentially empower deliberate and unintentional greenwashing alike for want of adequate regulation, sustainable finance expertise, ‘gold standard’ reporting frameworks or a clear enough definition of ‘sustainable’ investments.
Add to that the expense and complexity of going green in many sectors, plus the regulatory incentives and penalties designed to facilitate the shift to a net zero economy, and you have the perfect recipe for overblown marketing messages.
Many investors are thankfully, it seems, aware of this problem. Research from Quilter found that misrepresented investments were the biggest ESG worry for 44% of investors.
“Greenwashing threatens to undo all the good work and progress that has been made so far in responsible investing,” said Eimear Toomey, head of responsible investment at Quilter Investors. “It is crucial that fund groups invest in the way that they say they will, so it is important investors hold them to account on this.”
The last two years have seen a flurry of ESG-promoting and anti-greenwashing regulatory moves both sides of the Atlantic.
The UK government’s 2021 ‘Roadmap to sustainable investing’, for instance, sets out how financial organisations will have to substantiate their ESG claims under the Sustainability Disclosure Requirements (SDR). Similarly, the Competition and Markets Authority (CMA) published a Green Claims Code in the same year that said firms making green claims “must not omit or hide important information” and “must consider the full life cycle of the product”.
There are also proposals afoot to bring ESG ratings agencies under the ambit of the Financial Conduct Authority (FCA), which is due to consult on SDR for asset managers, certain FCA-regulated asset owners and the sustainable labelling system.
A similar agenda to the UK has been pursued in the last two years by the EU, through the Sustainable Finance Disclosure Regulation (SFDR), Sustainable Finance Roadmap and Renewed Sustainable Finance Strategy.
A globally significant development, meanwhile, was the launch of the International Sustainability Standards Board (ISSB) in 2021 with a mission to establish baseline standards for evaluating sustainability-related investment risks and opportunities.
Some experts anticipate that this regulatory drive could herald a wave of litigation against firms for misrepresentation of ESG products. This presents investment risks given “greenwashing allegations are highly publicised and lead to a subsequent fall in share price”, lawyers at Farrer and Co have noted.
ESA Risk’s Mike Wright has written previously that “due diligence is a must to ensure you’re investing in a responsible, sustainable business”. With ESG definitions so subjective, he continued, “it’s important to undertake independent research, rather than to always rely on the opinion of an investment manager”.
According to an FT Adviser piece from Maria Lozovik, a partner at Marsham Investment Management, that research should have a hardheaded focus on an investment’s likelihood of delivering market share growth and strong rates of return, “taking into account strong government support and subsidies” for sustainability.
Essentially, the implication is that ESG or climate-related marketing claims are more likely spurious if they don’t appear to be in the firm’s best interest financially.
Indeed, ESG score provider MSCI admits its ratings aren’t “a general measure of corporate ‘goodness’”, but “measure a company’s resilience to financially material environmental, societal and governance risks”.
It also notes that a company’s ESG score does not precisely reflect its carbon footprint. The financial risks presented by greenhouse gas emissions will influence the scores of power and steel companies much more significantly than healthcare firms, for which “the most financially relevant risks lie elsewhere”, says MSCI.
While useful – and perhaps increasingly so given regulatory developments – ESG alone won’t give a definitive picture of the climate-related risks investors are exposed to.
Investors should therefore research more broadly when evaluating a company’s or fund’s green credentials. This should include watching out for significant legal action or further regulatory developments and considering the implications for their investment strategy – perhaps with the help of an advisor who specialises in ESG.
If investors and their advisers can successfully sidestep greenwashing threats, then genuinely ‘responsible’ investments can potentially offer enormous returns when you consider the regulatory incentives and the innovation they spur. As Square Mile chief distribution officer Steve Kenny told FT Adviser, the money needed to make the economy “net zero is off the scale”, so the companies driving this transformation “are going to be massive”.
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