ESG investment and greenwashing: Myth and reality

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 (environmental, social and governance)". 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 InfluenceMap, some 71 per cent of the 593 ESG funds studied failed a test to determine whether or not they were aligned with the Paris Agreement's global targets. Worryingly, 55 per cent 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 Ecole des Hautes Etudes Commerciales du Nord (EDHEC) has found that climate data points represent at most 12 per cent of determinants of portfolio stock weights in an average climate fund. For example, nine of the 10 largest holdings in the US$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.

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 funds. IOSCO also noted potential conflicts of interest where consulting companies provided ESG services to companies but also produced ratings or data products incorporating the same companies.

A NEWSLETTER FOR YOU

Friday, 12.30 pm

ESG Insights

An exclusive weekly report on the latest environmental, social and governance issues.

Sign Up

NO UNIVERSAL AND DECISION-READY RATING

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, of 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.

One of the most important and relatively straightforward sustainability indicators concern greenhouse gas emissions (GHG). Clearer standards for GHG emissions calculations in a fund result from the work of the scientific and research groups and alliances such as Greenhouse Gas Protocol, Carbon Disclosure Project, Intergovernmental Panel on Climate Change, Paris Agreement Capital Transition Assessment and Partnership for Carbon Accounting Financials. 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 the 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.

QUALIFIED PROFESSIONALS NEEDED

In a surprising article in August 2021, Tariq Fancy, former chief investment officer for sustainable investing at BlackRock, suggested that ESG funds can be a "deadly distraction" from a real focus on systemic action on the part of governments. 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 is effective, profitable and 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 (for example, the level of carbon emissions per kilowatt hour of electricity consumed) are largely determined by government policies (for example, 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.

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 is 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.

• The writers are from Carbon Care Asia (CCA). John Sayer is a director, and Albert Lai is CEO.