Rarely a point of discussion before its first mention in the UN’s principles for responsible investment in 2006, ESG has been thrust into the spotlight in recent years, particularly since the EU’s sustainable finance disclosure regulation came into force in March 2021.
However, the ESG phenomenon has had a dangerous side-effect: greenwashing.
Greenwashing scandals are continuing to hit the headlines, with regulators scrutinising prominent financial institutions. It is a problem that will have increasingly serious ramifications if it is not soon addressed by the financial industry.
Despite all the rhetoric from investors, the question to ask is: 'Do they really care about ESG in its own right?'. My view is that most probably don’t.
Stefan Zeisberger, professor of financial economics at Radboud University, co-authored a fascinating study called "Do investors care about impact?", in which he assessed the willingness of investors to pay more for sustainable investments with a greater tangible impact.
Worryingly, yet unsurprisingly, the study found that "while investors have a substantial willingness to pay for sustainable investments, they do not pay significantly more for more impact".
Quality over quantity
According to Morningstar, the number of US sustainable mutual funds and exchange-traded funds launched in 2021 skyrocketed by around 70 per cent, which suggests that investors are seeing value in investment strategies that have ESG at their core.
However, many funds currently on the market have simply been re-packaged as ESG, net zero or climate focused, with minor adjustments to the holdings but little meaningful change to the actual investment approach.
In fact, many fund portfolios that are heavy on big tech stocks would easily fit into the ESG classification, even though the tech exposure is what has driven the returns over the past years, rather than a truly ESG-focused strategy.
As Roger Milbourn, investment committee chair at the Sustainable Pension Company, noted, plenty of funds have rebranded to include ‘sustainable’ or ‘ESG’ in their name.
The number of funds with ESG as their true underlying strategy is vastly overestimated, and in absolute terms, funds with an ESG strategy still represent a small percentage of the global investment industry.
>The inconvenient reality is that economies and corporate finance are still primarily driven by returns and profitability.
As such, the first step the financial industry needs to take towards resolving greenwashing is acknowledging that the pressure on fund managers to align with the new ‘green’ selection approach has not yet translated into real impact investing.
The pretence that this is not the case is leading to a cycle of positive reinforcement, whereby organisations are rewarded for being labelled as green, which incentivises further investment in superficially green stocks, regardless of the real-world impact these investments are having.
A reduction in the ‘greenium’ – the premium companies receive for issuing green bonds compared to conventional bonds – would help prove this point, by taking away the reward system that is currently in place.
The inconvenient reality is that economies and corporate finance are still primarily driven by returns and profitability. Removing the box-ticking pressure created by external forces means that companies and fund managers can assess their strategies on an objective basis according to the key questions:
- Is there an economical incentive for me to adapt to climate change prospects?
- Are there strong enough rates of return to invest in new climate change technologies (taking into account strong government support and subsidies)?
- Do I see a long-term benefit in this investment, such as increased market share in five, seven or 10 years’ time?
In other words, profitability will be a driver of ESG activities, and companies and fund managers will be financially rewarded for their impact, rather than viewing it as a compliance burden.
In for the long term
If companies and investment managers are pressured to say they are green rather than be green, that is when we have a problem. Climate change is a long-term game, which requires immediate action but may not produce visible results for another five to seven years.
Market participants need to be comfortable in this understanding. All attempts to force change from the outside, such as by activist shareholders, are doomed to fail and bring even more greenwashing as companies try to comply with these demands rather than generating real long-term value.
As with any topic in the financial world, climate change needs to be understood through the lens of profitability and risk.
>If companies and investment managers are pressured to say they are green rather than be green, that is when we have a problem.
Investors would do well to shift their focus to the incredible investment opportunity and monetary value that climate change solutions present. It is a huge driving force behind the next wave of innovation, transforming industries that have long been considered unexciting, such as utilities or industrials.
There are major incentives created by the governments that further enhance project returns. Routing financing to the right companies can be transformational for these sectors and drive excess returns.
However, too often, this is not the driving force behind sustainable investments, with investors distracted by the desire to appease the masses, slapping green labels on whatever might fit.
Climate change also presents an opportunity for active managers to take back market share from passive funds, which over the past decade have seen substantial inflows.
Beyond checking a company has ticked a few boxes, asset managers need to understand whether an investment will actually make a difference to the climate crisis. Actively managed funds can achieve this far more successfully through in-depth investment analysis.
The surge in popularity of sustainable investing has successfully drawn global attention to ESG issues. However, the financial industry now needs to translate this into delivering ESG-focused strategies.
The SFDR’s article eight and nine should not be treated as superficial labels, but reflect the true integration of ESG objectives and the resulting real-world impact this has.
Maria Lozovik is co-founder and portfolio manager at Marsham Investment Management