With fund managers interpreting ESG terminology “differently”, investors are begging for clearer prospectus explanations. (Photo by ilkercelik via iStock)
- Disputes around being ‘Paris-aligned’ reveal definition flaws, explaining why new research reveals clear labelling is a top investor priority.
- Capital Monitor reveals a list of funds recently rebranded as ‘sustainable’ but, at the same time, with portfolios that have an increased carbon footprint.
- The number of sustainable-branded funds are reaching dizzying heights, but this ‘fast evolution’ introduces litigation risk, says prominent lawyer.
The surge of ESG-labelled products hitting the market has been accompanied by accusations that financial institutions are misrepresenting or overselling their products as ‘sustainable’ or ‘Paris-aligned’. For example, in September, the DWS Group came under investigation for allegations it was inflating the number of its assets subject to ESG integration.
One month earlier, non-profit activist group Influence Map claimed that 421 out of 593 ESG equity funds (71%) have what it assessed to be a negative Portfolio Paris Alignment score, “indicating the companies within their portfolios are misaligned from global climate targets”.
In response to the report, Linda-Eling Lee, global head of ESG research at MSCI, wrote a letter to the Financial Times criticising its findings. She argued Influence Map had conflated various ESG strategies, when in fact most of the funds it mentioned never claimed to be Paris-aligned in the first place.
She said that “clarity matters”, as “of the 130 funds the group’s analysis labelled as ‘climate-themed’, most do not stipulate alignment with global temperature targets for the stocks they select”.
Her line of argument highlights the current confusion around fund labelling, which leads to accusations of mis-selling, and which regulators are attempting to resolve. As US Securities and Exchange Commission (SEC) chair Gary Gensler said in an address to the organisation’s Asset Management Advisory Committee in July: “There’s not a standardised meaning of these sustainability-related terms.”
Because of this confusion, regulators are establishing new rules that will help to clarify fund labelling, “but that regulation is very woolly in some regards – the definitions are lacking”, Gensler said.
As Sarah Wilson, head of ESG integration at Nuveen points out, the EU’s Sustainable Finance Disclosure Regulation (SFDR) “is probably the most advanced and well-established at this point”. However, there remains “a lot of subjectivity inside how asset managers have to interpret and decide where to place their strategies – Article 6, Article 8 or Article 9”.
While Nuveen takes a “conservative” approach to labelling, Wilson concedes others interpret SFDR regulating differently.
The number of SDFR-aligned ‘sustainable’ assets has grown substantially. Global assets in sustainable funds reached $3.9trn at the end of September, according to Morningstar data – an increase of two-thirds since the introduction of SFDR in March.
Also on the rise is the number of funds that have rebranded to sustainable. More than 69 funds shifted to include ESG criteria between 2013 and 2021, including 25 in 2021, according to Morningstar.
Depending on your definition, this does not necessarily mean these funds are more sustainable.
As the Wall Street Journal reports, funds like the USAA Sustainable World Fund, formerly the USAA World Growth Fund, hold millions of dollars-worth of shares in fossil fuel companies, despite an apparent move to green. Further analysis reveals that it has (unsurprisingly) increased its carbon footprint in 2021.
Capital Monitor analysis of data from As You Sow, a non-profit foundation promoting corporate social responsibility, reveals a selection of funds that have changed their names to reflect a sustainability mandate in the past 18 months, while increasing their carbon footprint. From the sample drawn from the list, the Aberdeen Select International Equity Fund is the only fund to have reduced its carbon footprint this year (see chart below).
Is it really okay to disagree?
When the USAA Sustainable World Fund rebranded, its owner, Victory Capital Management, put a note in the fund’s perspective that fund managers may disagree with an external provider’s ESG rating.
Disagreement over ratings between fund managers and rating agencies, or the rating agencies between themselves, is another contributing factor to confusion around sustainability labels.
Disputes around ‘Paris-aligned’ investments
Another confusion is around the term ‘Paris alignment'. As evidenced in Lee’s critique of Influence Map’s research, calling a fund Paris-aligned refers to specific criteria, which do not necessarily fall under general climate or ESG mandates.
The definition of Paris-aligned investments, according to Morningstar, is that they must invest in companies that reduce their emissions by an average of 7% annually, and the fund overall must have a carbon emissions footprint 50% below that of the broader market.
That so few funds actually claim to be Paris-aligned is not surprising, in light of the striking findings published in October by the Carbon Disclosure Project (CDP). Based on analysis of some 16,500 funds worth $27trn, less than 1% of global fund assets are Paris-aligned, something it describes as "catastrophic".
According to the CDP, these findings highlight the importance of net-zero strategies, which ultimately will ensure that more funds can be Paris-aligned.
Not all carbon is bad
That not all climate funds are the same, and therefore investors should carefully read the prospectus when choosing one, is a key message delivered in a report published in late November by analytics company Investment Metrics, which lifts the lid on the six best-selling European climate funds. It found that only CPR’s Invest Climate Action fund, and BNP Paribas’s Climate Impact fund score better than the MSCI World benchmark in terms of carbon exposure.
However, a crucial caveat is that climate funds are "known to favour investments in firms that are part of the transition to a lower-carbon economy in the longer term", which currently includes high-emitting industries.
The report also shows that energy efficiency and renewable energy have consistently high weights across the portfolios, as do the utilities and industrial sectors. In contrast, energy, financials and healthcare are underweighted.
The word 'greenwashing' – deliberately inflating a product’s sustainable credentials – is notably absent from the report, as many reports that expose that climate-labelled funds have a high carbon exposure make greenwashing a focal point.
Damian Handzy, one of the report’s authors, says that while you could superficially point to the data and cry greenwashing, “we didn't use the term because that's not our interpretation” of this finding.
While a “bulk” of these funds have a higher carbon footprint than the benchmark, Handzy says, “when you read the prospectus of the funds, and this is quite a common technique, you see that they're particularly interested in an ESG momentum – so, investing in companies that have a high likelihood of a positive impact on carbon”.
He explains: “If you're investing in the ones that have already reduced carbon, you can't reduce much more. In order to take advantage of alpha generation commensurate with the positive impact on reducing carbon, you by necessity have to invest in some companies that don't yet have a good carbon footprint.”
He adds: “If we believe their prospectus and we look at the other things that they're doing, there's good reason to believe this is not necessarily greenwashing.”
Keep it simple, stupid!
In Capital Group’s 2021 'ESG Global Study', published in late October, the majority of investors surveyed (just over 100) said that increasing the quality and transparency of fund reporting and literature is the best way to avoid greenwashing. The investors also said that the most important element of fund sustainability reporting is a clear explanation of the role ESG plays in the investment process.
During The Future of Climate Finance event hosted by Capital Monitor, Simon Clarke, a partner at Herbert Smith Freehills, warned that sustainable investing was in a state of “fast evolution” and the risk of investors litigating against false promotion was increasing.
Clarke is not alone in thinking this. According to Sustainable Fitch, part of Fitch Ratings, the financial markets should expect to see a “rise in climate-related litigation or regulatory investigations” in 2022 as disclosures become mandatory across the globe.
Clarke offered some sage advice to investors on how to avoid greenwashing accusations: “If there is a tension between PR and factual accuracy, resist the temptation to succumb to PR… and acknowledge the inadequacies of data that one possesses.”
As tempting as it may be, all fund managers must take note. Not just because a regulator like the SEC may come after them, but because it is the right thing to do.
