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October 20, 2021updated 21 Feb 2022 1:18pm

Why ESG funds are oblivious to net-zero transition plans

Research shows that ESG strategies that focus on companies’ fixed climate scores, rather than performance metrics, risk undermining the much-needed energy transition to net zero

By Polly Bindman

A protestor attends a climate change demonstration at London’s Heathrow Airport. (Photo by Carl de Souza/AFP via Getty Images)

  • The International Energy Agency’s latest ‘World Energy Outlook’ report shows current net-zero pledges would only deliver half the necessary capital.
  • Researchers argue that existing ESG fund strategies actually reward companies that increase their carbon emissions.
  • Failure to account for transition plans means 71% of climate funds are not Paris-aligned.

The annual ‘World Energy Outlook’ report from the International Energy Agency (IEA) carries a clear message: investment in clean energy must triple in the next decade in order to reach net zero by 2050.

While annual clean energy spending is expected to rise to around $1.9trn this year, around $370bn of which goes towards renewable power generation, this falls far short of what is needed to reach net zero by 2050.

The IEA report, published on 13 October, argues that a redoubling of international support for the transition to net zero and the unlocking of wider pools of private capital are needed to mobilise clean energy investment. This represents a challenge for investors as projections show that current announced net-zero pledges by the private sector dedicate only half of the necessary amount.

Investors face a "major challenge" in clearing up the "fragmented and complex state" of reporting and assessment within current sustainability frameworks, according to the IEA’s report, although it did not reference any specific examples.

In spite of there being “no shortage of institutional investor appetite” for sustainable energy, it finds that investors lack clarity around these frameworks, which require major improvements in order to better incentivise capital markets to fund sustainability in a “reliable” way.

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This report adds fresh urgency to conversations around greenwashing within ESG fund strategies, where there is an increasing sense that investors’ appetite for sustainable investments is not being met by the right investment products.

Climate strategies reward the wrong companies

For example, a recent report from France's Edhec Business School, called 'Doing Good or Feeling Good? Detecting Greenwashing in Climate Investing', argues that asset managers must think beyond simply excluding 'bad' companies from individual funds. Instead, they must consider how their ESG funds align with energy transition.

Among other critiques it levels at ESG fund strategies, the report makes the striking claim that rather than punishing high emitters, current investment strategies reward – inadvertently or otherwise – some companies for increasing their emissions. Edhec finds that 35% of companies with declining climate performance, or increasing emissions, are ‘rewarded’ with an increase in portfolio weighting.

Edhec bases its findings on simulated ESG equity strategies, meaning they are not supposed to reproduce directly the real-life characteristics of a specific fund product. Instead, it combines stock-level emissions data with ESG investment strategies, which it collates into a taxonomy that takes into account a range of portfolio construction methods used by popular index providers such as MSCI or Dow Jones.

The taxonomy is composed of four different investment strategies, which include ESG tilting (allocating more capital to companies with higher ESG scores and less to those with poorer scores) and an optimisation-based approach (maximising ESG scores subject to tracking error targets).

Edhec reaches its conclusions by calculating which companies have moved to a "higher carbon measure decile" from a lower decile between two dates measured on an annual basis. Those companies with deteriorating emissions performance are called "deteriorators", which the report finds enjoy increased portfolio weights.

Rules governing weightings are overwhelmingly focused on point-in-time characteristics, with little consideration for changes in climate performance indicators. Edhec Business School

It concludes that if companies can see that "bad behaviour is not penalised", the "incentive to improve climate performance will be weak". To some extent this is to be expected as long as fund managers are oblivious to the actions of individual companies.

As shown in Edhec’s table below, none of the strategies it analyses capture information at a stock level – just at an aggregate level. In other words, "rules governing weightings are overwhelmingly focused on point-in-time characteristics, with little consideration for changes in climate performance indicators".

Therefore, the issue here is arguably not wholly to do with the individual decisions of fund managers. Passive funds “have to have very clear robust rules” for a “pretty low cost”, says Kenneth Lamont, a senior research analyst at Morningstar.

He also notes the huge range of ESG exchange-traded funds (ETFs) now on the market, including ‘ESG momentum’ ETFs, which reward companies showing improved environmental performance.

A forward-thinking approach

Instead, the issue can be seen as relating to ESG strategies more broadly. A separate report, published in August by non-for-profit think tank Influence Map, makes a similar case for why ESG or climate-labelled fund strategies that fail to account for a company's climate performance are unlikely to have much real-world impact.

Assessing 723 equity funds with some $330bn in total net assets, specifically labelled as either ‘ESG’ or ‘climate'-related, Influence Map finds that 421, or 71%, have a negative "Portfolio Paris Alignment" score.

While Edhec employs a retrospective approach, the Influence Map report uses forward-looking data to estimate the total future production of more than 3,000 real economy companies in their respective sectors.

In this way, the report estimates how much of a company’s future production will be aligned with Paris scenarios. For example, if a car manufacturer plans to produce one million internal combustion engine vehicles and 50,000 electric vehicles, it would be 5% Paris-aligned.

This method of assessing a portfolio’s net-zero alignment illustrates the limitations of many existing passive fund strategies, which seek to track market indices while underweighting or excluding high-emitting sectors.

One exception the report identifies is the sub-category of ‘clean energy’ funds, which are highly invested in renewables and therefore have a high exposure to the power sector and "nothing else".

That to be Paris-aligned ESG funds should have more, rather than less, exposure to sectors such as power or energy is a point made forcefully in Edhec’s report. Specifically, the authors argue that the underweighting of key economic sectors in ESG funds deprives vital transition sectors such as energy or electric utilities of much-needed capital.

Capital Monitor analysis of Morningstar data confirms that ESG ETFs are typically underweight energy stocks compared with non-ESG equivalents.

For example, focusing in particular on electricity – "a key sector of the transition toward a green economy" – Edhec’s research finds that across its four different ESG strategy types there is a "drastic underweighting" of the sector, of up to 91% relative to the cap-weighted index.

Both Edhec and Influence Map emphasise the need to ensure these industries invest in technology that allows them to produce goods without emitting greenhouse gases, rather than cut them out of indices altogether.

This argument echoes a warning in the IEA’s report that in trying to align with net zero using existing approaches, investors risk excluding sectors with "more challenging" pathways. These include the energy and electrical utilities sectors, that are neither wholly ‘clean’ nor ‘dirty’, but are both carbon-intensive and key to the energy transition.

Both reports warn investors to be more vigilant about ESG fund labels while urging investors to tighten up rules on labelling, and that we need a paradigm shift in climate investing that is free from tracking error constraints.

Whichever approach they take, what is clear is that if investors are truly intent on addressing climate change, they will need to find a way of learning how to fund the energy transition, as opposed to just cleaning up dirty-looking portfolios.

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