As performance, regulation and conscience increase the focus on sustainable investment, advisers are asked to assess a market with a unique set of challenges. Many of the well-established approaches to gaining fund insights no longer apply as major research houses take a flawed approach and leading asset managers may attempt to ‘greenwash’ their portfolios. 
Here we’ll explore greenwashing, examine the processes of prominent research houses and address how regulation and international bodies might provide a reliable backdrop when assessing sustainable investments and building these portfolios.
What is ‘greenwashing’?
The popularity of ESG investing is now well established. In the UK, inflows into ESG focused funds rose 275 per cent in the first nine months of 2020. Impressive at any time, but especially so in the teeth of a pandemic.
As the focus on climate change, equality and corporate responsibility increases, clients are beginning to demand more from their investment than just financial returns. As a result, the incentive to position a fund or asset as ‘sustainable’ has increased and some have taken the opportunity to present their fund as having ESG credentials when the reality can be very different.
This ‘greenwashing’ may be the product of many issues, particularly an ‘over-zealous’ approach to positioning in an effort to enhance relatively weaker ESG credentials. But, regardless, it presents a substantial challenge for advisers wishing to create portfolios that deliver on investor’s ESG preferences and benefit from the performance upside ESG assets offer, including mitigation of sustainability risks.
Third-party research
A natural source would be the independent researchers who have reviewed and rated companies, funds and assets across a range of sectors over many years.
However, this might lead to outcomes the investor and adviser were not aware of and do not desire. In many instances, the approach prominent research groups take may not be consistent with client or adviser expectations leading to anomalous outcomes.
By way of example, we looked at how one of the leading research groups rated two companies. The first a major oil & gas company and the second a company that exclusively finances projects combatting climate change.
When most people think of environmental responsibility, they don’t think of companies that make profits drilling for oil or natural gas. Nor do they think of companies responsible for oil spills or the destruction of marine life.
With this in mind, they might be surprised to find such a company receiving the best possible rating from research groups as a result of reducing those oil spills or threatening a smaller area of the seas and oceans than competitors.
Unfortunately, because many reviewers make a relative assessment of a company’s ESG performance (identifying which companies have the best credentials within an individual sector while disregarding the credentials of the sector overall) this is the outcome.
Conversely, we see firms whose revenue is entirely derived from funding climate change solutions, providing capital to support companies in energy efficiency, renewable energy and sustainable infrastructure, receiving below average ratings.
While such a company may be the essence of what some would expect from an ESG portfolio, the firm scores poorly as it does not participate in certain international bodies or certification regimes. Despite having ESG and sustainability at its core, the company is not rated as highly when compared to the oil and gas company cited above.
This is because of the relative assessment, where companies are rated within their sector, relative to others in the same sector, rather than in absolute terms.
This means, where companies are held in collective funds, a fund holding some non-sustainable companies might score appreciably better than a fund investing in a range of other, more sustainable companies. It is for these reasons advisers should take care when considering sustainability scores and may benefit from looking more closely at the underlying holdings when forming a view.
Options for advisers
Advisers wishing to create portfolios that deliver the desired outcomes may need to take extra care in this context.
The twin challenges of greenwashing and flawed research make rendering an effective ESG portfolio more complex than one might anticipate. There are, however, several measures that might provide a more reliable appraisal of a fund’s ESG credentials.
First, the Sustainable Finance Disclosure Regulation (SFDR) launches in March 2021 and, although it is a piece of EU regulation (and so will not apply directly in the UK) it is likely to be visible in some UK funds and provide a useful guide to advisers. The FCA has committed to delivering a UK version of the regulation that will achieve the same outcomes.
The SFDR will create three categories of investment allowing investors and advisers to easily assess a fund’s ESG credentials. The regulation is designed to eliminate greenwashing by categorising funds as ‘Article 9’, where sustainable investment is the primary objective, ‘Article 8’, where ESG assessment is part of the investment process, and ‘other products’ where ESG is not considered in the investment process. This categorisation should provide a degree of certainty for advisers wishing to building true ESG portfolios and for investors wishing to avoid greenwashed funds.
There may also be merit in assessing a fund’s commitment to ESG through its affiliation to international sustainability initiatives. Fiduciaries that have committed to bodies such as the Principles for Responsible Investment (PRI) and the United Nations Global Compact (UNGC) are required to report annually on progress. These leading authorities on responsible investment and corporate sustainability encourage transparency and provide frameworks for companies to incorporate ESG and sustainability factors into investment decisions and, as such, are useful markers during the fund selection process.
Conclusion
The rise of sustainable investing has led to increased focus and increased inflows into the sector, which has tempted some funds to overstate their ESG credentials.
While this represents a challenge for advisers, track-record, regulation, international bodies and an increased understanding of the research pitfalls are useful guides to avoid greenwashing during the fund selection process.
Hugi Clarke is a partner at Foresight Group. The views expressed above are his own and should not be taken as investment advice.