Defining a green investment is crucial to boosting the expansion of renewable energy and preventing the mis-selling of investments by so-called greenwashing, whereby the environmental impact of a product is misrepresented.
Asset managers are under considerable pressure from portfolio and institutional investors to decarbonise portfolios and to find greener investment alternatives.
The issue is now of major importance, as the global investment industry now has $35.3 trillion of assets under management that are described as sustainable.
The Global Sustainable Investment Alliance (GSIA) said in its 2020 Global Sustainable Investment Report that sustainable investment grew by 15% over two years, and now accounts for 36% of all professionally managed assets.
Governments, regulators, pressure groups and the UN are becoming increasingly vigilant in policing how exposed all stages of the investors value chain, from investment managers to pension companies to fossil fuels producing companies, are to CO2 emissions.
The problem is that sustainability reporting, carbon accounting and taxonomies, and other concepts are all relatively new and in a continual state of flux, with no agreed methods of disclosing or accounting for environmental impact.
For example, in September the US Securities and Exchange Commission (SEC) and German regulator BaFin launched an investigation into allegations that Deutsche Bank’s DWS Group asset-management arm has been misstating the environmental – and possibly the social – credentials of some of its ESG-labeled investment products.
Desiree Fixler, the former global head of sustainability at DWS, alleged that it had made misleading statements in its 2020 annual report, where it claimed more than half of its $900bn in assets were invested using ESG criteria.
DWS last week defended how it represented its numbers, saying it was always clear that it differentiated between so-called “ESG integrated” assets, where sustainability issues were considered as part of the broader investment process for mainstream funds, and ESG assets, which are specialist products with a mandate to focus on sustainable investing.
All this is occurring as the creation of international standards for sustainable finance is far from complete. Climate standards, enforced by a range of statutory and regulatory bodies, and investment expectations are far from consistent or easy to understand.
“Carbon-related investment criteria and policies are still inconsistent and unevenly applied. However, standards will mature and converge – perhaps soon,” warned Wood McKenzie in an August report on how to square the carbon circle for oil and gas.
The report noted that it is now impossible to ignore green issues, or even wider environmental, social and governance (ESG) questions.
“The pool of investors that will agnostically invest in the oil and gas sector, indifferent to the energy transition, will continue to shrink. And ahead of the United Nations Climate Change Conference (COP26) later this year, governments are setting increasingly ambitious national emissions reduction targets. Stricter, mandatory corporate climate reporting will follow,” Wood McKenzie said.
However, climate reporting is a wider concept that is not fully understood, and offers a range of methods for defining how green a product or investment is and how easy it is to provide misleading information to improve the “green-ness” of a company or investment product.
For example, the UK’s Competitions and Markets Authority (CMA) has published a Green Claims Code, which focuses on six principles which are based on existing consumer law.
It is clear that firms making green claims “must not omit or hide important information” and “must consider the full life cycle of the product”.
The UK’s approach is based on research that found that 40% of green claims made online could be misleading.
Meanwhile, the EU has already made efforts to define green activities and to put in place rules to avoid greenwashing.
The EU’s Sustainable Finance Disclosure Regulations (SFDR), which it launched in March 2021, require fund managers to provide information about the ESG risks and negative impact of their investment.
Furthermore, the European Commission has drawn up a common taxonomy in its Action Plan on Sustainable Growth to classify sustainable activities, together with benchmarks to measure their impact.
The main aims of the Taxonomy Regulation are to provide financial market participants with a common language for environmentally sustainable activities and to encourage financial investments to businesses engaged in or moving towards more sustainable activities.
The plans aim to incentivise both public and private companies to pursue sustainable finance, with green bonds being a popular vehicle.
According to a study by law firm Linklaters at the end of last year, a total of more than 680 green bond issuances were launched globally in 2020, raising a sum of $227.6bn. Social bond issuances raised more than $163bn, more than 10 times the $13bn raised in 2019.
Yet greenwashing remains a risk for fund managers. Research by the UK’s XPS Pensions Group found that while the UK funds industry has demonstrated strong progress in ESG risk management in 2021, greenwashing is still a risk. Some 26% of equity funds – and 11% of all funds – are unable to provide any examples of ESG being incorporated into ESG decision-making, the study by XPS Pensions Group found.
However, progress is being made. XPS awarded 23% of UK investment funds with a green rating for ESG, up from 10% last year.
Similarly, a report from the EDHEC Business School in France found that climate data accounted for only 12% of the determinants of portfolio stock weights that investors and managers used to manage portfolios.
The report, called “Doing Good or Feeling Good? Detecting Greenwashing in Climate Investing,” called for a minimum threshold of 50% for avoiding any risk of greenwashing. As such, an investment portfolio with under 50% for this metric cannot be regarded as climate-friendly or aligned with net-zero ambitions.
A recent paper by the green think-tank E3G found that sustainable finance regulation will play a central role in the decarbonisation of the economy and the reduction of emissions.
However, it warned that in the global economy, the creation of international standards for sustainable finance could become a contested battle, one where European, American and Chinese interests may create frictions.
The paper noted that a number of options exist for regulating sustainable finance. These include prescriptive government regulations on the one hand, and the use of price signals and the free markets on the other.
The first option is a system of taxonomies, which are prescribed by governments and define what economic activities are sustainable, and/or unsustainable, and/or what activities potentially fall in between.
The second option is strict disclosure rules, which depend on transparency and flexibility, and favour market-driven adjustments as companies disclose the environmental impact of their activities.
A third option is somewhere between the two, using sustainability reporting standards to disclose information, with varying degrees of detail, on the relationship between its activities, climate-related risk and other sustainability risks.
The E3G report concluded that it is unlikely that markets alone can steer the quantum leap required to re-orient existing socioeconomic structures towards a more climate-safe model. A more realistic goal would be the creation of common minimum global guidelines that combined taxonomies, disclosures and reporting standards.
For taxonomies, E3G called for the US, the EU and China to create a global baseline for taxonomies. A crucial step would be for the US to rejoin the International Platform on Sustainable Finance, where so far the EU and China have made headway on developing global taxonomies.
Furthermore, the G20’s Sustainable Finance Working Group is due to issue a report in October that should include agreement on taxonomies.
Put simply, E3G argued this government must act in concert to create more confidence in the system of green investment, and to lessen fears of greenwashing, which could leave investment managers open to accusations of mis-selling.
Indeed, E3G called for more diplomatic action to enable taxonomies in different jurisdictions to work together.
Both the International Platform on Sustainable Finance (IPSF) and the G20 Working Group on Sustainable Finance must create consensus between government to create what it calls a baseline and a set of guidelines to help make individual national taxonomies mutually intelligible.
Nevertheless, the emergence of taxonomies, and also sustainability disclosure and reporting, could make raising green capital, especially cross-border, more expensive and complex as compliance costs rise.
Yet green investment is becoming more and more popular, and is also being mandating more strictly by government and regulators. Therefore regulations must become more streamlined and unified if greenwashing is to be avoided and investment managers do not lay themselves open to accusations of mis-selling.