The inconvenient side of ESG investing

Incomplete sustainability regulations

As the focus shifts from words to actions, the contradictions in ESG are becoming brutally clear. The investigation concluded that almost half of the 838 European dark green funds were partly investing in the fossil and aviation industries. According to the SFDR regulation, Article 9 funds should pursue a sustainable objective and aren’t allowed to invest in activities that could harm the planet or humans. But it doesn’t include clear rules on how they should be composed.

On top of that, the description of such funds does not always match the effective composition. It is sometimes even difficult to distinguish between a fund that does not promote ESG characteristics and a green fund. Due to the lack of clear guidance by the regulator, the interpretation and application can differ between asset managers. For example, some Asset Management companies justify their choice of investing in oil companies and airlines, claiming that they have clear sustainable objectives. Not only does this look like greenwashing, but it also raises the question of the effectiveness of the current regulatory framework laying down transparency requirements on financial products. The lack of a clear definition of sustainable investment is an issue often put forward, given that the current definition is too broad and open to interpretation.

An Article 9 fund has a sustainable investment as its objective. But the critical question remains: what is a sustainable investment?

According to the European Commission's definition, this implies that an investment manager could, for example, decide to invest 100% of its assets in companies that generate at least 50% of its revenue from activities that contribute towards the global transition. This means that 50% of the remaining revenue could be allocated to non-sustainable purposes.

SFDR has been applied for more than a year, and we have no choice but to note that its goal is far from being achieved.

Should we automatically consider the inclusion of fossil fuel activities in a green fund as greenwashing?

First, we could raise the question of whether the simple exclusion of fossil fuel activities from all funds with sustainability-related claims is the solution to the transition. These companies could find financing from other institutional investors without any ESG integration process in their investment selection or without any engagement policies. Undoubtedly, such activities should be phased out in the future. Still, fund managers should probably support these companies in redefining their business model through engagement and a voting strategy rather than divesting from them, which is rather a convenient risk management solution. Some pioneers have already demonstrated the feasibility of such a transition. This is the case of Ørsted, which has switched from being the most coal-intensive company in Europe to becoming a leader in renewable energies. The good news is that part of fossil-fuel infrastructures can be reused for sustainable activities such as the production and transport of green hydrogen. A share of financial flows should be redirected toward deploying these technologies.

So, on the contrary, investing in companies deriving a significant share of their revenue or Capex from fossil fuel-related activities can support the transition IF certain conditions are met: the portfolio manager should conduct a deep analysis to assess the company's sustainability strategy by looking at its CapEx plan and the validity of its targets. At the portfolio level, a strict engagement policy should be developed to encourage companies included in the fund to adapt their business model. Furthermore, an exit strategy should be defined to divest from companies that do not reach targets.

Lastly, end investors pursuing sustainable investment objectives should prefer funds actively managed rather than passively managed, as active investing strategies seem to show better ESG performance with a higher leverage power from the portfolio manager to support the transition. Moreover, funds which are actively managed include a lower number of assets. It is, therefore, easier to verify their composition.

Clear signals that the EU is serious about tackling greenwashing

The European Commission has decided to apply new reporting rules regarding SFDR classification from January 1st, 2023, to improve the quality and comparability of sustainability reports.

On the one hand, according to the European Supervisory Authority ESMA, the new reporting rules won’t prevent dark green funds from continuing to invest in fossil fuels in 2023 and beyond. On the other hand, the FSMA has decided to subject banks and asset management companies to a professional ban if they don’t apply these rules.

Will these new regulations be enough to create more transparency and clarity regarding the various funds? We’ll leave it open for debate. Tackling greenwashing requires a long-term approach to ESG, that is for sure. But, unless market participants resolve the dilemma by playing the game fully, ESG is doomed to fall short on actions.

Text written by Nawar Benchiguer, Project Consultant at TriFinance Financial Institutions