Environmental, social and governance (ESG) investing has solved a number of problems for the financial industry. For fund companies, ESG revived active management at a time when low-fee indexing appeared unstoppable. Advisors can build rapport and strengthen relationships with clients by talking about values. And investors can choose investments that align with issues that matter to them.
That’s how it works in theory. But the whole proposition collapses if the funds don’t do what they say they’re doing.
Global ESG assets have soared to US$35 trillion, according to Bloomberg Intelligence — about one-third of all assets. In Canada, assets managed using at least one ESG strategy topped $3 trillion by the end of 2019, according to the Responsible Investment Association, accounting for more than 60% of all assets.
Regulators are asking if all that money is doing what it’s supposed to. Clients may be asking, too.
In August, the U.S. Securities and Exchange Commission (SEC) and Germany’s financial regulator, BaFin, started looking into allegations that Deutsche Bank AG’s asset management arm, DWS Group, overstated the environmental merits of some of its ESG products. DWS has denied the claims.
The investigation may be a warning shot. SEC Chair Gary Gensler said he’s directed staff to consider whether fund managers should disclose the criteria they use when branding funds as “green” or “sustainable.”
There are indications of a widespread problem. U.K.-based non-profit InfluenceMap reported that more than half of funds branded as low-carbon or green energy exaggerate their merits.
And the Global Sustainable Investment Alliance reported a US$2-trillion decrease in the size of Europe’s sustainable investment market after the EU’s anti-greenwashing rules took effect this year, suggesting there was considerable fat to trim.
What would happen if similar rules around fund marketing were introduced in other jurisdictions? No advisor wants to find themselves explaining to clients why an ESG investment is suddenly a plain old fund.
Help may be on the way. The CFA Institute stepped into the void last year with voluntary ESG disclosures. The original draft proposed a matrix matching products’ ESG-related features to common investor needs. After a round of consultations, however, the second draft gave up on defining ESG-related features and determining minimum thresholds for labelling products. Instead, the focus is now on disclosure: describing products rather than prescribing features an ESG product must have. Investors can check the ingredients themselves rather than trusting the label.
That didn’t go far enough for Canada’s fund companies. The Investment Funds Institute of Canada’s submission to the CFA consultation said that, without minimum requirements for naming ESG products, the proposed standards “could facilitate rather than mitigate ‘greenwashing.’”
Hopefully someone else will step up. The Responsible Investment Association has indicated it wants to develop its own audited fund-certification framework to complement the CFA disclosures.
But it’s not just the fund companies. Determining which issuers belong in a fund is challenging when disclosures aren’t mandatory.
Regulation may be coming for the issuers themselves. Ontario’s Capital Markets Modernization Taskforce recommended this year that securities regulators require issuers to provide material climate-related disclosure in line with the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures. And the Ontario Securities Commission said it would introduce climate disclosure requirements for public comment before the end of its fiscal year in March 2022.
All this comes as the risks from global warming become more acute. The latest report from the United Nations’ Intergovernmental Panel on Climate Change stated that human-induced climate change is already responsible for extreme weather conditions, and that more warming is assured even if emissions are cut.
Demand for investments that mitigate the climate problem is likely to grow — unless clients stop believing the products they’re buying live up to their purpose.
That’s why labelling standards are needed. Advisors have cited ESG as a way to strengthen relationships with clients. Any trust gained would be lost several times over if disillusioned clients come to believe it was all a lie.