ESG Risk: Navigating green claims and credentials

ESG claims are under increased scrutiny and investors and advisers need to take care.

If the financial markets regulators in Australia want to make some headway on their much-publicised crackdown on “greenwashing” of investment products, they could make a start by talking to the Responsible Investment Association of Australia.

RIAA chief executive Simon O’Conner says that around 90% of professionally managed funds (measured by funds under management) in Australia, make some sort of claim about adhering to ESG (environmental, social and governance) factors. But only 40% of them can demonstrate leading practices to back those claims.

In other words, half the funds do not substantiate the claims in their product statement.

Independent investment consulting firm Evergreen Consulting estimated 5-10% of funds carrying the ESG or responsible investing label are guilty of greenwashing.

That should be a warning sign to investors and advisers to be very careful in selecting funds that appear to meet their demands for green, responsible or impact investing. Survey data shows Australian investors are alive to the risk of greenwashing and would change funds if their provider were found not to be living up to their claims. As importantly, it’s a warning to fund managers and promoters to be careful about the claims they make on their products and be prepared to back them up or risk prosecution for misleading and deceptive conduct or false and misleading representations under the Australian Consumer Law.

True to label

After years of dramatic growth in funds under management, the ESG sector is suddenly under increased scrutiny for the practice of “greenwashing”, giving their investment products a false sheen of adherence to environmental, social and governance virtues.

Last month, German police raided the Frankfurt headquarters of the trillion-dollar fund manager DWS Group (DWS) and its majority owner Deutsche Bank, to investigate claims of greenwashing in investment products. DWS is also under investigation for similar offences by the US Securities Exchange Commission, which also fined Bank of New York Mellon $US1.5 million for misleading claims about the use of ESG in stock selection for some funds.

The Australian Securities and Investments Commission announced last year it would probe “greenwashing’ and the chief compliance officer of the Australian Securities Exchange (ASX), Janine Ryan, announced in May, a review of ESG claims made by funds listed on the ASX to ensure they are true to label.

“It is all about accuracy and clarity, being truthful in the claims you make about the funds,” O’Connor says.

“The days of being broad and vague about these claims are now clearly over when you see police raiding the offices of the like of DWS,”

Rich rewards for getting it right

It’s not hard to see where the incentives lie for fund managers to embrace ESG. The total of funds under management in this part of the global industry has surged by 50% to $US2.8 trillion to meet growing demand for investments that can deliver returns while doing good for society and the environment. Going without ESG credentials might mean that the fund attracts fewer investors and smaller management fees.

“Demand for responsible investments has skyrocketed, and managers are seeing the money moving into these kinds of products. A plethora of new products have come to market to fill this demand, and with this comes the risk of greenwashing,” O’Conner says.

Exchange traded products have been a popular avenue for investors to pursue sustainable investment themes, with ESG funds valued at $8.2 billion of $128 billion local Exchange Traded Fund (ETF) universe.

According to the RIAA, the appetite for ethical and responsible investments continues to grow, with the number of Australians already investing responsibly rising by more than a quarter to 17%.

Five out of six Australians believe it’s important their super fund or bank commits to reducing greenhouse emissions (84%), sets targets for emissions reductions (83%), and 81% want to see them pledge to achieve net zero by 2050, according to the From Values to Riches 2022 survey by the RIAA in January.

The ‘S’ in ESG is also of increasing interest; almost three-quarters (74%) of Australians say social issues are important when they think about investing their money, up from 64% in 2020.

Specificity and standards needed to de-risk portfolios

But a growing criticism of the funds sector is that with the explosion in funds and FUM in the sector, ESG has become a vague catchall expression unsupported by precise definitions and commonly accepted, measurable outcomes.

Data vendors such as S&P and Refinitiv also score public companies on ESG standards, but the ratings can vary between ratings firms. Tesla founder Elon Musk labelled ESG a “scam” after S&P removed the battery and electric car manufacturer from its ESG index and gave its place to global oil and gas major Exxon Mobil.

Some managers avoid the term altogether. Leading local ETF manager BetaShares prefers the term ethical or sustainable for its suite of ETFs, with a combined value of $3.8 billion which incorporate both stringent negative screens, and sustainable investing techniques by positively tilting towards environmental and social factors.

Tougher labelling standards such as those developed by the EU would be welcomed by many in the local funds industry and could also help investors make better informed choices about their investments.

RIAA has certified 280 funds after taking a deep dive on the claims made by the managers about the practices and portfolios that are pitched to investors. It is not screening for a particular approach to investment or model portfolio. Rather its concern is to verify whether the claims made by the fund be that ESG, sustainable, responsible, impact or otherwise; are backed up in the funds’ holdings and that their practices adhere to the policies they promote.

O’Connor recommends that investors and advisers keep three “critical” things in mind to avoid being fooled by greenwashing.

  1. The fund should be able to provide clear and detailed definitions of the claims that it is making. “They should be precise, rather than vague about the claims they make and the processes they use, and they need to be able to substantiate those claims. It is not enough to make broad statements with a few nice sentiments. Where it seems vague, you may not be getting what is on the label”.
  2. The fund manager should be prepared to disclose their full portfolio holdings so that investors can see how it lines up against any claims they make to sustainability, ESG and the like. “A manager may say they don’t invest in fossil fuel companies when in fact they employ a revenue threshold that allows them to invest in companies that earn less than 20% of their revenue from fossil fuels. Generally, if an investor is looking to exclude gambling stocks, they don’t want any gambling revenue in the portfolio, not only stocks that have less than a certain percentage of gambling revenue. This is a real litmus for fund managers,” O’Connor says.
  3. It’s important to seek third party verification of the claims to ensure that investors are getting what is on the label. Third party accreditation involves a deep dive into the fund’s portfolio and practices and can lead to changes to ensure that the product is properly labelled. O’Connor says that around 80 per cent of the funds that approach RIAA for certification are sent away to make changes to their policies, practices and even the indices used or stocks included in the portfolio, before they receive a tick from the RIAA.

Investors can contribute to achieving better environmental, social and governance outcomes through their choice of funds. But it is worth doing the homework to ensure those funds are living up to their promise.