If I held shares in an “S&P 500” exchange-traded fund, it would surprise me if the investment manager allocated any less than 100% of my assets to the S&P 500, and not, say, Indian stocks, or American bonds. Yet this is not necessarily the case for funds branded as ESG, or sustainable. A cursory browse of ESG funds on my brokerage account reveals that ExxonMobil, an infamous oil major and frequent target of environmental activists, is the 7th largest holding of the second result, “Flexshares Stoxx US ESG”.
The European Securities and Markets Authority has had enough. They now require sustainable funds to actually invest sustainably. New rules mandate that when a fund’s name says it invests in “ESG” or “Sustainability,” at least 80% of its assets must be directed to ESG or sustainability-related investments. If funds were what they said on the tin, this would be a redundant requirement. Yet Clarity AI reckon that 44% of funds are unlikely to meet these new standards.
ESMA also highlighted that many fund managers were opposed to this idea, which is no surprise. Customers are willing to pay a premium for ESG products, 40% on average according to CFA Institute. Yet investors can keep costs low by just re-branding existing strategies, given that “ESG” and “Sustainability” are sufficiently vague terms. Without oversight on what counts as ESG, funds could feasibly get away with changing nothing and clipping higher fees.
The EU defines sustainability through “Sustainable Finance Disclosure Regulation” (SFDR) and sets out qualifying activities for sustainable investment in the EU Taxonomy. Funds claiming an environmental impact are also required to make investments aligned with the Paris agreement to limit global warming to 1.5 degrees Celsius.
A counter from fund managers is that customers may have different definitions of sustainability, and limiting the ability to use the word may be unfair. However, ensuring funds are appropriately named avoids misleading retail investors about what constitutes sustainability. If a sophisticated investor has an unconventional view on sustainability, then it seems they would be more likely to do detailed diligence on funds. If a fund’s investments do not conform to the EU’s definitions of sustainability, there is nothing to stop managers from explaining the nuance of their “contrarian” approach with disclosures.
The fossil fuel industry, however, has still made their mark on ESMA’s new regulation. There is an exemption from aligning with the Paris agreement for energy “transition” funds, or funds that select for the “Governance” and “Social” parts of ESG but not the “Environment.” This allows energy transition funds to be exposed to the very companies that we are supposedly transitioning away from, so long as the overall fund is on a “decarbonisation trajectory.” If investors believe “energy transition” implies “sustainable,” they may be misled by this exception.
It is also unclear what impact a more robust labelling system will have on the success of ESG and sustainability investing. The intent of the legislation is to reduce greenwashing and hold fund managers accountable. However, I suspect that many funds will choose to exit the ESG market, finding it unviable to manage a genuine ESG portfolio.
Another risk is in the quality of the EU’s sustainability definitions themselves. Sustainable activities already include the ability to generate electricity using natural gas and burning wood. These might be important transition fuels, but are far less sustainable than their renewable counterparts, like solar and wind. Lobbyists may redirect their attention to diluting these EU’s standards further now that this definition has weight.
It is understandable that we would look to private investments to address ESG issues, given its enormity relative to public spending. But without clear rules on what that means and what we are really optimising for, change will be slower than our environment can afford.
Requiring products to meet minimum sustainability standards when they are marketed as such is a good first step. Governments should also raise the bar for those standards. Perhaps one day we will live in a world where all investments are required to be aligned with climate goals, protecting our way of life, and allowing us to keep investing in our future in the first place.