Environmental, social and governance (ESG) investments still face the challenge of ‘impact washing’, where the promised ethical returns turn out not to exist, at least in any meaningful sense. In a speech at the end of last year, Richard Monks, director of strategy at the Financial Conduct Authority (FCA), highlighted that the UK watchdog is clearly aware of this issue and is pushing for greater information to be available to investors, alongside clearing up misleading fund names and improving reporting against sustainability characteristics.
As with any novel area of financing, teething problems are only to be expected, particularly when it comes to the challenge of defining and regulating investments. For all the recent explosion of interest in ESG, which has seen the amounts invested in sustainable finance more than double over the past seven years to over $30tn, we must remember that this is still a relatively new sector.
This is not intended in any way to disparage the sector, or to suggest that interest will be fleeting. Properly structured, ESG investments can significantly help the world meet the UN Sustainable Development Goals and blunt some of the sharp edges of pure market capitalism.
But it pays to be cautious, not least when it comes to trumpeting the performance of the funds. Whilst it is true that ESG funds have produced excellent returns during the Covid crisis, often at odds with wider market conditions, this can largely be attributed to an extremely low exposure to the energy, commodities and aviation sectors, all of which have suffered in 2020.
This approach is instructive when it comes to examining the investments themselves too. As Mr Monks’ speech laid out, there is a temptation for investors, who often lack complete information, to overly rely on ESG metrics or to invest on the basis of a name alone. It is a situation strangely reminiscent of the 2008 crash, where a high credit rating was often enough to compel an investment. And though the ESG sector is far healthier than the mortgage-backed securities (MBS) market of 2008, conditions and attitudes are, nonetheless, conducive to impact washing. It might come as a surprise to ethical investors, for instance, that a number of apparent ESG funds are sinking their money into telecoms, supermarkets and large UK banking groups.
Much of the problem is rooted in the fact that many of the terms used in the ESG world have vague definitions
Much of the problem is rooted in the fact that many of the terms used in the ESG world have vague definitions and, to combat this, the FCA is reportedly considering releasing a set of guiding principles following consultation with the industry, which will surely direct financiers’ attention this year. Indeed, the lack of accepted definitions in this space led to the US Department of Labor’s (DoL’s) recent rule on a fiduciary’s consideration of environmental, social and governance factors not actually containing any explicit references to ESG. The DoL concluded that there was no precise or generally accepted meaning of the term, making it unsuitable as a regulatory standard.
The EU Taxonomy Regulation (whose disclosure obligations are due to come into force in 2022/2023) seeks to address this issue, at least in the EU, by harmonising the various standards used in the sector. While the current focus of the regulation to date has very much been on the ‘E’ of ESG, it is part of the European Commission's wider Action Plan on Financing Sustainable Growth and the intention is for further regulation to follow with more detailed provisions concerning social and governance factors. The taxonomy is already being implemented in the amendments made to the EU Regulation on sustainability‐related disclosures in the financial services sector (which imposes transparency and disclosure requirements on certain financial market participants).
Similarly, at an international level, the International Financial Reporting Standards (IFRS) Foundation is seeking to assess demand for international sustainability reporting standards and how it can contribute in this area through its own, currently ongoing, consultation process. In the US, president-elect Joe Biden is expected to back greater ESG-related disclosure as part of a broader green focus for his administration.
Efforts at both the EU and international level mean that increasing levels of available standardised data will help stem the tide of incipient impact washing. However, to truly clean the sector up will take time and greater investor awareness. Just as the world looked on with shock as the 2008 crash revealed wholesale flaws in the ratings process, it may be that an ESG ratings upset is lurking, largely unnoticed, around the corner.
Andrzej Janiszewski is a partner at law firm Reed Smith.
