It is not as simple as ESG: Watch out for the rise of a new form of ‘greenwashing’

Socially responsible investors need to be alert to the signs of greenwashing as more fund firms jump on the ethical bandwagon.

In the run up to the tax year end in April, eagled-eyed investors will notice a profound change of rhetoric in fund management companies’ marketing messages. Whether it was triggered by Sir David Attenborough’s television programmes or the ‘Greta Thunberg effect’, over the past couple of years climate change has become even more widely accepted as the biggest challenge facing the world.

As a result increasing numbers of investors are looking to ensure their money is invested in a socially responsible fashion. Although at present funds classed as “responsible” by the Investment Association only have a 2% share of overall assets under management, the marketing teams of various fund management groups have latched on to the trend in an attempt to capitalise on an anticipated increase in the sizeof the sales pie for environmental, social and governance (ESG)-focused investments.

On one level increased choice is welcomed, as currently there is not an overwhelming choice of options for investors to peruse. Money Observer’s parent company interactive investor has comprised an ethical ‘long list’ of funds in various sectors; only 14 names are in the UK equities category and six in the UK equity income bracket.

But the about-turn in the status of ESG investments, from the wilderness to the current fashionable heights, increases the risk of ‘greenwashing’. This is a term coined to describe the situation when asset managers push themselves or their funds as ‘green’ through marketing, rather than fully integrating ESG and sustainability into their investment processes.

It risks becoming a worrying trend, notes Patrick Thomas, an investment director and head of ESG investments at Canaccord Genuity Wealth Management. He says:

“We are seeing a lot of fund management marketing departments jumping on to what is now a bandwagon by either launching a new ESG-focused fund, making modifications to an existing fund to give it some sort of ESG tilt, or talking more and more about how ESG has been part of the fund managers’ investment process for a number of years.”

Widespread misclassification

On the greenwashing front, research from SCM Direct last November raised a number of concerns that it says amount to widespread misclassification, and by extension the risk of mis-selling, of ESG and socially responsible investment (SRI) funds.

One of the key issues identified by SCM Direct was that several funds listed as ESG or SRI-focused held significant positions in stocks that could be deemed unethical. L&G Future World ESG UK Index, they pointed out, held 11.4% in tobacco, alcohol, gaming and defence stocks: Diageo (LSE:DGE), British American Tobacco (LSE:BATS), William Hill (LSE:WMH), and BAE Systems (LSE:BA.).

Meanwhile, the Vanguard SRI European Stock had 5.7% of the fund invested in alcohol, gaming and defence stocks. In addition, the report also found that Fidelity’s investment platform misclassified 47 fund share classes as being socially responsible funds.

Another area of potential greenwashing that has been brought to Money Observer’s attention relates to the United Nations’ (UN) 17 Sustainable Development Goals, which collectively amount to a blueprint to achieve a better and more sustainable future for all. The goals are multi-year targets that range from battling poverty to keeping cities’ air clean.

Each goal comes with a timeline and specifications, such as achieving universal access to safe and affordable drinking water for all by 2030. Since the goals were created in 2015, many companies have taken note and used them as a framework to improve sustainability.

Fund managers with a mandate to invest sustainably have also been paying close attention to the UN’s goals, but in some cases at the risk of potential greenwashing, as managers attempt to invest in as many of the 17 goals as possible.

UN goals a recipe for greenwashing?

Mona Shah, director of investment strategy and research at Stonehage Fleming, has concerns. She says: “The UN’s sustainability goals can sometimes cause greenwashing; for instance the ‘life below water’ goal (which aims to manage temperature, chemistry, currents and life in our oceans) is a difficult place for fund managers to make a positive impact. But in order to have a company that fits this goal, some fund managers have justified holding Carnival, the cruise ship company. Some point to the fact that the company gives some of its profits to good causes, rather than focusing on its enormous fuel consumption.”

Thomas shares the same concerns. He says: “The goals represent the world’s biggest problems. But the way some fund managers are looking at them runs the risk that they are being used as a marketing tool.” Google (Alphabet) (NASDAQ:GOOGL) is the example he highlights, pointing out that some managers have cited one of the UN’s goals as a reason why they hold the company in their ESG portfolio.

“I have heard some fund managers say it fits into the ‘quality education’ goal, due to its Google Glass teaching tool software.”

While this is indeed a positive tick from an ESG standpoint, the case can also be argued that the way in which the firm uses personal information to generate advertising revenue makes it more of a ‘sinner’ than a ‘saintly’ stock.

Therein lies the big problem with ESG – it is extremely subjective. Rebecca O’Keeffe, head of investment at interactive investor, underlines the point:

“The point at which a company stops being unethical and starts to become ethical is hugely open to interpretation and a matter of personal opinion, and therefore there is immense scope for disagreement.”

The rapidly developing ethical investing sector and the wider investment industry are trying to navigate their way through all these issues, notes O’Keeffe.

“Using data alone to differentiate between investments runs the risk that people will play the ESG ‘language bingo’ game, littering their prospectuses with relevant terms.”

This, O’Keeffe adds, runs the risk of leaving investors and the industry somewhat confused about just how much an investment actively adopts ethical or ESG practices. She concludes: “We would suggest that investors also scrutinise so-called ‘ethical’ launches and look closely at the manager’s heritage in the sector. Being slightly cautious and taking the time to investigate the underlying issues is essential.”

Fund greenwashing: three things to size up

When it comes to heritage, the point highlighted by Rebecca O’Keeffe, the fund management group’s knowledge and experience are key. Resource also fits into this; and on that front if it employs a large team of ESG fund managers and analysts, this arguably shows a healthy level of commitment towards sustainable investing. Conversely, a novice fund manager at the helm may do a good job but certainly raises a red flag.

In addition, another factor to consider is the level of emphasis the wider fund management firm places on ESG. If, for instance, a fund firm has 70 funds and only a handful invest in a sustainable manner and added to that have been launched relatively recently, it raises the risk of potential greenwashing.

Canaccord Genuity’s Patrick Thomas notes he has less of a problem with mirror fund launches – ESG versions of existing portfolios – but warns that investors need to be aware that some of these mirror funds just simply put a negative screen in place to avoid the sinners. So, therefore, they are essentially ‘ESG lite’ funds. He adds: “Having a huge number of non-green funds is certainly a warning sign.”

Another red flag, which admittedly is harder for retail investors to spot, relates to how a fund manager invests. Some fund managers make heavy use of ESG rating agencies when considering the ‘green’ credentials of an individual company. Transparency, here, is key, so it is important to gauge how a fund manager invests and arrives at a decision as to whether a company meets its ESG definition. If this is not clear, it’s probably best to steer clear.

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