ESG Funds: The Green Versus the Greenwashed
By Tom Polton, Skytop Contributor / May 24th, 2022
In 2019 Tom formed NV Sustainability LLC, a consulting organization to advise companies, financial institutions, business coalitions, and non-profit organizations to better manage environmental risks, seize opportunities, create leading sustainability programs to address emerging environmental issues and societal expectations.
Previously, Tom has more than 30 years of experience leading environmental, health and safety (EHS) programs for Pfizer. In 2010 he was appointed to lead Pfizer’s Environmental Sustainability program. Together with his responsibilities for Product Stewardship, Tom led efforts to reduce Pfizer’s environmental impacts throughout the product life cycle – from research, to procurement, to manufacturing, to product disposal. In a prior role, Tom directed Pfizer’s global health and safety programs associated with process safety, fleet safety, fire life safety, occupational medicine and occupational hygiene. Tom joined Pfizer after finishing his master’s degree from the Department of Environmental Health Sciences at the Harvard School of Public Health.
Tom has a Bachelor’s degree in Biochemistry from Brandeis University. He has served on the Harvard School of Public Health Leadership Council since 2006. Tom also served as President of the Board of Directors of the Pharmaceutical Product Stewardship Working Group, a 200-member coalition to address the responsible collection and disposal of unwanted medicine.
Green or Greenwashing
Socially conscious investors hoping to “do well by doing good” poured a record-breaking $120 billion into sustainable investments in 2021, doubling the $51.1 billion captured by Environmental, Social, and Governance (ESG) funds in 2020. The Global Sustainable Investing Alliance (GSIA) estimates the market for ESG assets at around $40 trillion and sees it rising to $50 trillion by 2030. Morningstar believes that $2.7 trillion is a more accurate figure for funds meeting meaningful ESG criteria. What might explain the huge difference between these two estimates? Morningstar removed the ESG tag from funds that merely consider ESG in the investment process vs. funds that incorporate specific ESG criteria for selecting their investments.
ESG funds are meant to represent portfolios of equities and/or bonds for which environmental, social and governance factors have been integrated into the investment process. The intent is that equities and bonds contained in the fund have passed stringent tests over how sustainable the company or government is regarding its ESG criteria. Yet, all too often it is impossible for investors to know the rationale for the fund’s use of the ESG label.
The Security and Exchange Commission Wants Investors to Know “What’s in a Name?”
The US Securities and Exchange Commission (SEC) wants to help investors by requiring fund managers to define the criteria used by their “ESG” funds. In March 2020, the SEC solicited public comment on applying the “Names Rule” under the Investment Company Act of 1940 to ESG funds to prevent the investment companies from using materially deceptive or misleading names. The Act requires a fund to invest at least 80 % of its assets in the manner suggested by its name. Therefore, the SEC noted that funds with “ESG” in their name consider applying the Names Rule depending on whether they treat ESG as an investment strategy (to which the rule does not apply) or investment type (which is subject to the rule). The SEC requested comment on whether the Names Rule should apply to terms such as “ESG” or “sustainable,” which can reflect certain qualitative characteristics of an investment.
On March 1, 2022, SEC Chair Gary Gensler tweeted a highly entertaining and informative three minute video explaining that he wants ESG to be backed by facts and details rather than a few subjective measures. The Chair draws the analogy to the grocery aisle where shoppers find milk containers labeled “non-fat” that are substantiated by a nutritional label on the back indicating the “grams of fat.” I strongly encourage you to watch the video.
Investors Need to Get Their Hands on More than Carbon Footprints
Indeed, companies do report objective metrics, such as Scope 1, 2, and 3 greenhouse gas emissions, that can assist fund managers in selecting better environmental performers. While these quantitative metrics are helpful in tracking the progress of a company to better manage their carbon footprint, the data is often of limited value or potentially deceptive when used by investors to compare companies in a sector.
To illustrate this point, let’s compare two drivers with the same carbon footprint for their annual commutes to work. The first driver has a short commute to work using a big truck getting poor gas mileage while the second driver travels long distances every day using an electric vehicle. An investor interested in finding the most efficient performer will want to know details on their plans to lower expenses and not just a snapshot of their carbon footprint. The investor looking at our commuters wants information on the first driver’s plan to purchase a more fuel-efficient automobile and seeks details from the second driver on their intentions to telecommute as a way to avoid these long and wasteful drives. Both actions reduce footprint but focus on factors unique to the circumstances associated with each driver’s circumstances.
Improving Climate Disclosures
The SEC, and other regulators around the world, are asking for more than just a few data points in companies’ climate disclosures. Under the principles of the Task Force for Climate Related Financial Disclosures (TCFD), a thorough disclosure must also include information on the company’s climate strategy, governance structure, and an analysis of specific risks and opportunities. It is far more useful to have the details to know about a company’s vulnerability to physical risks from climate (floods, severe weather, extreme heat, fires, drought), their plans for managing the transition to a low carbon economy based upon foreseeable restrictions and regulations developing, and potential opportunities for the business from new or expanded markets.
Advice for Authenticating Your ESG Fund
Just because ESG has its flaws today does not mean we should abandon the concept. Research has shown that using financially material ESG information leads to better informed investment decisions and better risk adjusted returns in the long run. Certainly, governmental regulators can make it easier for fund managers to gain access to material ESG information, and then too fund investors must also ask the right questions of the fund managers. And to make sure your own ESG fund adheres to meaningful principles and isn’t just greenwashing, consider these eight questions from the SEC Environmental, Social and Governance (ESG) Fund Investor Bulletin published in 2021:
Is ESG a core component of the investment selection process, or is it one of many factors that are considered to select investments?
To what extent does the fund focus on ESG factors versus more traditional factors?
How does the fund weigh each of the three ESG factors within its ESG portfolio holdings?
What specific criteria within a factor does the fund use when determining its portfolio holdings?
How do the fund’s fees and expenses compare to other investment options?
What types of investments do you expect or desire the fund to be invested in, and what types of investments do you expect or desire the fund NOT to be invested in? Compare those expectations with published fund holdings to better understand whether the fund’s investment strategy is consistent with your preferences.
How does the fund explain and discuss its ESG practices, and how do those practices affect the performance and risk of the fund?
Is the fund employing an ESG practice that is of importance to you, such as voting proxies in a certain manner or engaging with issuers to influence their ESG practices?