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Time to clean up greenwashing: How to make climate funds less fancy

Time to clean up greenwashing: How to make climate funds less fancy

How can a retail investor tell the difference between funds marketed as Green, Clean, Sustainable, Net-Zero, Low-Carbon, or Climate Impact? At worst they can’t, at best it’s not easy.

A surfeit of complicated naming conventions coupled with a lack of transparency in green-marketed investment funds create an “information asymmetry” between fund managers and individual investors. The result is a heightened potential for “greenwashing,” or marketing climate solutions that don’t hold up to scrutiny. In fact, all investors — whether an individual planning for her retirement or a large financial institution — can be easily misled without regulation that provides common standards to guide corporate disclosures and fund labeling.

This lack of transparency not only risks being deceptive, but it may also hold back the industry from supporting the capital flows that will be necessary in the low-carbon transition.

The dangers of greenwashing

Just last month, U.S. and German regulators began investigating the DWS Group after their former sustainability officer, Desiree Fixler, alleged that the German asset manager had greenwashed their total “ESG integrated” assets by applying an outmoded Environmental, Social, and Governance (ESG) risk management system. The DWS episode may be indicative of the wider market. A recent study by Influence Map shows that a majority of climate-themed funds aren’t aligned with the Paris Agreement. These challenges in the existing system may have a chilling effect on the market for climate investment funds, prompting former-BlackRock exec Tariq Fancy to warn that sustainable investing has become a “dangerous placebo” that harms the public interest.

These scandalous reveals are enough to make the market cynical as to whether climate-themed funds (or even woolier ESG funds) mean anything at all. That cynicism could be dangerous too. We need as many investors as possible to allocate capital toward the low-carbon transition to address the climate crisis. Individual and institutional investors are clamoring to invest in these vehicles, and that could super-charge change or amount to wasted heat.

Three types of climate funds

Instead of rejecting sustainable investing altogether, we need more simplicity and clarity regarding publicly-listed investment products being offered and how to assess the true climate attributes of a portfolio. While there are a growing number of climate-related offerings on the market, they typically span three broad approaches:

  • Climate funds that screen out polluters: these funds generally have restrictions on buying fossil fuel linked assets — primarily coal, oil and gas. Screened portfolios were introduced to help investors align their portfolios with their values and avoid investments in controversial business activities. Recently, however, they are also seen as a tool to manage financial risk within investment companies and avoid the potential for stranded assets. While there’s still controversy about the real economic impacts of screened funds, there is also clearly demand for them, and consumers of financial services should be confident that a “fossil free” fund is truly fossil free.
  • Climate funds designed to outperform financially: this newer category of climate funds seek to grow by investing in companies well positioned to benefit in a low-carbon economy. This can be done by targeting a particular set of companies or re-weighting the securities in a portfolio based on a companies’ preparedness for the low-carbon transition. These products are generally benchmarked to familiar indices and control differences in their “active” risk and investment return profile accordingly. This category may or may not exclude fossil fuel producers (sometimes they just reweight them based on a different calculus of a company’s value) and thus may have exposure to oil and gas, for example.
  • Climate funds designed to have impact: In theory these funds are designed to help reduce global greenhouse gas emissions or create positive environmental change. In practice their impact is arguably the most difficult to demonstrate (particularly for a publicly listed investment strategy) as there is no consensus on how climate investment portfolios impact the real economy. These strategies can span direct investments in renewable infrastructure projects, to green bonds (bonds designed to fund environmental or climate projects), to funds that prioritize direct investor-company engagement and voting, for example.

It’s scandalous for an investor to think they are buying a “carbon-free” financial product when in reality the product is filled with fossil fuels. At the same time, in a functioning capital market that meets investors’ varied demands, each of these products can potentially appeal to different investors.[1]Disclosure: One of the authors reviews the design of ESG funds as a judge for the UN Principles of Responsible Investing Award on innovation in ESG. https://www.unpri.org/showcasing-leadership/the-pri-awards/4189.article The other author previously worked on developing funds positioned to benefit from the low-carbon transition. Given the differences in climate-themed approaches, though, what can be done to bring clarity to investors and stop greenwashing? This is precisely why we need prudent regulation.

How regulators can make climate investing simpler and more transparent

Introduced this year, the EU Sustainable Finance Disclosure Regulation and accompanying sustainable finance proposals are a good first step to help evaluate and tier different climate investment approaches. In March of last year, the SEC solicited comments to improve the rules regulating how funds are named, and recently signaled that these rules should more strictly limit how ESG funds are marketed. But these don’t go far or fast enough. To preserve the integrity of a growing climate investment market, clear labeling and standardization needs to occur globally and consistently.

Financial regulators can stamp out greenwashing and improve the transparency of climate finance, starting with these three steps:

  1. Set standards for company data disclosure: clear standards for measuring and reporting emissions and sector-specific plans associated with the low-carbon transition are necessary so that funds and fund managers have clear and comparable data to assess. This is a prerequisite, upstream step to ensure climate funds can be appropriately assessed and labeled by investors.
  2. Provide clarity on the different climate fund approaches, consistent with consumer expectations: the categorization we presented above can serve as a starting point to help market participants better understand climate fund offerings and make choices accordingly. While there may be overlap between these categories (e.g., a climate fund designed to outperform may also have screens), a simple framework would bring more transparency and eliminate the more obvious forms of greenwashing. Rather than increasing the red tape for green funds, this should standardize and greatly simplify their marketing.
  3. Assess and disclose fund managers’ overall climate offerings: Many investors will want to consider the overall performance of the fund manager, and not just an individual fund. Fund manager disclosures could inform consumers of the composition of their climate offerings within total assets under management, and their performance on issues like climate voting. This would empower investors to make informed choices at the fund and fund manager level.

These priorities aren’t a panacea. For example, they leave open whether investment advisors are properly eliciting and responding to investors’ demands for sustainable products, which products have the most meaningful impact, or how to balance diversification and impact objectives. They do, however, lay a foundation on which further policy can be built.

To start, we hope that regulators will take the perspective of the credulous consumer when they inevitably ask themselves: is this prospective climate fund really doing what I am asking it to? In combination, these three steps can help reduce incidences of greenwashing, bring investors more transparency to inform their choices, and drive more capital toward investment funds designed to create change and support the low-carbon economy.

Let’s make it easy for investors to do the latter.

Published September 30, 2021

Ilmi Granoff

Senior Director, Sustainable Finance

Mike Kent

Program Manager, Food & Agriculture