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The hidden pitfalls of ESG investing

The hidden pitfalls of ESG investing 1

By Kevin Braine, Global Head of Research and Operations in Kroll’s Compliance Risk and Diligence Practice

The practice of environmental, social, and governance (ESG) investment has seen a meteoric rise over the past two years. According to Bloomberg, over $117 billion flowed into funds that claim to embrace ESG factors as part of their core investment strategies between June 2020 and June 2021, with estimates anticipating the market to rise to a value of $53 trillion by 2030. Over the next four years, ESG funds are expected to account for up to a third of all investments, arguably cementing the whole of the ESG market as a staple practice.

News of this explosive growth has become the most headline-catching characteristic of the ESG market, but there are other important features of this new trend of which investors should be aware.

The potential for pitfalls

Following the G7 Summit in June, world-leading nations have begun discussing a new round of regulation to ensure greater compliance with ESG practices. France is currently leading the way and already has mandatory ESG declarations in place for businesses with 500 or more employees, following on from the EU’s Sustainable Finance Disclosure Regulation. Germany is following suit and will demand that businesses with over 3,000 employees identify and solve ESG risks within their supply chains from 2023 onward. The UK aims to implement a similar policy with even wider reach, requiring mandatory climate disclosures, economy-wide by 2025. As such, it’s clear that regulators are putting greater pressure on businesses to become more ESG-friendly, especially as deadlines for net-zero carbon emissions near closer.

Despite recent initiatives to regulate it, another defining feature of the ESG market has been its lack of effective standardisation on either definition or reporting. The term ESG is open to interpretation, and scoring for sustainable funds is still a new field. Rating agencies are yet to form a consensus on how companies are scored, resulting in a disparity of ratings, giving firms license to declare themselves as ESG-compliant without any accountability.

These characteristics—huge growth over a short time, new developments in regulation, inconsistencies in ratings—make ESG investing riskier than it looks on the surface. The market may be on track to become the new norm, but there are still pitfalls to avoid.

Greenwashing

The most prolific of these, garnering the most media attention and controversy, is greenwashing. Greenwashing involves misleading investors and consumers into believing the ESG credentials, or an exaggerated account of those credentials, of a fund or business. Since the term was coined by Jay Westervelt in 1986, it has been associated with uncovering actual or perceived failures by companies to live up to their stated ESG policies or standards.

There are many high-profile cases of greenwashing that have come to light as investors have paid more attention to ESG. A prime example is the offsetting initiative adopted by many top fossil fuel providers. The stated plan would reduce the environmental harm of their oil exploration through carbon capturing techniques. The reality was extremely different, and their actions were condemned by environmental groups as unethical.

Greenwashing also takes less blatant forms. Funds claiming purely ESG opportunities for investment often balance their portfolios with companies who have good ratings but suspect practices. According to CNBC, one of the largest ESG funds in the world, Parnassus, had a 17.26% share in big tech firms. Representing a large proportion of this share was Amazon, which in 2020 registered a carbon footprint of 51.17 million tons. To put this into context, BP’s worldwide annual carbon emissions are approximately 55 million tons.

There are a series of negative implications associated with greenwashed investments. Firstly, it means investors can end up with shares in a business with which they do not ethically agree. This undermines the entire purpose of ESG investing, which is to provide purpose other than revenue return for stockholding.

Secondly, the associated increase in performance and revenue of ESG stocks is tied to their authenticity and their value for society. If it is announced that an ESG investment is non-sustainable or more harmful than claimed, it will hurt returns more than if it had originally been labelled as non-ESG.

Ultimately, the effect of greenwashing is that investors, who aren’t directly hoodwinked, are less able to clearly identify the opportunities they want; it becomes harder to spot the genuine from the fraudulent.

However, regulators like the U.S. SEC are beginning to take action. Greenwashing has historically been either undetected or unpunished, on the whole, but the U.S. SEC has declared its intention to hold companies accountable to their stated ESG policies, with guilty parties possibly in breach of securities laws.

Standardisation

The challenges of greenwashing are compounded by the lack of standardisation. There is currently no market standard for ESG rating, meaning that they can vary depending on the agency that conducts the rating. Research from MIT Sloan found that the correlation between ESG scores by rating agencies was on average 0.61. For context, credit ratings by Moody’s and Standard & Poor’s correlate at 0.99.

With prevalent greenwashing and inconsistencies in ESG ratings, investors need to be extremely thorough when investigating whether a firm is truly ESG-compliant or not. Market growth and plans for more extensive declarations are set to make ESG investing a ubiquitous practice, so picking the correct opportunities while the market is still in its infancy is, therefore, crucial.

Supply chain risks

New legislation and changes to global supply chains also pose a challenge for businesses and, by extension, ESG investors. As businesses expand their operations globally, sourcing more from developing nations with less rigorous safety infrastructure, the chances for unintended human rights violations increase.

Genuinely ESG-friendly businesses may be unintentionally complicit in harmful practices due to global supply chains that are difficult to fully vet and are often less visible and transparent. Identifying abuse and preventing it can be challenging as it often falls under the guise of legitimate practices within expansive autonomous networks.

Modern slavery is a prime example of this challenge. In 2020, the Home Office reported that there were over 10,000 people, under the National Referral Mechanism, who came forward as victims of modern slavery in the UK.  Legislation in the UK, such as the Modern Slavery Act of 2015, requires companies to publish an anti-slavery statement, which outlines their actions taken to ensure their practices and supply chains are not involved with any abuse of human rights. Other jurisdictions have since upped the regulatory ante, with France, the Netherlands, and Australia taking the lead. Due to the ever-growing spread and complexity of supply chains, compliance with this regulation can be difficult and the measures taken are not always foolproof. The ultimate result of this is that despite ethical intent, a business may well be complicit in poor ESG practice through its wider operations.

Avoiding the pitfalls of ESG

Whether it’s the potentially problematic impact of global supply chains or new claims of environmental sanctity from dubious businesses, the best tactic for avoiding the pitfalls of the ESG market is in due diligence. Due diligence means that investors can properly understand the environmental, social and governance stance of a particular investment to ensure it’s aligned with their own corporate ESG strategy.

Fund managers must take a multifaceted approach to investigating—one that looks at a business’s internal practices and corporate culture and its far-reaching impact. It’s important not to shy away from asking hard questions during this process. Supply chains can be the usual suspect for hidden non-ESG practices. Investors should, therefore, be conscious of a business’s diligence practices. It is the responsibility of international companies to ensure their supply chains comply with human rights and environmental legislation. The mark of due diligence is, therefore, a necessity for compatibility with ESG markets and should signal to investors that the opportunity is genuine.

Ratings aren’t the be-all and end-all of an opportunity. Identifying specific ethical benchmarks are vital for addressing the supposed ESG value of some businesses that have managed to secure a positive rating. Investors can know the legitimacy of an opportunity if there are indicators in each sector: e.g., emission standards in environmental, community relations in social and ethical lobbying practices in governance. Savvier investors will target businesses that not only comply with legislative benchmarks but also take active measures to commit to improvements in each of these sectors.

Ultimately, an investor or fund manager is responsible for the investments they make, and ESG opportunities must be thoroughly researched. The consequences of getting this wrong could be severe, so instead of just thinking about the pure capability for returns, certainty that investment opportunities demonstrate a corporate culture and a sustainable business model, which truly supports ESG, is essential.

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