ESG’s unsustainable irony: A lack of transparency

While Europeans have forged a path, they, too, have struggled to develop a coherent standard

If you only tuned in to ESG in 2019, you would think the strategy, which invests with environmental, social and governance matters at the fore, represents the latest magic elixir for the investment community. Every client wants it, every adviser touts access to it, and every asset manager swims in dollars allocated to it.

For reference, Morningstar reported net flows for 2019 of $20.6 billion into sustainable funds, more than three times the net flows of 2018. In the most recent evidence of the urgency now surrounding ESG, BlackRock launched an exchange-traded fund dedicated to this strategy on Feb. 7. By last Wednesday, a Finnish pension insurer had invested $600 million in the new
ETF.

This reads like the stuff of Pets.com — if you haven’t been paying attention for the past 20 years.

However, ESG’s sudden influx of relevance is the culmination of the work and dreams of many altruistic investment professionals over the years. Yet, strikingly, given the years spent building this business that has governance in its name, the sector seems ill-prepared for its moment. And just as ardent believers see their dream become reality, they find themselves beset by challenges around the governance of the products they have built up for so long.

In this week’s cover story, Jeff Benjamin examines “greenwashing,” the practice of making a fund appear ideologically purer than it really is. The most salient anecdote appears to be a case of unintentional malfeasance, a situation created by a lack of standards.

An exchange-traded fund launched in 2016 touting itself as “Fossil Fuel-Free” — an attractive label to ESG purists. But astute observers discovered that the name was inaccurate, causing consternation about the purity of the ETF, or lack thereof.

The fund’s creators acknowledged the oversight and amended the name, adding the word “Reserve” to more accurately reflect the ETF’s components. But given that the financial industry must always fend off allegations of impropriety, this imprecise labeling, purposeful or not, undermines the efficacy of the ESG initiative.

Practitioners argue that the challenge grows because current ESG nomenclature is analogous to the value versus growth situation. While the general concepts are clear, the underlying definition varies from shop to shop.

There are “gaping holes” in the consistency of ESG data, Vanguard’s head of ETF product management, Rich Powers, told Jeff Benjamin. And that inconsistency yields accusations of greenwashing from groups that increasingly seek a standard definition of what ESG is.

Because Europe has led the way on ESG for years, there might be hope for a breadcrumb trail to follow. But while the Europeans have forged a path, they, too, have struggled to develop a coherent standard. The European Union instituted a reporting directive, but an expert at ESGClarity.com argues that the current formulation of the EU’s reporting directive must lead to comprehensive disclosure of nonfinancial information. The author argues that under the current directive, “Investors are unable to take sufficient account of sustainability-related risks and the opportunities of their investments.”

Several firms, including Morningstar, MSCI and As You Sow, have started rating ESG investments, but as with the funds, there’s no consistency, and it’s at the portfolio level. For the ESG sector to succeed, an organized effort must be launched to establish clear rules of play.

The industry must reach a state where clients and advisers don’t need to perform deep-dive research to determine if the term “Reserve” must be included in an investment vehicle. To do that, industry leaders need to set standards and grades for all types of ESG investments so that the investing public, thirsty to support sustainability, can be confident there is sufficient governance of ESG portfolios.

Now that it’s attracting real dollars, the ESG world must act like a real industry.