Net Zero: Zeroing in on Substance over Form

Net Zero: Zeroing in on Substance over Form

The recent drive towards net zero and ESG investing has had an unfortunate side effect – greenwashing. Greenwashing scandals are continuing to make headlines as regulators scrutinise bulge bracket financial institutions such as DWS, Deutsche Bank and Goldman Sachs with more certainly to follow.

The origins of greenwashing lie in the centuries-old dilemma of substance versus form. When a trend becomes fashionable, the substance is often sacrificed, as has been the case recently with ESG investing. As ESG rose rapidly into fashion, investors started implementing negative screening of non-ESG funds – or at least the market thought they did.

Fund managers have been under pressure to align with this new selection approach, but this has led to many existing funds being re-labelled as ESG, climate change or net zero focussed. The funds selected to be re-labelled would often not have had any particular focus on ESG as part of the original underlying strategy, being simply ESG- friendly by default or once minor adjustments had been made. An example of funds that easily fitted into the ESG bracket include those that focussed on Big Tech.

This changeling process has been quietly ongoing for the past couple of years, and as the overall market performance was on the up, asset managers were happy to promote the superior returns of their ESG strategy, without reference to the real underlying strategy that was driving the growth.

It is important to note that, in most cases, the underlying strategy of these changeling funds was fundamentally solid within the category in which they were operating. However, greenwashing has arisen because investors have ultimately been misinformed on what they were buying. Whereas many ‘green’ funds are marketed as being designed around their ESG component, plenty have portfolios that, at a basic level, are founded on a strategy completely unrelated to ESG. Furthermore, once the markets started falling, fund managers were all too quick to blame ESG as a concept. Many investors are now asking themselves whether they should sacrifice returns in order to save the planet.

The response to this question is a strong ‘NO’. As ever, active investment and asset management should have returns as the number one priority. Fund managers will have differing views on what trends to pursue in order to deliver maximum returns, and these views will define their fund strategy.

An ESG fund should have, at its core, the principle that investing in ESG champions, climate change leaders and issuers truly dedicated to net zero goals will achieve the best returns for investors through tapping into the biggest growth opportunity available today. Recent studies by BlackRock support this hypothesis, suggesting that impact investing has historically outperformed non-sustainable investing.

The second pillar of sound ESG investment is fundamental research and analysis. The market is full of different measurements and statistics on how issuers are performing in relation net zero targets. This is largely because most of the ESG data disclosed by companies is unstructured and is analysed by investors and ratings agencies against differing frameworks. Among these frameworks are the CDP, the Global Reporting Initiative and the UN Principles for Responsible Investment, each with divergent core principles and areas of focus. However, fundamental research should remain at the core of asset management analysis and sound investment decisions, and more demanding regulation and reporting requirements would therefore help in achieving this.

Fashion for ‘everything ESG’ has served a good cause of attracting global attention to important matters. But the industry now needs to go back to the basics and focus on delivering real ESG focussed strategies. Fund managers should not be hiding behind a fund name and Article 8 or 9 should not be a rubber stamp, but a true representation of a fund manager’s underlying strategy.

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