Regulators need to help ESG investing grow up

Regulators need to help ESG investing grow up

Sustainable investing needs help maturing – not smothering.
Sustainable investing needs help maturing – not smothering.

ESG investment is reeling in the glare of the regulatory spotlight. The US Securities and Exchange Commission is preparing new rules intended to combat “greenwashing” – part of a rising tide of regulation for ESG investing globally – and some of the world’s biggest names are now in focus. The Wall Street Journal reported last week that the US Securities and Exchange Commission is investigating Goldman Sachs Asset Management over certain Environmental, Social and Governance claims made by its funds.

This is raising concerns that over-regulation will burn up an asset class that – at its best – aims to stop the planet from burning up around us. On the other side, however, it is undeniably true that many investments presented as aligning with ESG considerations actually do little to make the world a better place.

Regulation, of course, is necessary, and misrepresentations must be prevented. But sustainable investment must also be allowed to live up to its intended purpose as a tool for the transition to a cleaner, greener and more equitable future. As this industry matures, regulators have an opportunity to make sure it grows up in the right way.

In markets flush with liquidity and optimism last year, sustainable investing soared into the stratosphere. Massive demand for ESG-themed funds seemed to reflect growing awareness of the climate crisis in particular. According to Morningstar, sustainable mutual funds and ESG-focused exchange-traded funds rose globally by 54% in 2021 to US$2.7 trillion, with a net US$596 billion of inflows.

Before this year’s bout of market volatility, investors also did well by doing good. ESG indices outperformed broader market benchmarks: the MSCI World ESG Leaders’ index rose by over 25% in 2021 compared with the MSCI World index’s return of 22%.

Alarm bells

All the while, though, alarm bells were ringing. How could oil and gas companies feature in supposedly sustainable funds, people wondered? Tariq Fancy, the former Chief Investment Officer of Sustainable Investing at BlackRock, the world’s biggest asset manager, stoked the fire when he turned ESG critic in a now-famous USA Today op-ed in March last year. “In truth,” he wrote, “sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community.”

Subsequent research has appeared to support this point of view. More than half of climate-themed ESG funds are not aligned with the Paris Agreement’s goal of limiting climate change to less than 2°C above pre-industrial levels, according to a study by InfluenceMap, a climate change think tank.

Now global regulators including the SEC, European Securities and Markets Authority, UK Financial Conduct Authority and Hong Kong’s Securities and Futures Commission are joining the fight against greenwashing. The SEC aims to prevent misleading ESG claims from asset managers and enforce more standardised disclosures. Among other things, its proposed new rules will require certain funds to hold at least 80% of their assets in accordance with the focus suggested by the fund’s name. In other words, funds will not be able to use the ESG label if these factors are not central to their investment decisions.

In Europe, ESMA is working on a legal definition of greenwashing, which would be an important step towards a common understanding of a term that is perhaps as loosely used as ESG itself. Britain’s FCA launched a set of principles for ESG-labelled funds nearly a year ago and is working on regulation in this area. The SFC in Hong Kong has likewise provided guidance on enhanced disclosures for funds that incorporate ESG factors. Regulators from Switzerland to Singapore are moving in the same direction.

This is important work. It goes without saying that funds should be accurately labelled and marketed; to do otherwise can harm investors and undermine confidence in the investment industry.

But it’s equally important that regulators don’t unintentionally thwart the growth of ESG investing at a time when the world needs unprecedented volumes of capital to finance the transition to net-zero emissions – not to mention the delivery of the other UN Sustainable Development Goals. McKinsey reckons that the shift to carbon neutrality by 2050 will require US$9.2 trillion of annual average spending on physical assets, or US$3.5 trillion more than today.

Structural shift

Much of this money will come from individual and institutional asset owners, and be deployed via asset managers. The imperative of financing the transition makes it essential, then, that ESG investment continues to grow at a rapid clip. There is a risk, though, that a constant drumbeat of regulatory statements and enforcement actions will cast such a shadow over the ESG investment industry that capital in fact gets drawn away. According to Morningstar, net inflows into sustainable funds globally already declined by 36% over the previous quarter in the first three months of 2022. Clearly, stemming the flow of capital to truly sustainable purposes is not any regulator’s intention; nor is it in anyone’s interests.

There are reasons to be confident that stricter regulatory policing will not crash ESG investing, though. Even if the rush of fund launches cools for a time – 121 new funds came to market in 2021, versus 71 in 2020 – ESG is now hardwired into the investment processes of many of the world’s biggest asset owners. That structural trend will not be reversed by more robust regulation; if anything, it will be reinforced.

But regulators should still move swiftly and decisively towards clarifying what is and isn’t an ESG fund – and ensure that there is a high degree of global consensus on this question. It will not be an easy process but it should encourage a valuable debate and a more mature understanding of sustainable finance.

And a more grown-up definition of sustainability will be critical if the ESG investment industry is going to help finance the decarbonisation of our economies.

It’s easy to see, for example, how a fund that only invested in renewable energy companies would deserve an ESG label. But simply excluding carbon-intensive companies from the ESG universe will do little to catalyse the energy transition and may simply drive these firms to private and less selective sources of capital.

A narrow concept of sustainability is not the answer, then. Instead, a more mature definition of ESG investing must recognise the progress companies make towards transitioning to net zero, and the alignment of their trajectory with the Paris goals. As regulators work towards greater transparency in the labelling for ESG funds, they have a great opportunity to help sustainable investment grow up too.

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