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What is greenwashing, and why some green funds own fossil fuels

Jon Hale, Ph.D., CFA  |  02 Nov 2021Text size  Decrease  Increase  |  
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The rapid growth of sustainable investing has led to concerns about greenwashing. Given the increase in the number of sustainable funds and the range of approaches they employ, investors are asking whether fund managers are making misleading or unsubstantiated claims about the sustainability characteristics and benefits of their investment products. Investors may feel disappointed or even cheated to find that the sustainable funds they have selected are not delivering the benefits the funds seemed to promise.

And greenwashing poses problems for the planet if money doesn’t flow into activities that help solve environmental issues like climate change, or social issues, like improved worker conditions and rising inequality.

It can be easy for investors to suspect greenwashing ... and difficult to spot it. This guide provides some tips and answers to common questions about greenwashing.

What is greenwashing?

In the context of sustainable investing, greenwashing is making unsubstantiated or misleading claims about the sustainability characteristics and benefits of an investment product. Sometimes other terms are used, such as “sustainability washing,” “impact washing,” or even “SDG watching,” referring to misleading claims about a product’s adherence to the UN Sustainable Development Goals.

Greenwashing is generally seen as intentional, occurring when asset managers overclaim and oversell what they are actually providing. Such practices are clearly problematic and corrosive to long-term trust and credibility.

What is sometimes seen as greenwashing, however, may not be intentional but instead result from differing definitions of “sustainability” and/or a mismatch between an investor’s expectations and the specific approach used by a sustainable fund. This is even more of a challenge because there are no universally agreed-upon definitions for “sustainable,” “green,” or “impact” investments. An investor with a specific, even personalized, idea of what a sustainable investment should look like may assume that any sustainable fund would be consistent with that view.

Both intentional greenwashing and the mismatch of expectations can be addressed through disclosure and investor education. Asset managers need to be upfront about what’s green or sustainable about their products and report on the environmental, social, and governance characteristics of their products. Companies must do the same and be transparent about their business practices, including what is happening in their supply chain.

My sustainable fund looks a lot like a conventional fund. Why?

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Sustainable funds employ a variety of approaches, ranging from excluding companies or choosing best-in-class operators to investing around certain sustainability themes or trying to generate positive outcomes beyond good returns for people and planet.

For example, many sustainable funds use ESG evaluations to determine if a company's stock belongs in their portfolio, but they also use traditional investment criteria to assess a company’s growth prospects or a stock’s valuation, which may play an important role in how much of a stock the fund owns. While the ESG assessment may disqualify a company, many of today's most familiar and successful companies have ESG assessments that are good enough for them to earn a spot in an ESG portfolio.

Company-level ESG evaluations consider the positive and negative impacts of the products a company makes and sells; how that company manages its environmental challenges, its workforce, and supply chain; and the impact of its operations on the places where it operates, among other criteria. In sustainable funds that use broad ESG assessments, it’s not uncommon for market-leading quality growth companies to be among the top holdings.

Passive sustainable funds are often market-cap-weighted, so their top holdings will be some of the largest, most familiar companies. And some passive sustainable funds may look a lot like conventional index funds because they employ a tilting approach: They underweight companies that have lower ESG assessments, while overweighting those with better ESG assessments. Still other funds may intentionally hold companies with lower ESG evaluations and seek positive change by engaging with these companies.

My sustainable fund has fossil fuel exposure! Why?

Many sustainable funds do avoid fossil fuels, but there’s no formal requirement or informal consensus that they do so. Some sustainable funds limit some fossil fuel exposure but not completely. They may avoid investing in companies exposed to thermal coal or other controversial or particularly emissions-heavy practices. If they do invest in fossil fuel companies, they may focus on "best-in-class" firms that perform better on ESG issues than peers in the industry. The sustainable funds that do invest in fossil fuel firms often argue that engaging with these firms as shareholders prods the firms into making commitments to reduce emissions and adjust their business models, which can produce greater impact than avoiding them altogether.

Many sustainable funds also invest in so-called "transition companies." These are utilities or oil & gas companies that are transitioning away from their highly carbon-intensive activities and setting net-zero-emissions targets. These include operators that are building their renewable energy business but still operating their legacy fossil fuel business.

For funds that do exclude fossil fuels, it’s important to understand the specific parameters around the exclusion. Is it a total exclusion, or is it focused on excluding the worst fossil fuel types and practices? Excluding thermal coal, Arctic oil & gas exploration, and oil sands extraction has become common practice among most sustainable funds. But it’s less the case with other types of fossil fuel activities.

In our opinion, all sustainable funds should articulate and make available to investors their approach to investing in fossil fuel companies.

My sustainable fund has “bad” companies in it. Why?

One reason is that company-level ESG evaluations don’t categorize companies as “good” or “bad.” They compare firms to their peers based on specific ESG issues that could have a material impact on the firm and its stock. Different sustainable fund managers draw the line of acceptability at different levels. Some avoid only the firms with the worst ESG ratings. Others may include companies with the best ESG evaluations within their specific industry or sector. A sustainable fund using this approach, for example, may select a “best-in-class” fossil fuel company to represent exposure to that sector. This may not sit well with an investor who considers all fossil fuel companies as “bad” and wishes to avoid them.

If a fund defines itself as a sustainable fund in its prospectus and marketing materials, investors instinctively expect the portfolio to favor companies with leading ESG practices. At the very least, an investor might expect that the fund won’t expose them to controversial industries, such as weapons or tobacco, or controversial companies that violate international norms such as the U.N. Global Compact principles. While a majority of sustainable funds have extensive exclusion policies, some exclude only a couple of controversial sectors and/or just a few companies with the most severe controversies.

My sustainable fund doesn’t own Tesla, or other companies creating the products that will lead us to a more sustainable, low-carbon economy. Why not?

Sustainable funds follow different approaches. A fund may be more focused on company ESG evaluations than on product impact or broad sustainability themes. A firm like Tesla (TSLA) has ESG risks related to its employee relations, product governance, and overall corporate governance that may lead some sustainable funds to avoid it. Some funds, on the other hand, do take a broad thematic approach, looking specifically for companies like Tesla.

When choosing a sustainable fund, investors should carefully consider their "green" preferences and risk appetite. A fund that holds only companies that provide solutions to climate change, for example, may not be as widely diversified as one that uses broad ESG evaluations and “best-in-class” selection.

What are some ways I can spot greenwashing so I can avoid it?

Due diligence is key. Look beyond a fund’s name or label and understand what the fund’s objective is: What does the fund aim to do? Does it aim to invest in companies with lower ESG risk? Does it aim to invest in companies that offer solutions to the world’s biggest challenges? Does the fund claim to have some sort of impact?

Many greenwashing accusations come from investors who expected their fund to do something different. But as we point out, funds come in many flavors. One helpful guide is Morningstar’s own sustainable investing framework, which describes the different approaches to sustainable investing and helps investors identify their preferences so they can find the funds that best fit them.

And of course, look under the hood at the fund’s holdings and their ESG characteristics. Many funds with a climate theme don’t invest only in green companies. They may invest in so-called “transition” companies. These companies don’t necessarily have good green credentials today but plan to improve their environmental profile. Morningstar provides ESG metrics and ratings that enable investors to assess the sustainability profile of investment products.

Regulators are working to address the problem of greenwashing. Europe introduced the Sustainable Finance Disclosures Regulation, or SFDR, in March 2021, requiring funds marketed in the European Union to disclose ESG risks as well as impact on society and the planet. In the United States, the Securities & Exchange Commission has launched initiatives to identify material gaps or misstatements regarding ESG risk at the company level and also among investment advisors running ESG strategies.

is head of sustainability research for Morningstar.

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