How green is your fund? Beware of greenwashing

As interest in sustainable investing continues to grow, there has been a corresponding increase in environmental, social, and governance (ESG) or "green" investment products. One of the biggest challenges that sustainability-oriented investors face is the lack of universal ESG standards, which can make it difficult to ascertain how green a fund is.

According to leading sustainability expert Ma Jun, chairman of the China Society for Finance and Banking's Green Finance Committee, there may be 200 ESG taxonomies in existence
already. Standards vary across countries; what may be considered a green investment in one country does not make the grade in another.

When ESG standards differ, it creates inefficiencies. Meaningful comparisons then can become more difficult and, in turn, may inhibit efficient allocation of capital. Further, ambiguity leads to increased risks of greenwashing.

What Is greenwashing?

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 washing," referring to misleading claims about a product’s adherence to the United Nations' Sustainable Development Goals.

Greenwashing is generally seen as intentional, occurring when asset managers overclaim and oversell their green credentials. Such practices are problematic and corrosive to long-term trust and credibility.

Sometimes greenwashing, may not be intentional but instead results from differing definitions of sustainability and/or a mismatch between an investor's expectations and the specific approach used by a sustainable fund.

Intentional greenwashing and the mismatch of expectations can be addressed through disclosure and investor education. Asset managers need to be up front about what's green or sustainable about their products and report on the ESG characteristics of their products. Companies must do the same and be transparent about their business practices, including what is happening in their supply chains.

Greenwashing is on regulators' radar

The Australian Securities and Investments Commission (ASIC) has flagged greenwashing as a potential issue, and it has been reviewing funds to determine whether those that purport to be green live up to those claims.

To further help manage greenwashing risks, ASIC is involved with the International Organisation of Securities Commissions' Sustainable Finance Taskforce; one of the key issues the task force addresses is greenwashing.

ASIC has also advised that it is monitoring the International Sustainability Standards Board (ISSB)  which was set up to address the need for the development of global sustainability standards. The regulator indicated that the work undertaken by ISSB may have implications for future reporting practices locally, particularly for listed companies.

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

Knowing that greenwashing exists is a great start. Look beyond a fund's name or label and understand what its objective is: 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?

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 also invest in so-called "transition" companies. These companies don't necessarily have good green credentials today but plan to improve their environmental profiles. Morningstar provides ESG metrics and ratings that enable investors to assess the sustainability profile of investment products.

Many greenwashing accusations come from investors who expected their funds to do something different. But funds come in many flavours. To help investors understand the different approaches to ESG investing, Morningstar has built a Sustainable Investing Framework that provides guidance on the types of approaches that can be taken when investing sustainably.

The Morningstar Sustainable Investing Framework

Source: Morningstar

It is not expected that asset managers will fit neatly into only one sustainable investing approach. Funds can and will deploy multiple approaches, depending on a variety of issues, such as the available investment opportunity set, market conditions, the ability to influence via active ownership, and the trade-off between generating returns and managing ESG quality, to name but a few.

At one end of the sustainable investing framework are exclusions, where the asset manager will screen out or reduce undesired exposures to controversial products such as tobacco, gambling, palm oil, or armaments.

At the opposite end of the framework are impact assessments. Asset managers that take this approach positively invest for impact, aiming to address known ESG issues. Often impact funds will link their investments to the UN Sustainable Development Goals, transparently monitoring, measuring, and reporting on the positive impacts generated by their investments. The types of investments within an impact portfolio can be wide-ranging, from supporting innovation occurring in traditional industries such as the automotive sector's production of electric vehicles to help reduce carbon emissions, to supporting newer industries like wind and solar farms as alternative energy sources to fossil fuels. Typically, impact strategies will incorporate multiple sustainable investment approaches into their portfolios such as exclusions, active ownership, and sustainability themes.

ESG investing is not a binary pursuit, understanding the different approaches available can help investors better assess their options and articulate their preferred investment style.

This piece was adapted from "What Is Greenwashing, and Answers to Your Other Questions," by Jon Hale, Morningstar's head of sustainability research for the Americas, and Hortense Bioy, Morningstar's global director of sustainability research.