Transparency of sustainability objective is key to combat greenwashingTransparencyofsustainabilityobjectiveiskeytocombatgreenwashing

Eugenia Unanyants-Jackson, global head of ESG at PGIM, says unblurring the lines between investment strategies that solely focus on mitigating ESG risks and those delivering environmental and social benefits will help reduce greenwashing.

Why does greenwashing happen and why is it a big issue for investors?

Greenwashing happens partly because varying definitions lead to misunderstanding and misinterpretation. At the heart of greenwashing concerns is the confusion over what it means to be green.

Often when investors think of sustainability, they understand it in terms of the environmental or social impact of their investments. If they’re investing in green assets, they might think about things like wind farms and electric vehicles.

But when investment professionals think about ESG, they often think in terms of financial risks and opportunities ESG factors create. When it comes to climate change, they think of how resilient their investments are to the changing climate or how significant the business opportunities arising from climate solutions are. There’s a real disconnect between the expectations from many funds and products labelled as “ESG” and the actual investment approaches, which focus on ESG risks and opportunities, and not so much on environmental and social benefits.

It’s also important to understand how the fund is seeking to achieve sustainability. People who have a very purist vision of how to achieve that sustainability would argue that investing in climate funds means financing companies that provide credible real-world climate solutions now. Whereas those with a more pragmatic approach would argue that allocating capital to green assets only today is not going to lead to an orderly transition to a low-carbon world. This is firstly because there are not enough “pure green” assets in the world today to meet the needs of all sustainability-minded investors.

Secondly, while the pace of change is accelerating, the transition is going to happen over time, and only if sufficient capital is allocated to both finance the transition [1] and also hold the management of companies accountable for executing on this transition strategy. There also needs to be more focus on reducing the demand for fossil fuels in the real economy rather than on cutting the supply, which will happen organically.

How can investors overcome the challenges that greenwashing brings?

Due to the lack of common definitions and common interpretations, transparency around the sustainability objective of an investment product is the key. Investors still have too little understanding of the difference between mitigating sustainability risks and creating positive sustainability benefits.

Every ESG strategy should be stating up front whether its ESG objective is to reduce investment risks arising from ESG factors or to create environmental and social benefits. Despite being critical, it is not actually required at the moment explicitly by any of the regulatory proposals out there. If it were required, it would be clear that a large proportion of ESG products in the market are currently focused on managing or reducing ESG risks, rather than creating environmental or social benefits. Partly, this is because most of the ESG ratings commonly used in such products are clearly focused on risk assessment rather than the sustainability of a company’s business model or its product and services, and even then there is a high degree of divergence between ratings agencies [2].

Of course, there is an overlap between mitigating risk and creating positive impact. If a company decarbonises its operations, it reduces the climate transition risk for itself, and by removing emissions it also creates an environmental benefit. But there are multiple cases where it’s not a complete overlap.

It’s like a Venn diagram: on one hand, we have sustainability benefits, on the other hand, we have mitigation of  ESG risks. There is a happy place in the middle where the two overlap. Yet investment products focusing on mitigating risk and those focusing on creating benefits look rather different. To resolve this, we need to create a clear definition and transparency around it.

How do ESG commitments, targets and pledges play a part?

Firm-level commitments help drive certain types of organisational behaviours. Yet the existence of these commitments and pledges does not guarantee an action plan behind them. Equally, the absence of public commitments doesn’t mean that a financial institution is not doing enough. The latter is a conservative path focused on developing internal methodologies and tools before making any public commitments. Therefore, to avoid greenwashing claims associated with these commitments, the public pledges need to be supported by disclosed concrete action plans that are transparent on what is actually achievable and what external conditions need to be in place in order for the targets to be met.

The divergence between the need to limit temperature increases to 1.5 degrees and the state of current pledges from governments is creating a challenge for investors who are keen to play their part in facilitating a low-carbon transition [3]. Many are compelled by the nature of their investment mandates – including the need to achieve a certain risk/return profile and diversification of their investment portfolios – to invest in the broad economy rather than just a small subset of the global economy.

The very pragmatic approach here would be for investors to look beyond the pledges and determine what each financial institution is doing in practice. They need to look at the institution’s organisational structures, strategies and resources, and determine their ability to help clients to achieve their ESG and climate objectives with integrity.

Why do we need better data to combat greenwashing? Are the current regulations like the SFDR enough to put an end to greenwashing?

The first step is to be transparent about the sustainability objective we’re trying to achieve and whether we’re focused on mitigating ESG risks or on generating positive environmental and social impact. Secondly, we need data on the environmental and social impacts of the products, services and operations of companies that we invest in. With more and better data, we can move away from relying on proxies and estimates, and we can create better tools and design better products that match the sustainability preferences of the end investors.

We still need much clearer regulation. The SFDR, for example, has been extremely successful in moving a large proportion of assets in Europe into strategies with some degree of sustainability considerations. However, the very same regulation is vague around critical aspects – we still don’t know what “sustainable investment” means. Obviously, this creates a lot of uncertainty, but also hampers transparency around those products. Many funds are being reclassified on the back of clarifications around the regulation, which has added to the perception of greenwashing.

On the positive side, we’ve also had significant progress toward a global baseline standard for sustainability disclosures [4]. In time, the definitions will become much clearer, and the mandatory standards will become more effective. But to speed up this process, any standard needs to embrace a double materiality approach. We really need to be able to meet the needs of investors who want to put their money to work toward positive environmental and social outcomes.

So, regulators shouldn’t rush proposals through, and need to understand the full spectrum of ESG investing to then create regulations to enable the comparability of labels. That’s when the labels will become reliable and when investors will start to really trust what those labels mean.

What should asset managers do differently in order to provide asset owners with more clarity on ESG practices?

Asset managers should be clear with their clients about what can and cannot be done within their investment parameters, and they need to be very clear about the implications of the chosen ESG investment strategy on investment returns. All investment strategies make some trade-offs – a large proportion of the investable universe might be excluded from consideration in an ESG strategy, for example. Investors need transparency so they can choose the right strategies to meet both their financial return expectations and their sustainability expectations within the time horizons that are appropriate for them.

The reality is that we have a very broad spectrum of investors. There’s definitely no one-size-fits-all. We have investors who are perfectly happy to invest on the basis of the investment strategy being focused on mitigating ESG risks in their portfolios. And we have investors with very sophisticated views and approaches around their sustainability goals. So, you can’t really design strategies that will be good for every type of investor.

Asset managers need to be very honest about the constraints and limitations that they might be facing in achieving these objectives. They really need to act with integrity and show the asset owner what is achievable, and what that might mean from a risk and a return perspective.

Managers also need to make sure the marketing on products really is consistent with how the portfolios are constructed and invested. When we get that clarity around what is achievable under certain conditions, the fact that we have no common definition of ‘green’ or ‘sustainable’ or ‘ESG’ becomes less problematic. When asset owners and managers are on the same page, investments can be chosen based on very specific priorities across the ESG categories.

 

^{[1] The Intergovernmental Panel on Climate Change (IPCC) estimates that global mitigation investments need to increase by a factor of 3 to 6. In developing countries, this gap is even larger. Sourced from Climate Change 2022: Mitigation of Climate Change, chapter 15, “Investment and finance”, co-authored by Silvia Kreibiehl, Tae Yong Jung, Stefano Battiston, Pablo Esteban Carvajal, Christa Clapp, Dipak Dasgupta et al (2022).}

^{[2] “Aggregate Confusion: The Divergence of ESG Ratings” – Florian Berg, Julian Koelbel, and Roberto Rigobon found significant discrepancies between the ESG ratings issued by six prominent ESG rating agencies.}

^{[3] The UN EP Emissions Gap Report 2022 found that climate policies currently in place point to a 2.8°C temperature rise by 2100. Implementation of the current pledges will only reduce this to a 2.4-2.6°C temperature rise by 2100.}

^{[4] For example, the ISSB made key announcements towards the implementation of climate-related disclosure standards in 2023.}