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As sustainability reporting kicks in, ESG investing faces global credibility risk

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Paul Clements-Hunt, who coined the acronym ESG, said that the ESG fund industry is headed for a ‘shakeout’ over the next five years As sustainability reporting kicks in, ESG investing faces global  credibility risk

In two days’ time, from April 1, new corporate governance rules as mandated by the Securities and Exchange Board of India (Sebi) will become operational. The top 1,000 companies ranked by market capitalisation will be required to include Business Responsibility and Sustainability Report (BRSR) in their annual reports. This, many experts see, as the precursor to formalisation of Environmental, Social and Governance (ESG) disclosures in India through a set of standard metrics.

The actions that corporations take for sustainability, and to protect the planet, is important for investors to understand corporate purpose, strategy, and management quality of companies.

From an investors’ point of view, ESG rankings can be a useful way to hold companies accountable, and measure them on their sustainability actions and efforts. That said, it may well be worthwhile to flag a caveat. How does one measure outcomes, and impact on a quantifiable scale that are not nationally, if not globally, standardised?

Paul Clements-Hunt, who coined the acronym ESG, said that the ESG fund industry is headed for a “shakeout” over the next five years. He is of the view that the finance sector has “sprinkled ESG fairy dust” on products that do little to account for environmental, social and governance risks.

“Anybody who uses ESG, sustainability or green purely as a marketing device is really heading for trouble. You’ll see a developing queasiness from marketing departments where, perhaps, ESG funds aren’t all what they’re cracked up to be,” he said in an interview to Bloomberg.

Experts have been cautioning about the risks associated with opaqueness in ESG measurement. In an essay in the Harvard Business Review last year, Jennifer Howard-Grenville, Diageo Professor of Organization Studies, at the Cambridge Judge Business School, said that the “current focus on ESG measurement is dangerously narrow. It fails to capture the complex, systemic nature of social and environmental systems, and indeed that of business organizations themselves”.

ESG funds and their managers from across the world are gradually, but increasingly, showing signs of acknowledging that a more restrained approach may be required in ESG investing, which may also be partly drawn by disproportionately greater commissions that incentivises them to skew their portfolios towards such investments.

The key question for asset managers is: What are classified as ESG investment, and what are not?

A recent Schroders Institutional Investor Study, ‘Gearing up against greenwashers: investors seek clarity on sustainability terminology,’ has revealed that investors want a better understanding of sustainability terminology so as to avoid ‘greenwashers’. ‘Greenwashing’ happens when companies falsely communicate and make unsubstantiated claims about environmentally-friendly products, and processes.

“A dearth of clear, agreed sustainability definitions present a challenge to investors looking to invest sustainably”, it said. The study surveyed 650 institutional investors across 26 countries during April 2020.

Tariq Fancy, who was BlackRock’s first global chief investment officer for sustainable investing between 2018 and 2019, has also cautioned about the errors that are beginning to creep into these investments, guided by incomplete information, and interpretation.

“Green bonds, where companies raise debt for environmentally friendly uses, is one of the largest and fastest-growing categories in sustainable investing, with a market size that has now passed $1 trillion. In practice, it’s not totally clear if they create much positive environmental impact that would not have occurred otherwise,” Fancy said in a recent online essay.

This is because “most companies have a few qualifying green initiatives that they can raise green bonds to specifically fund while not increasing or altering their overall plans. And nothing stops them from pursuing decidedly non-green activities with their other sources of funding,” he added.

Financial institutions may have an extra motivation to push for ESG products, driven by higher fees that they earn.

According to data from FactSet and published by the Wall Street Journal, ESG funds had an average fee of 0.2 percent at the end of 2020, whereas other more standard baskets of stocks had fees of 0.14 percent. The Wall Street Journal said that “socially focused exchange-traded funds give asset managers higher fees in a low-fee industry.”

The lack of reliable and standardised data and metrics has opened up the precarious possibility of pitting one investors’ views against another, meaning one portfolio manager could classify a firm as ESG-friendly, while another might view the same firm as not doing much on sustainability efforts.

Sheila Patel, chair of Goldman Sachs Asset Management, underlined this with caution. “When you think about the composition of ESG funds it’s first of all important to remember they are still meant to be a fund invested to get a return for the portfolio. And so they can tilt based on industry groups, based on sector views and that may or may not relate to an ESG view,” Patel told CNBC.

There is no gainsaying that ESG investing today is big business. Trillions of dollars are at stake, based on the individual fund managers’ interpretation about companies. This can be fraught with risks as the absence of a standardised, transparent system of gauging sustainability efforts may allow fund managers’ biases to influence ESG investment decisions, rather than informed choices guided by prudent, globally accepted norms, and audit.

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