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With ESG, Things Aren’t Always As Green As They Seem

By Mintz - Energy & Sustainability Viewpoints on 02 November, 2020
1 min read | Industry Insights Insights Home

esg

Environmental, social, and governance (“ESG”) investing has captured the attention (and dollars) of more institutional investors each year and continues to grow exponentially. However, how can an ESG investor be sure that the investments it is making truly align with the values those funds purport to prioritize? The answer is unfortunately not always clear on an investment’s face and, with no standardized systems or regulations establishing clear ESG criteria, institutional investors and the financial services companies that deal with them should proceed cautiously. The possibility of “Monday-morning quarterbacking” by regulators and future litigants is real, and one area particularly ripe for such second-guessing arises from a practice known as “greenwashing.”

“Greenwashing”

The term “greenwashing” was coined by environmentalist Jay Westerveld in 1986 to describe the effect of hotels seeking to appear environmentally-conscious by leaving out placards inviting guests to reuse their towels (which he called the “save the towel movement”) when, in reality, large hotels were generating enormous amounts of environmental waste in myriad other ways. Essentially, “greenwashing” now refers to any instance of a company placing more focus on appearing “green” than actually being “green.” In the ESG arena, the term is used to describe the act of making statements or providing descriptions that make an investment seem more committed to or reflective of ESG criteria than it really is.

Because ESG investing is rapidly growing in popularity and because what makes an investment ESG can vary widely, companies face a temptation to seem environmentally-, socially-, and/or governance-conscious even when their actions do not justify the ESG label. For example, it is not uncommon for a fund, even inadvertently, to be marketed as ESG when, in reality, only a small portion of the investments that make up the fund are actually ESG. This is another form of greenwashing, because it may deceive an institutional investor into thinking a fund is “greener” overall than it actually is or, worse still, may convince that investor to choose a fund that contains investments contrary to its investment policies—subjecting it to potential liability.

Not Always the Work of Bad Actors

Although greenwashing sounds like a mischievous attempt at passing off investments as something they are not, not all greenwashing is malicious or even intentional. Rather, institutional investors (and the asset managers that service them) often lack the resources or expertise in environmental, social, and governance issues to accurately assess the relative compliance of a particular portfolio investment. Others simply place too much emphasis on a few ESG-conscious aspects of an investment without considering all other aspects, some of which might be less in line with ESG interests. Further, as there are no uniform metrics for evaluating ESG criteria, the analysis is quite subjective—and, as a result, even artificial intelligence tools are of little value in identifying and evaluating ESG investments.

Similarly, although there are ESG scoring agencies that claim to help make sense of all of this, they, too, lack standardized methodologies and rating systems, so those scores do little to dissipate the greenwashing fog. At this time, there are no clear disclosure requirements that would help guide an investor through the haze. In addition, different scoring agencies prioritize different aspects of ESG criteria, whereby a company may score well because of its environmental initiatives even while it is falling quite short on the “S” and “G” elements. Finally, it is important to note that these scoring agencies rely on corporate self-reporting, and, consequently, their data is limited by the completeness of a company’s report, as well as its accuracy. Particularly for companies outside of the United States and Europe, ESG criteria may not be widely (or accurately) reported, which obviously makes it difficult for a scoring agency to meaningfully assess.

The SEC Considers Stepping In

Acknowledging this problem, in March 2020, the United States Securities and Exchange Commission (“SEC”) issued a request for public comment on potential changes to the so-called Names Rule (Rule 35d-1 of the Investment Company Act of 1940, as amended), seeking input as to, among other things, whether the rule should be updated to help protect investors from misleading fund names purporting to be ESG investments. The Names Rule, adopted in 2001, requires a fund whose name denotes a certain type of investment to have at least 80% of its assets invested in that type of investment and prohibits the use of certain “words that the Commission finds are materially deceptive or misleading” in fund names.

The SEC asked for public comment as to whether the Names Rule should apply to the terms “ESG” and “sustainable,” and sought input as to how investors rely on these terms. The SEC also specifically requested input as to how the agency should determine whether an investment meets ESG criteria (which, again, is no easy question given how subjective it can be and the extent to which different investors value different aspects of ESG). The SEC also recognized that the use of the term “ESG” varies across funds. The Names Rule applies only to fund names referencing specific investment types and does not apply to descriptions of fund strategies, objectives, or policies. Whether “ESG” refers to an investment type or a strategy, however, remains unsettled, and thus the very application of the Names Rule to ESG investing is, at best, unclear.

Advice in the Absence of Regulatory Action

Although the public comment period ended in May 2020, as of now, the SEC has not taken any action in follow up to its request for public comment, and there is no indication that the Names Rule will expand to reach ESG investing anytime soon. Any change would require the formal rulemaking process to be followed, which would take quite a bit of time. As such, for now, both institutional investors and the financial services companies that assist them must evaluate ESG investments with a skeptical eye and really do their homework before accepting all ESG-related claims as true. This will require seeking out and evaluating non-financial information in addition to the usual financial criteria. Simply put, investors must seek out detailed information and remain skeptical of broad generalizations and empty taglines. Investors should examine as closely as possible the underlying investments, their ownership structure, management, and leadership, and their corporate objectives and priorities—and, in turn, be wary of any investment that seems to be making such examination difficult or murky. Until strong ESG definitional guardrails are put in place, along with a robust compliance infrastructure to ensure that ESG investments are what they purport to be, the litigation and regulatory risks to all those involved are significant. In short, institutional investors and financial services companies beware: things are not always as green as they seem.

 

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