Investing according to environmental, social and governance (ESG) principles emerged as a major focus of COP26, the United Nations Climate Change Conference, which wraps up on Nov. 12.
But the international rendezvous of government and industry leaders has also become a catalyst for criticism about so-called “greenwashing” in the financial industry.
“Sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community,” Tariq Fancy, the former chief investment officer of sustainable investing at financial giant BlackRock wrote in an opinion piece for USA Today in March.
Sustainable investing has ballooned into a US$35 trillion (CAD$44 trillion) industry, according to the Global Sustainable Investment Alliance. At the start of 2020, more than a third of investment assets managed globally were classified as sustainable, the organization estimates.
Driving that growth is demand from both small and large investors for more focus on ESG factors in addition to financial returns, says Jan Mahrt-Smith, an associate professor of finance at the University of Toronto.
The hype about ESG investing, though, doesn’t always live up to reality, he cautions. Making sure your financial portfolio is in line with your values usually requires some legwork, he adds.
What exactly is ESG investing?
ESG metrics help evaluate firm performance based on sustainability priorities. The “E” stands for “environment,” reflecting a focus on aspects like resource use and pollution. The “S” stands for “social,” which looks at issues like a company’s treatment of its own employees or labour practices within its supply chain. The “G” stands for “governance,” which draws attention to questions such as gender diversity within the board of directors.
The idea is to rate companies based on how they’re doing on those dimensions, in addition to traditional ratings based on information about financial returns and risk, Mahrt-Smith explains.
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Applying ESG weightings to a financial portfolio or fund is just one way to incorporate a sustainability lens in investment portfolios. Another one is so-called negative screening, which outright excludes industries considered undesirable and has traditionally targeted sectors like gambling, tobacco and arms manufacturers. Yet another approach is impact investing, which puts the emphasis on investing with the goal of generating positive impacts on the environment and society, along with generating returns.
But sustainable investment claims these days are a bit like the organic labels of yore, says Tim Nash, founder of Good Investing, a financial planning company that helps small investors put their money where their heart is.
At the dawn of ethical consumerism, there was no standardized certification for organic products, Nash says. Companies could make improbable organic, green or eco-friendly claims without much repercussion, he adds.
As Nash sees it, that’s the stage sustainable investing is currently at.
“It is a bit of a Wild West,” he says. “It is a bit of a ‘buyer beware’ (environment): you kind of have to do your homework.”
One problem is that there are no globally accepted standards for ESG metrics, Nash says.
Another issue is that there are no strict parameters forcing firms to disclose crucial information about their performance on sustainability goals, according to Mahrt-Smith.
When it comes to financial disclosures, “firms can get in real trouble if they are not disclosing something or they’re disclosing something (incorrectly),” he says.
But when speaking about environmental or social impacts, companies have plenty of latitude to cherry-pick information to paint the best possible picture without outright lying, he adds.
Yet another stumbling block for ethical investors is that ESG ratings are mostly focused on “how well your money is protected from environmental risks, social risks or governance risks,” Mahrt-Smith says. “What they are not really capturing yet is the impact that the firms are having on the world, be it positive or negative.”
Regulators around the world are increasingly pledging to bring order to the sustainable investing chaos.
In March, the European Union implemented rules that spell out how asset managers should disclose information both about how ESG risks could impact the value of their investments and how the conduct of the companies they invest in affects the environment and society.
During the same month, the U.S. Securities and Exchange Commission (SEC) announced it was creating a Climate and ESG Task Force to “identify ESG-related misconduct.”
And one of the outcomes of COP26 was the creation of an International Sustainability Standards Board, with offices in Montreal and Frankfurt, Germany, in charge of establishing transparent and globally consistent ESG reporting standards.
How to avoid greenwashing when investing
Despite the recent regulatory push, if you want to invest sustainably, you should do your own research, both Nash and Mahrt-Smith say.
Whether you’re looking at mutual funds or exchange-traded funds (ETFs) that carry the ESG label, keep in mind there is often a gap between the claims you’ll see in a fund’s brochure and what you’ll find in the fund’s prospectus, Nash says. The first is a marketing document. The latter is where you’ll find the nitty-gritty investment details.
If you have an investment advisor or a financial planner, you can ask them to help you wade through the prospectus and walk you through the approach the fund is taking to sustainable investing, Nash says.
But if you’re fending for yourself and unfamiliar with financial jargon, Nash says, a simpler approach is to just look at the list of companies the fund is investing in, which you’ll also find in the prospectus.
“It’s not enough just to see the top 10. You really should see the full list of holdings,” he says.
You may be surprised to find your ESG fund invests in oil and gas companies, for example.
Few funds exclude the oil and gas sector from their holdings, Nash says. Instead, many use ESG metrics to select energy companies considered most responsible within the industry, he adds.
Still, Nash says he’s constantly seeing clients who are shocked to discover their ESG portfolio includes shares of major oil and gas producers.
If there are certain industries you don’t want to invest a single penny in, make sure they are listed in a fund’s exclusions or negative screens, he says.
“What’s great is that there are now so many different ESG ETFs that hopefully we can find one that’s a little bit more aligned with your values.”
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