Greenwashing occurs when companies overstate their green credentials in a bid to attract consumers or investors.
Many people are familiar with the idea of greenwashing from a consumer standpoint. For example, the oil industry famously misled the public into believing that plastics would be recycled when they are currently ending up in landfills. Unfortunately, some of these same trends could be occurring in the financial industry’s ESG space.
Let’s take a look at the growth of the ESG market, concerns over greenwashing, upcoming regulations, and how you can avoid greenwashing in your portfolio.
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ESG Sees Tremendous Growth
Bloomberg Intelligence estimates that global ESG assets will exceed $53 trillion by 2025, representing more than one third of the $140.5 trillion in projected total assets under management. ESG-focused exchange-traded funds (ETFs) alone could see $1 trillion in capital inflows over the next five years, while the ESG debt market could swell to $11 trillion by 2025.
Of course, there are many different ways to define an ESG focus. For example, exclusionary funds track a mainstream index, such as the S&P 500, and exclude companies that aren’t ESG friendly. However, in some cases, oil companies may qualify if they are improving over time. Other funds only invest in companies that are advancing ESG causes.
There are no global—or even national—ESG standards. Therefore, rating companies are free to use their own judgment when evaluating companies. Despite the frequent lack of transparency, asset managers and investors rely on these ratings to build portfolios. These dynamics have led to concerns over greenwashing.
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A Push to Regulate ESG Ratings
The Biden administration recently called for better guidelines and standardization around ESG investments. In an executive order earlier this year, he directed Labor Secretary Marty Walsh to review previous rulings on including ESG funds in workplace retirement plans, such as 401(k)s. These inclusions could spur stricter regulations, given their broad impact.
The International Organization of Securities Commissions (IOSCO), a group of market regulators across the U.S., Europe, and Asia, recently recommended that regulators consider formally regulating the sector. Many of their concerns echoed the concerns of credit rating agencies (CRAs) in the aftermath of the 2008 financial crisis.
Without better regulation, the ESG industry could see lower adoption rates in the future. According to Quilter, a UK wealth manager, greenwashing was a more significant concern than investment fees and performance among investors. That said, a slowdown in growth could prompt the industry to self-regulate to reassure investors.
How to Avoid Greenwashing
The best way to avoid greenwashing is to conduct adequate due diligence on the funds and stocks you own. In particular, you should read each fund’s prospectus to understand its ESG criteria and how it meets those criteria over time. You can also look at each fund’s holdings to see if they match your expectations.
For example, the Calvert Equity Fund (CSIEX) prospectus includes key ESG metrics that go above and beyond. The fund managers vote proxies on climate change and gender pay equity, and selectively invest in companies with lower carbon emissions, toxic emissions, and tobacco exposure than the Russell 1000 Growth index.
On the other hand, the iShares ESG Aware MSCI USA ETF (ESGU) says it avoids businesses involved with civilian firearms, controversial weapons, tobacco, thermal coal, and oil sands. However, the company’s portfolio includes many large oil and gas companies that don’t fall under the exclusionary criteria, a problematic fact for some investors.
Many individual companies are also including ESG reporting in their 10K or 10Q SEC filings. These disclosures may be especially valuable for oil and gas companies transitioning to renewable energy insomuch as you can see if ESG investments are accelerating. In fact, you can use that information as a basis to build your ESG portfolio.
The Bottom Line
Greenwashing is a common concern among ESG investors. Without standards, rating agencies use their own judgment when it comes to picking ESG-friendly stocks. Investors must read through fund prospectuses or SEC filings to determine the suitability of these investments toward their ESG goals until regulators step in to fill the void.
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