ESG investor scrutiny and the impact on corporates: setting the context

Recently, we’ve seen regulators, the press and other stakeholders increasingly focusing on ESG investing, which is often described interchangeably as either responsible investing, sustainable investing, ethical investing or socially-responsible investing (SRI). 

To start with, we’ll look at the reasons that led to this increased scrutiny on asset managers’ ESG claims, their likely responses, and our views on what this means for other stakeholders, especially for corporates that may issue sustainable debt in the future. The next three articles, published monthly, will then be covering the impacts and considerations for corporate issuers, including: how those issuers consider their wider ESG strategy, disclosure and reporting of their sustainable debt instrument, and the effect on pricing of debt.

ESG investing, greenwashing, and regulation

ESG investing has its foundations in investment strategies that excluded industries not aligned to religious values, and the divestment movements focused on college endowments in the 1970s and 1980s. It has now expanded to various strategies that consider ESG information as part of portfolio construction. Over the last two years, there has been an increase in inflows from both retail and institutional investors[1], driving a significant uptick in the number of funds available[2].

In order to differentiate their funds, asset managers have sometimes made unclear claims about the underlying investment process, use of ESG information, or the impact that investing in these funds actually has – with any of these actions to be considered as ‘greenwashing’. Environmentalist Jay Westerveld used the term greenwashing for the first time in 1986[3] while referring to the practice of making diverting sustainability claims to cover a questionable environmental record. For asset managers this means providing misleading information about how a fund or investment strategy are more environmentally friendly. The outcome from this increased assessment of manager claims may have a wider effect on the entire sustainable finance and investment ecosystem.

During this same period, attempts have been made to codify the disclosures around how asset managers use ESG information in the investment process, so that investors have the information they need. The most well-known of these is the EU’s Sustainable Finance Disclosure Regulation (SFDR), which requires asset managers to label all funds marketed in Europe according to one of three categories. The definitions for the labelling funds are not very clear, (but more granular criteria are coming)[4], and there are currently limited consequences for asset managers if they mis-label a fund or do not make the appropriate disclosures to support the labelling, as regulators allow for some bedding in time for asset managers to comply with the new rules. However, this is expected to change very soon.

SFDR definitions as they stand

The specific disclosures vary depending on whether a product is classified under Article 6, 8 or 9.

Source: NatWest and Macfarlanes[5]

Claims, whistleblowers, and investigations

As ESG investing is becoming more mainstream, asset managers are making significant commitments and claims regarding their ESG credentials. However, criticism has started to come from staff inside asset management firms, claiming that credentials and reality do not always match. Disputes are even occurring in ESG ‘leaders’, such as investment company BlackRock. BlackRock’s CEO Larry Fink started to reference ESG issues in his annual CEO letter back in 2017 – his 2021 letter was almost completely dedicated to sustainable investing and BlackRock’s net zero initiatives.

However, Tariq Fancy, BlackRock’s former Chief Investment Officer of Sustainable Investing, in his initial op-ed[6] and follow-up essay[7], stated that BlackRock is overstating how managing climate change-related risks in portfolios is helpful in the fight against climate change itself. Similarly, a former sustainability executive at DWS, Desiree Fixler, went public[8] more recently with her claims that what DWS publicly reported, on how much of its AUM were invested using ESG data, was overstated compared to what is actually occurring.

The key to selling the product was to keep it simple, even if that meant glossing over how it directly contributed to fighting climate change, which was always hard to explain and at best a bit uncertain.

Tariq Fancy
Blackrock's former chief investment officer of sustainable investing

It's not necessarily that DWS has wrongly defined what ESG-compliant investments are, but rather it's about misrepresentation, the difference between what the company says internally and what it says externally.

Desiree Fixler
Former sustainability executive at DWS

Following the whistleblowing from Ms. Fixler, the U.S. Securities and Exchange Commission (SEC) and Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) have started to investigate DWS, resulting in DWS’s share price dropping by more than 10% with little in the way of recovery at the time of writing. Noting this swift reaction, other asset managers have announced they are reviewing existing disclosures, evaluating the SFDR labels and names given to funds, and ensuring that their investment process could stand up to examination on how ESG information is used. It’s likely these firms will continue to improve their investment processes so that the portfolio decision-making process matches the expectations of investors and regulators.

Changing expectations for issuers

While it’s likely that more prescriptive regulations for corporate ESG disclosures are coming, we envisage that borrowers accessing sustainable financing are likely to need to meet additional scrutiny coming from investors, who will be asking for more evidence to decide whether a corporate issuer or issuance belongs in a sustainable portfolio. This may mean that corporate issuers may have to provide more detail on their sustainability strategy and goals and specify the real-world impact of the projects they are financing, or how their targets go beyond “business as usual” whilst ensuring compliance with emerging regulations, taxonomies, and principles.

Key takeaways for corporates

Source: NatWest

Investor analysis is already moving beyond box-ticking that confirms issuers meet policy thresholds (e.g. don’t operate in excluded sectors) or that sustainable debt instruments have the appropriate label or align to a specific taxonomy. This will mean that investors will want to understand better how the issuer’s overall sustainability strategy aligns to or is supported by the sustainable debt structure (e.g. how a diversity target drives sustainable outcomes for the issuer).  This approach will also likely expand to reviewing the type of sustainable financing framework or instrument, not only if the use of proceeds or KPIs and targets are relevant, but whether the structuring (use of proceeds or KPI-linked) allows the financing to fulfil the sustainability strategy or if the financing is limited in its impact. Additionally, there may be less reliance on benchmarks to indicate acceptance of a sustainable debt issuance (for strategies that allow such an approach), due to those benchmarks relying on sometimes opaque ESG scores and lack of engagement with issuers.

In our next article in this series, we’ll be covering how investors will likely move beyond solely relying on ESG ratings as the basis for investment decisions and inclusion in sustainable portfolios, and what that means for corporate issuers in developing their sustainability strategy, constructing relevant KPIs and targets, and communicating that as part of transaction marketing.

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