Looks Can be Deceiving

Blog post by Roland Kölsch, CEO of the Quality Assurance Organisation for Sustainable Investments and responsible for the FNG-Label, the SRI quality standard for the german speaking markets

Recently, a so-called “Certificate of the Month” based on a “strict” sustainability index with the name element “Climate Impact” was advertised in a financial publication. In other words, the two terms “impact” and “strict” suggest that this really must be profound sustainability. Unfortunately, when you look at the content, you find a large, well-known, conventional stock index that, while relying on the pioneer of CO2 data collection CDP and one of the major ESG agencies, actually lists many companies that merely “manage” climate change (less than 1/3 stand out as best-practice, let alone thematic solution providers), thus separating the better from the worse half. The product then includes stocks such as Total, Royal Dutch Shell, Anglo American, BHP, Eni, Neste Oil, Lundin Petroleum, OMV, ThyssenKrupp, Endesa, Fortum, RWE. Compared to other large corporations, these companies contribute at best to a necessary transformation, but they are by no means stocks for a future-oriented impact investment!

Describing the index on which this certificate is based as a “strict” sustainability index sounds like sheer mockery compared to very selective indices such as the Natur-Aktien-Index or the Global Challenges Index of the Hannover Stock Exchange. The quotation marks here can only be meant in an ironic way. And the designation of the index itself as “Climate Impact” is a farce!

Unfortunately, this is a striking example of “impact washing”

Giving a fund, ETF or certificate the name IMPACT when it exclusively deals with large corporations traded on the secondary market is simply misleading and fueling criticism from SRI activists, who often state that deception in the form of an illusion about impact is being practiced. Even more so if one is not able to measure and demonstrate the suggested impact – a main characteristic of impact investments.

Impact investing primarily aims at investing in companies and organizations to generate concrete, measurable, positive impacts in a sustainability context. The social or environmental impact is part of the investment strategy and will be measured. Therefore, impact investing differs from classic sustainable investments, but also from donations and philanthropy, i.e. impact investing closes the gap between (mostly) risk-return balanced sustainable investments and donations. The main difference to sustainable investing is the explicit definition of impact goals and their evaluation. The primary focus is on the provision of additional equity or debt capital, i.e. mostly private equity or private debt.

Cabbage of the month

It’s time to launch a “golden raspberry/golden lemon” column or some other vilifying award. I plead for “cabbage or greenwash of the month.”

The excesses of misleading advertising messages must be pointed out! In the sense of product transparency and product honesty it is about credibility of the investment products and finally about investor protection and product liability.

Excesses of advertising messages enrage consumer advocates in particular, so e.g. If statements are made that an investor with its investment effects this and that or x% things. In the case of secondary markets, this is something that must be fundamentally questioned in the first place. Here, money is invested in companies whose products and/or business practices help to live or do business more sustainably, e.g. By consuming x% less or contributing to specific goals (ESG, SDG, planetary boundaries, etc.). Nothing less, but also nothing more.

Impact investing aside, there is a good argument to be had about how “strict” an investment approach needs to be to be considered “sustainable”. Ranging from very consistent convictions that do not allow investments in the car, aircraft or cement manufacturing industries because they are simply environmentally damaging (in an absolute sense), to approaches that do not exclude anything at all but have a great deal of impact on companies through the exercise of voting rights and active, targeted engagement in general, to approaches that deliberately invest in stocks with poor sustainability records, since the leverage for improvement/transformation is particularly easy to apply here and, above all, a small relative jump in KPIs already leads to a large absolute footprint or risk reduction (especially in the case of corporate debt, especially high yield has been empirically proven).

As far as impact is concerned, the correlation and causality between CSP (corporate social performance) and CFP (corporate financial performance) has been scientifically proven.

Thus, it makes perfect sense and makes a difference when investors invest specifically in these more sustainable business models. Over the past two decades, the following investment styles have evolved:

The question “What is a sustainable investment?” is increasingly being answered by regulators

While the term is not legally protected, it has been formally defined for several years by industry standards such as SRI labels and, more recently, by regulators. Since 2018 the EU entered the playing field with its action plan on financing sustainable growth. Since then a variety of different delegated acts changes current legislation and for the fund industry the most important ones are (1) the taxonomy defining a well-defined set of 6 groups of environmentally sustainable economic activities, (2) Sustainable Finance disclosure regulation (SFDR) prescribing who has to report on what about their financial products depending on different claims on sustainability and (3) MiFID-II that makes advice with regard to sustainability preferences of each client mandatory. Unfortunately, the separate regulation strands are not linked or harmonized, yet and confusion is high. Even an ESMA call for help had not been answered sufficiently by the Commission. Thus, it seems that no one really has a clue on how to make all this operational.
This is one reason why some efforts had been initiated on national level.

The German BaFin’s fact sheet on dealing with sustainability risks has already led to controversial reactions, especially among established, conventional market players and much more debate arose recently about a proposition regarding product specifications that are not connected to the EU’s taxonomy in some parts and that are criticized as “gold plating” within a common effort on EU-Level. The French financial market regulator AMF already presented regulations almost two years ago applicable at the product level and has outlined a clear expectation to take extra-financial criteria into account as well as unambiguous requirements at the level of the brochure and KIID: The question is how much investor information a product must provide if it calls itself a “sustainable investment”. Here, the French regulator strongly relies on transparency tools such as the Eurosif Transparency Code and their label ISR.

In the context of the MiFID II SRI advisory obligation, this is a necessary step to provide clear guidelines for the definition of the target market. Incidentally, the three major German financial associations BVI, DK and DDV have also recognized this in their so-called typology of sustainable investments and therefore refer to products with a dedicated ESG strategy.

This is to avoid that, for example, funds that only meet some minimum exclusion criteria and take ESG into account (whatever that means in practice), or, for example, integrate ESG aspects into risk management, which is required by EU regulation anyway, are marketed as sustainability products. A current investigation by the SEC and the German BaFin about potential misleading SRI claims (in terms of AuM volume) of a big German asset manager shows the immediate evidence of a necessary clarification. Even if the accusations are probably not legally founded, the reputational damage such allegations create can be quantified in this particular case: A sharp loss in market cap by EUR 1bn (stock price dropping nearly 15% in two hours).

About the author:

Roland Kölsch

The former fund manager is managing director of the Quality Assurance Organisation for Sustainable Investments, which is responsible for the FNG-Label. He has been working in the field of sustainable investments for more than 15 years and currently contributes his expertise to EU task forces on sustainable finance.