Avoiding the Greenwash Peril

Although one of the key aims of SFDR is to prevent greenwashing, it still allows room for firms to report misleading and inaccurate representations of their portfolios.

Specifically, investment managers can rebalance their portfolios prior to the reporting dates and as such ‘drop’ investments which are not ESG aligned.

Subsequently, the portfolio will appear more sustainable than it is, positioning it in a more sustainable light. To avoid this form of greenwashing it is recommended that portfolio positioning is captured on a higher frequency than is required by the regulation. 

• Robust Internal Controls: Create separation of control oversight;
  • Separate officer to monitor portfolio
  • Implement pre-trade ESG clearance programs
• Track Portfolio Holdings: Frequently download/backup portfolio holdings to create a record.
• Document Investment Rationale: For every investment decision;
  • include written thesis or view of the ESG considerations for the investment
  • consider PAI data points in the investment thesis and record expectations

Data collection and disclosure under the SFDR will prove challenging due to the lack of availability of non-financial ESG data. It is therefore unlikely that firms will be able to collect 100% of ESG data from one provider and consequently multiple data providers will be required to satisfy the SFDR reporting requirements.

This creates room for portfolio managers to pick and choose data from different providers as to present their investment most favourably.

Where firms are collecting data from multiple vendors, there needs to be consistent structures in place and consistent application of policy when selecting one metric over another. The firm will need to be able to provide clear justifications for data and metric selection in line with the SFDR requirements.

• Data Due Diligence: Fully understand the methodology and limitations (e.g. coverage) of third party data providers.
• Written Data Policy: Record the data procurement process and establish KPI’s that when violated require review.
• Consistent Policy: When multiple data providers are engaged, ensure consistency in application of data across multiple funds consistently.
• Question Data Sources: Frequently check data versus other data providers and implement reasonability checks.
• Do Not Depend on Ratings: Ratings represent an opportunity for ambiguity.  Understand the methodology for creating a rating and require notice for any change in methodology. 

Portfolio management bias has its greatest applicability to investment strategies that are dependent on an index.

This is common in passive investment approaches whereby a third party index provider will create a basket of securities based on certain criteria. 

The calculation of jurisdiction, sectors, industries and weightings for each constituent can sometimes be misunderstood by the fund manager and lead to a mismatch in naming conventions versus the actual underlying investments. 

For example, a fund might represent sustainability in marketing materials and name, but have exposure to fossil fuels if the index is transitory in nature. 

In an effort to not have the appearance of greenwashing, a number of passive funds have downgraded from Article 9 to 8, in part, for this reason. 

• Investment Dependencies: Fully understand and document rationale associated with the use of external investment management mechanisms (e.g. reference indexes)
• Vendor Alignment: Ensure that third party vendors, such as investment sub-advisors, are required to provide ESG related information.
• Embed Compliance: Tailor an ESG compliance programme that fits specific investment strategies. For example, pre-trade clearance for public equity strategies or required assurance of portfolio companies for private equity investments.
• Marketing Oversight: Require an ESG review prior to authorised use of marketing material; 
  • Ensure consistency with regulatory reporting.
  • Require audit trail of firm metrics (e.g. Sustainable AUM)
  • Require plain language disclosures for all metrics and qualitative elements

Written and implemented policy is the cornerstone of anti-greenwashing.

Policy starts with agreement of leadership and documentation.  Similar to a compliance manual, and ESG manual should set out the basic policy specific to that investment strategy.

In the European context, regulators are keen on the concept of “show me, don’t tell me.”  Those that have written policy have a better chance of concluding such a review unscathed. 

• ESG Regulatory Manual: Documentation of all considerations, methodology, limitations, remediation approach, policy and regulatory register associated with regulation on every jurisdiction of distribution.
• Management Commitment: Senior staff should have remuneration attached, in some part, to ESG compliance and policy.
• Expert Oversight: Upskill or hire senior staff for ESG expertise. 
  • If the investment vehicle is a regulated fund structure, add at least one board member with ESG expertise that can be applied in an oversight function.
  • Engage third party vendors for ESG assurance. 

As the demand for ESG investment products increases, investors are struggling to find attractive and adequate ESG investment opportunities, leaving room for unintentional greenwashing. In some instances, firms will overstate ESG AUM as a result of miscalculation of funds’ defining variables. 

For example, let’s assume that a firm with $500mm in AUM has $50mm is in a fund called Sustainable Transition that only considers companies which will benefit by a transition from fossil fuels to renewable energy, representing a component of the ESG agenda. It is possible that these assets might be counted by an ill-informed staff member to be ESG assets when the investment objective does not take Social or Governance factors into account. As a result of an error, the firm would unintentionally represent exaggerated levels of ESG assets under management. 

• Policy Driven: Ensure firm policy for AUM calculation; 
  • takes into account the specific categorisations; based on the investment process’ consideration of E, S & G factors.
  • policy describes calculation methodology
  • AUM matches regulatory disclosure
• Calculation Oversight: Compliance officers should review all externally distributed material to ensure policy is being adhered to.
• Detailed Disclosure: Create plain language disclosure that fully describes
  • the calculation methodology
  • what the firm defines the AUM label as
  • what ESG-related theme the AUM does and does not include
  • any investment restrictions or permitted investments associated with the AUM

ESG assets are on a pace to constitute 21.5% of total global Assets under Management (AUM) in less than 5 years.

Historically, product managers and other distribution professionals seek fund names which catch the interest of investors through the use of buzzwords relating to a market or investment trend. With ESG funds under significant demand, this form of greenwashing has become particularly prevalent.

The current deficit in industry standards against which to measure the sustainability performance of a fund makes it hard for investors to understand exactly how sustainable their investments are.

Funds claiming to be ‘sustainable’, ‘green’ or ‘ESG’ in nature may prove to have no significantly lower carbon intensity than regular funds. Thus funds claiming to be sustainable, without material evidence, may ultimately mislead investors. 

• Require Rationale: In the product launch process, require staff to provide the rationale for the fund name. Most notably, compliance officers should ensure;
  • no inference is being made
  • that the name matches the investment strategy
  • the name does not violate regulation in each jurisdiction of distribution
• Set Expectations: Clearly state the intentions and investment strategy in plain language. 
• Data Proof: If a fund claims to be “green”, for example, then the observed data related to environmental metrics should  be relatively better metrics than “non-green” peers.