What Is Greenwashing?

The attraction for investment advisers and investment companies for developing ESG-labeled funds is influenced by consumer and investor demand for corporate responsibility, which has transitioned over time from the traditional socially responsible investing (SRI) movement to a more comprehensive approach to ESG investing. ESG metrics are being integrated into traditional financial analysis to varying degrees, largely in response to evidence that suggests good corporate sustainability performance can be positively correlated to positive financial results. A 2021 study , entitled “ESG practices and the cost of debt: evidence from EU countries,” conducted by The University of Portsmoth examined the impact of a firm’s ESG disclosures and performance on their cost of debt. The results found a negative correlation between the two, meaning that when a firm’s ESG performance was poor, their cost of debt was higher (and vice versa), which further indicates materiality in the association between ESG investing and alpha generation.

Examples of greenwashing

In trying to keep up with quickly growing demand for sustainable investing, certain investment advisers were found to have misled investors and undermined the credibility of ESG matters. After months of greenwashing accusations, DWS, the asset management unit of Deutsche Bank, was raided in June 2022 by officials on the grounds of misleading investors about ESG investments. Investigations were launched by both the Securities and Exchange Commission (SEC) and BaFin (Germany’s federal financial supervisory body) after the former head of sustainability at DWS came forward with allegations that the company overstated the factor to which sustainability investing criteria was used to manage investment in DWS fund sales prospectuses. The raid and findings resulted in the resignation of DWS CEO Asoka Woehrmann. DWS shares plummeted 26 percent once the news was made public and raised questions about the firm’s reputation.

In another example, the SEC charged BNY Mellon Investment Adviser for falsely advertising the level of ESG quality review for their investment funds. After investigation, it was found that the firm had been misstating and omitting information regarding the ESG considerations it used in making investment decisions between July 2018 and September 2021. As a result, the firm agreed to settle the charges by paying a $1.5 million penalty. As with any investment decision, the degree to which ESG impact is evaluated is under the discretion of the managers and can range from broad consideration to intentional, thematic focus. Managers have launched ESG strategies in recent years with varying measurements and standards, which makes it challenging to consistently score ESG application.

The SEC’s action for transparency and accountability in sustainable investing

In an attempt to prevent misleading or deceptive claims and to increase disclosure requirements of investment funds, the SEC has proposed amendments to current regulations that specifically target ESG funds. The proposed amendments would result in significant changes to address the current issues surrounding the categorization of funds engaging in ESG investing to minimize the level of greenwashing and maximize transparency on funds’ intentions.

The goal of the proposal is to ensure that the name of the fund accurately reflects its investment intentions, whether that be a particular asset class, industry or geographic region. Under the current regulations, market participants are free to characterize funds with an eye towards marketing. The amendments would increase transparency by requiring the fund name be precisely descriptive of the underlying investments.

The SEC noted three key changes within the proposal:

• Funds engaging in ESG investing would be newly categorized as either Integration Funds, ESG-Focused Funds or Impact Funds. Under the categorization, funds that “consider one or more ESG factors alongside other non-ESG factors,” with no greater prominence on the ESG factors, would be labeled as Integration Funds. By contrast, an ESG-Focused Fund would use significant consideration of one or more ESG factors during its investment process or engagement with companies. Impact Funds, a subset of ESG-Focused Funds, would be “comprised of those with a goal of achieving a specific ESG impact.”
• Additional disclosures that would be appropriately tailored to address the risks each poses. The depth and materiality of the disclosures would increase appropriately in correlation to the level of ESG integration. At a minimum, Integration Funds would be required to disclose what ESG factors are evaluated as well as how they are implemented into both the investment and decision-making processes. Given the greater prominence of ESG factors in ESG-Focused and Impact Funds, they would be required to additionally provide more granular information, with Impact Funds relaying information in even greater detail in the form of a prospectus (which is a legal document that the funds would be beholden to follow).
• Require the reporting of aggregated, quantitative greenhouse gas (GHG) emissions data for climate-orientated ESG-Focused and Impact Funds. The rule will only apply to the funds that actively consider and evaluate emissions data in the investment process. Under the proposal, Integration Funds will not be required to report GHG emissions data even if they have implemented the data into their assessments.

On August 16, 2022, the comment period for the proposed amendments ended. During that period, investment advisory firms, managers and organizations had the opportunity to provide opinion and feedback to the SEC. While much of the investment industry is open and willing to increase transparency to minimize greenwashing, many had concerns that the proposed rules would have the opposite effect and exacerbate it.

The first concern raised was by the Investment Adviser Association, which urged the SEC to only require disclosure on material information, as providing immaterial information could mislead investors as to the impact of the ESG factors on the fund. The concern about further confusion is shared by the Managed Funds Association (MFA), which proposed that fund advisors should be given a “good-faith standard” in which they should be responsible for classifying their strategies.

The MFA and Morningstar both responded with the idea to exclude ESG Integrated funds from the final rule or to redefine them as ESG Considered Funds. The firms found the ESG Integrated Funds classification overly broad, given the defining element that such funds include a minimum of one ESG factor, thus leaving room for misinterpretation.

Implementing ESG due diligence to bridge transparency between managers and investors

As with any aspect of the investment industry, what is presented must always be supplemented with an in-depth understanding of what is occurring under the surface. The SEC proposed rules have opened discussion as to how funds should be classified on ESG and what disclosures are necessary, but this does not eliminate the need to question such managers and evaluate the extent to which the investments, rather than the marketing, are driving the naming of the fund.

Segal Marco Advisors addresses greenwashing directly in our inquiries of managers. Segal Marco’s Alpha Research Team, along with Segal Marco’s ESG Committee, have worked together to implement ESG analysis at the firm and strategy levels as well as within the investment process of the managers under review. The ESG Committee is continuously developing and upgrading a proprietary ESG survey in which managers are scored and tiered based on their responses regarding the implementation of ESG considerations at the firm and product level. This scoring system is applied across all asset types, including public equity, fixed income and private market/alternative products.

In addition, the Alpha Research Team implements ESG into the due diligence and evaluation process with both new and currently rated strategies. The team primarily evaluates products that would be considered as ESG Integration Funds under the SEC proposal and have managed to develop questions which help to develop an objective, qualitative opinion on the degree to which managers are being transparent with their intentions on ESG matters. The team has also held meetings with ESG-Focused and Impact products and is able to offer insights into those strategies as well. With such, Alpha Research seeks to support consultants and clients with comprehensive and educational information on managers’ ESG considerations. That said, we support the SEC’s actions to require fuller transparency as a good-faith measure.

The implications of greenwashing

Greenwashing may result in a failure of managers to meet client expectations of ESG and financial results. The SEC’s recent enforcement action and the proposed new amendments aim to ultimately help align expectations.

Given greenwashing’s implications and direct impact on clients, the SEC aims to improve the culture around ESG investing. Through the proposal for regulation change, it will be much more difficult for investment advisers and companies to dishonorably capitalize on the growing demand for sustainable investing, while the heightened enforcement will penalize those who attempt to do so.

Segal Marco, through its Alpha Research team and ESG Committee, remains focused on working with investment firms to evaluate their ESG integration efforts, monitoring potential ESG-Focused and Impact products for their clients and educating and informing clients on the ESG efforts of investment managers in accordance with their financial goals and expectations of ESG impact. Our role is to look beyond the book title, or in this case, fund labels, to present an accurate account to our clients.