Shades of green: Funds slash ESG rankings on legal worries
How green is your ETF? Investors need to look closely
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(Mark Hulbert, an author and longtime investment columnist, is the founder of the Hulbert Financial Digest; his Hulbert Ratings audits investment newsletter returns.)
CHAPEL HILL, N.C. (Callaway Climate Insights) — It’s hard — in theory — to be against requiring mutual funds and ETFs to disclose more accurately and completely the ways in which they are “sustainable.”
In practice, however, those requirements appear to shed more heat than light. In many fundamental ways, “sustainability” is in the eye of the beholder. To ensure that the climate-friendly ETF you’re considering is indeed climate-friendly, you have no choice but to closely analyze the companies in which it invests.
That’s the conclusion I draw from reviewing the European Union’s “Sustainable Finance Disclosure Regulation” (SFDR). Though the SFDR was adopted last March, a number of specific standards for its implementation didn’t go into effect until this month. In many ways the SFDR is attempting to define the undefinable, and it faces many serious and perhaps insuperable obstacles.
This isn’t just a problem for European investors, by the way. The SEC is in the process of finalizing its own set of ESG disclosure rules, and the challenges the EU is facing are a harbinger of what almost certainly will be the case in the U.S. as well.
The SFDR’s motivation is laudable, of course: Reducing greenwashing, in which fund managers wrap themselves in the “green” and “sustainable” flags when they construct portfolios that are not materially different than those of any other managers. But it’s not at all clear that the regulation will help climate-friendly investors become better informed.
The SFDR
First, a bit of background: The SFDR requires fund managers to self-classify their offerings in three categories, according to how fully and completely they are committed to sustainability:
Article 9: So-called “dark green” funds. This is the highest standard for sustainability. Funds in this category are supposed to invest close to 100% of their assets in companies that contribute to specific environmental or social objectives and which adhere to good governance practices. While pursuing these objectives, none of these companies should significantly harm other environmental or social objectives.
Article 8: “light green” funds. These funds have as one of their stated goals the promotion of the “E” or “S” objectives but have not made them their sole or primary objective.
Article 6: all funds that aren’t in Articles 8 or 9.
As is always the case, however, the devil is in the details. For example, how much does a company need to “contribute” to specific environmental or social objectives to be considered sustainable? And when does “harm” to other environmental or social objectives become “significant” enough to make a company ineligible? Even more basically, which environmental or social objectives are to be considered in the first place?
There also is an intractable accounting challenge, having to do with how a fund calculates the proportion of its assets under management that are committed to sustainability. Consider a company that derives 20% of its revenue from sustainable activities. One fund manager might count that 20% towards its total sustainability commitment, while another manager could decide that this 20% is significant enough to justify counting that entire company’s revenue towards that commitment. Both approaches are allowable under the SFDR.
This is not a hypothetical problem. Consider a recent Morningstar analysis of 12 European ETFs, all of which are benchmarked to indices whose constituent firms are aligned with the Paris agreement on preventing global temperatures from rising more than 2°C above pre-industrial levels. Yet the dozen funds report sustainable-investment exposures ranging from a low of 0% to a high of 80%.
As Morningstar concluded: “Different interpretations of the [SFDR] regulation have led asset managers to adopt different approaches to the calculation of sustainable-investment exposure, rendering it impossible to compare competing products directly.”
Notice carefully, furthermore, that regardless of the accounting methodologies that the fund managers use to calculate sustainable-investment exposure, they must rely on individual companies to report the proportion of their revenue streams that promote various sustainability objectives. That reporting doesn’t currently exist for most companies.
Many European fund managers have responded to these classification quagmires by downgrading their funds’ sustainability rankings. They evidently have decided that claiming one of their ETFs is an Article 9 fund opens themselves to too much potential legal liability. BlackRock, for example, recently downgraded to Article 8 a number of its ETFs that they previously had classified as Article 9, including its iShares Global Clean Energy ETF ICLN 0.00%↑ and iShares MSCI USA ESG Enhanced ETF (EEDS).
My hunch is that many of you would be more than happy to invest in either of these two ETFs, comfortable that the companies in which they invest exemplify your climate goals. If so, then you couldn’t care less whether they are classified under SFDR’s Article 8 or Article 9.
But the only way for you to find out whether these funds are consistent with your climate goals is by examining the specific companies in which they invest. And that’s the overall lesson of the classification challenges the EU is facing.
An analogy to organic food
An analogy is to the process the U.S. Department of Agriculture went through many years ago in developing the criteria for what foods get to call themselves “organic.” Almost everyone agreed that something needed to be done, since the food industry was guilty of the same kind of “greenwashing” that asset managers were in the mutual fund and ETF industry. But not everyone agreed on what the answer was.
The result was that the USDA enshrined just one particular definition of organic, which many find particularly unsatisfactory. For example, farms are allowed to use certain pesticides and still label their produce “organic.” In addition, there are dozens of non-organic ingredients that are allowed to be added to “organic” foods. The USDA does not certify the companies or farms that label their food as “organic;” certification is instead outsourced to third parties. The companies or farms pay the accrediting company for their certification, creating an inherent conflict of interest.
The farmers I’ve gotten to know at my local farmers market insist that, if you’re serious about eating genuinely organic foods, there is no substitute for getting to know individual farmers and looking into the practices they employ. The same goes for investing in truly climate-friendly mutual funds and ETFs.
Read more from Mark Hulbert:
This is how investors can really help mitigate climate change
Why climate adaption stocks might be more profitable than climate solutions
Eureka! This one chart shows that divestment of oil stocks works
The most vital letter in ESG ratings is not what you might think
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