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How green is my fund?

New EU rules mean all investment funds must disclose to investors how sustainability risks are taken into account in investment decisions

‘Funds must also be categorised into one of three categories: funds which promote environmental or social characteristics; funds with a sustainable investment objective; and all other funds’
‘Funds must also be categorised into one of three categories: funds which promote environmental or social characteristics; funds with a sustainable investment objective; and all other funds’

Green investing has been increasing in popularity in line with the growth in awareness of the impact of climate change and other sustainability issues. The investment of choice for many people tends to be a green labelled fund, but doubts are still raised in relation to just how sustainable some such funds really are, as well as the returns on offer. And the term green can often be open to interpretation.

"Although the term green fund might sound like it refers only to environmental issues, it is often used interchangeably to refer to any fund with a focus on sustainability, whether that be in relation to environmental or social issues," says Brian Haugh, head of valuation & financial modelling with BDO.

“The term is also often used interchangeably with environmental, social and governance (ESG) investing. In addition to the warm fuzzy feeling of investing in products that align with their ethics, there is also evidence that sustainable investments are less volatile and provide better risk-adjusted returns for investors compared to conventional funds.”

According to KPMG director Conor Holland, the growth in this form of investment has been little short of remarkable in recent years and that, at least in part, reflects the superior returns mentioned by Haugh.

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“Morningstar says more than 40 per cent of European assets are now sustainable,” says Holland. “Capital will always flow towards yield, and over the long term ESG funds have outperformed non-ESG funds. The expectation is that by 2025 there could be between $50 and $53 trillion in assets under management (AUM) out of a total of $140 trillion worldwide.”

That outperformance shouldn’t come as a surprise, he adds. “If you think about it, this is a more holistic measurement of value. For example, if a company has good social policies it is at less risk of employee conflict or reputational damage. It makes sense that companies with good ESG policies will do well in the longer term. Some people are understandably sceptical and ask if it is a fad. But the evidence is that we are seeing a culture change in how businesses are operating and reporting.”

Revaluation

And those returns have driven a marked change in attitudes towards green investing.

“A long while ago it was very much a conscience salver, but we are now seeing a revaluation of assets,” says Johnny Mattimore, a member of the Irish Funds Industry Association’s ESG Servicing Data Working Group and managing director, global head of risk & sustainable finance with First Derivative.

“Over time green and non-green assets will have different valuation metrics. If two assets are the same, the one with the better decarbonisation credentials will have a higher value.”

He also points to the prospect of an abrupt revaluation of an asset or group of assets which can lead to significant losses for investors.

"It's not a smooth curve," he says. "Take the example of the BP subsidiary exiting Russia. The company took a hit of $30 to $40 billion. In a lot of cases these changes creep up over a long period and then hit quite abruptly. We're going to experience many more of these events in future."

That will naturally drive investors and fund managers towards more sustainable assets which are not subject to these sudden changes.

But that raises the prospect of greenwashing. How can an investor be sure that the fund they choose really is green?

"Growing investor appetite for ESG funds has led to regulatory concerns that asset managers were describing funds as green in order to meet investor demand when in fact the underlying investments made no positive contribution to environmental objectives such as climate change mitigation," says Tara Doyle, head of asset management with Matheson. "There were also no harmonised standards to allow investors to meaningfully compare the green credentials of various investment products."

Taxonomy

She says to address this greenwashing risk, and to facilitate the investment of capital in sustainable investments, the EU has introduced new disclosure rules for financial products, including funds, and a common EU classification system – or taxonomy – to help investors identify sustainable investments and to select products that match their green investment ambitions.

“Under these new EU rules all investment funds must disclose to investors how sustainability risks are taken into account in investment decisions and how those risks may impact on the return on investment,” says Doyle.

“Sustainability risks include environmental, social or governance events that have the potential to negatively impact the value of the investment. Funds must also be categorised into one of three categories: funds which promote environmental or social characteristics; funds with a sustainable investment objective; and all other funds.

“The EU has sought to be a global leader in introducing these sustainable finance rules, which advance the European Green Deal agenda directed at transitioning the EU to net zero greenhouse gas emissions by 2050.”

Holland welcomes the new rules. “The EU is often criticised for being overly bureaucratic and rigid, but it has taken a lead on this, and the US and UK are following,” he says.

“The intention behind the new EU disclosure rules and the EU taxonomy is to protect investors against greenwashing,” Doyle adds. “By standardising fund disclosures and requiring funds to disclose the extent to which their investments are in activities that have been deemed environmentally sustainable under the EU rules, the rules should put investors in a position to compare investment options and make decisions that match their sustainable investment ambitions.”

Definitions

Investors will still need to be careful, however. “While improved regulation and definitions are welcome, it is still not easy for many investors to ensure that their green investments are having the positive impact that they are hoping for,” says Brian Haugh.

“They say the devil is in the detail, well in this case it’s specifically in the disclosures. An investor that is looking for a fund that aligns with their ethics and ambition for impact they will need to carefully identify whether the fund falls under Article 6, 8, or 9 of the taxonomy and then the extent to which its activities align with the ESG taxonomy.”

The good news is that he believes that the number of funds specifically targeting truly green activities is likely to grow significantly in the coming decade. "At Cop26, the Glasgow Finance Alliance for Net Zero pledged $100 trillion to finance climate action projects," he notes. "This will no doubt fuel significant growth in climate action-focused funds over the coming decade."

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Jillian Godsil

Jillian Godsil is a contributor to The Irish Times