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The appetite for ethical finance shows no sign of slowing. But as the interest in Environmental, Social and Governance (ESG) finances rises, so too do concerns about impact- and green-washing: the practice of making false or misleading claims about apparent ethical credentials.

Naturally, as an embryonic sector, many complex questions about ESG investment remain unexplored. Institutions are thus actively navigating this constantly evolving landscape in order to develop a financial ecosystem where investments are, as the governor of the Bank of England, Mark Carney, put it, “both financially rewarding and environmentally sustainable”.

Defining ESG

ESG criteria are various performance indicators that provide insight into the environmental and social impact of financed activities and also evaluate corporate governance through this lens. While there is no market standard, considerations typically include climate change, social development, diversity and a company’s internal controls and audits. Recent data suggests that assessing an investment on such non-financial indicators creates a more accurate valuation of the investment and results in better investment decisions. As a result, ESG-integrated portfolios tend to perform better than non-ESG-integrated portfolios.

The growing demand has provided incentive for regulators and market participants to develop a uniform response. In addition to various global initiatives to establish standardised indicators, policymakers are increasingly focussing on various corporate governance and reporting standards as well as banking regulations. In the European Union, large companies are required to disclose non-financial information in their annual reports on management of ESG challenges. International organisations, such as the International Capital Markets Association, have also identified definitions and criteria to harmonise investments in green infrastructure. Such collaboration is a positive step towards creating a sustainable finance ecosystem where investments are consistent with policy commitments.

However, progress is slow and despite more than 2,300 investors adopting the United Nations Principles for Responsible Investment (PRI), current data indicates that few are actually integrating ESG factors. A potential hurdle to institutionalising these considerations is the lack of a market-standard definition of ESG and the spectrum of values that market participants prioritise with potential further limitations based on business structures and commercial goals.

Does the end justify the means?

There has been an increase in the number of investment products marketed as having ESG characteristics. However, due to the lack of standardised measurement metrics, there are material concerns that not all investments are as ethical as they are marketed to be. The ongoing regulatory and industry initiatives on disclosures and standards would certainly help to lower the risk of ‘greenwashing’.

Progress also requires investors to be more engaged and evaluate not just the investments, but also the intentions of the fund manager. There are various investment strategies that fund managers use to construct their ESG integrated portfolio with the aim of maximising risk-adjusted returns, but investment strategies have gone beyond the ‘screening’ strategy of blacklisting sectors and/or companies based on ESG factors, to comparing the ESG rating of the investment.

However, despite the development of innovative strategies, some investments still appear ESG compliant only at the headline level, without actually being aligned to the spirit of the ESG principles. While greenwashing exists, investors are becoming more diligent in evaluating ESG characteristics and looking for an objective measurement of the impact of investments. The FCA recently signalled that it will challenge funds with potential greenwashing but it will do so in “a proportionate way that allows firms to innovate to meet consumers’ needs and preferences”.

Innovation in developing investment strategies works towards fostering transparency and long-termism in financial and economic activity.

Measuring the impact

The PRI defines impact as “the proportion of the total observed outcome that can be attributed to a company’s activity, above and beyond what would have happened anyway”. It is common for investors to analyse the impact of their investments by tracking “the outputs and outcomes using indicators that imply rather than prove impact”. Outputs are the measurable results occurring from a company’s activities, whereas outcomes are the intended and unintended changes in a system that result from the aforementioned outputs. When structuring impact deals, investors prefer to align impact metrics to outcomes rather than outputs. However, in order for outcome metrics to be a truly valuable investment tool, the market requires standardised indicators.

Notwithstanding the challenges, it is encouraging to see an increase in scale in the number and value of transactions which contemplate ESG factors. Mark Carney recently explained that in order for the market to allocate capital to deliver the necessary innovation and growth that is needed to create a viable and sustainable financial ecosystem, it is critical that the “eventual market standards are as comparable, efficient and effective as possible”. To efficiently integrate ESG factors into the investment process these market standards must, ultimately, stand up to scrutiny against the dangers of impact washing.