ESG Investing - How to Navigate the Jargon

Many people would like to consider ESG factors when investing but don't know where to start, and the lack of clarity about terms doesn't help

Andy Pettit 11 November, 2020 | 3:21PM
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Escalating concerns about damage to the environment, negative publicity about working conditions at the Leicester suppliers of fashion group Boohoo, the fraud that led to the bankruptcy in June of German fintech firm Wirecard. These are examples respectively of the "E", "S" and "G" terminology that has become so prevalent in the description of investment products.

Environmental, social and governance issues like these make the general news headlines and increase public awareness of bad practice and its consequences. Asset managers have been quick to associate features of their products with improving or avoiding such issues, with some increasingly idealistic product names like the "Love our Planet and People Fund", the "Epiphany ESG Fund" and the "Vegan Fund" to name a few.

At the same time, governments need huge amounts of private investment to supplement the public funds they have earmarked to help them meet increasingly pressured national targets. Even after budgeting a quarter of its expenditure over the next decade toward climate initiatives alone, the EU estimates a funding gap in the order of €180 billion to achieve its wider sustainable goals.

Regulators are Being Challenged

Consequently, regulators have been tasked with creating an environment that encourages more sustainably minded investment, alongside their traditional role of ensuring fair markets that provide investor protection and prevent mis-selling. In particular, this expanded brief means minimising the risk of investors being seduced by products that over-hype their own credentials – so-called greenwashing. They have approached this with gusto, and it's good news that there is so much attention on the topics from so many different players. What isn’t clear though, is how the wealth of associated factors that must be considered, and resultant glut of information that must be produced, can best be synthesised to help investors.

The fund industry doesn’t have a good track record of providing succinct and intelligible information to investors, even before these additional ESG disclosure requirements. Prospectuses are typically intimidating, lengthy documents full of technical details in industry and legal lexicon. Annual and semi-annual reports are a bit more penetrable, typically including a fund manager overview and the latest portfolio holdings. The saving grace for investors was supposed to be the Key Investor Information Document (KIID) – a two-page summary, using simple and clear language and providing the same information in the same format across all products. These have been moderately successful for funds but the EU is in the throes of replacing them with a more complex document, which serves no one well, least of all investors.

Starting next year, this library of reports will be further expanded under EU regulation: the prospectus and annual reports will be supplemented with pages of standardised ESG disclosures, together with new sections on fund company websites that provide detailed product and aggregated firm-wide data. Brexit adds a further twist for UK investors and fund managers, because it's not yet known how similar or different UK fund disclosures will look to those of their European counterparts.

Investors are Being Challenged

In the past, a fund's name has generally provided an immediate indication of its area of investment focus – the ABC UK Equity Fund and XYZ Emerging Markets Bond Fund have been typical naming conventions.

But as ESG terminology increasingly dominates fund names, it both masks what asset types a fund investments in and adds the new challenge of determining funds different approaches and definitions of ESG investment. Consequently, the category systems that Morningstar and others have developed will start to take on added significance and also require an extra dimension.

The extra dimension will, in part, be dictated by EU regulation. New rules will see fund managers demarcate their products into one of three categories that will come to define the entire universe of European funds and dictate what has to be disclosed about each product. Although, given that the three categories are already colloquially known as Article 8, Article 9 and non-Article 8/9 it doesn’t bode well for the chances of broader ESG information being made available in a consumer-friendly way.

The terminology comes from a specific regulation and, to translate:

  • Article 9 refers to Sustainable funds, defined as those investing in activities contributing to environmental objectives according to the proposed EU regulation on taxonomy.
  • Article 8 refers to general ESG funds, and acts as a catch-all category of financial products with different environmental or social ambitions that do not qualify as sustainable investments.
  • By default, the third category encompasses all other funds that have no stated ESG ambitions.

Is There a Win-Win?

To be fair, regulators have a difficult job of balancing many different views of what ESG investing constitutes and the many approaches to executing it, while also establishing metrics that truly identify how funds measure up to their stated aims and conveying that information to investors in a timely, consistent and interpretable way.

Coupled with the three-way split of funds, the EU proposals also specify a range of 34 numerical indicators that firms would have to generate, together with these new documents. While fund firms prepare for these changes, their pension scheme clients have been quietly moving ahead in meeting their own ESG obligations. Already, trustees of pension schemes are supposed to set out in their Statements of Investment Principles how they approach ESG considerations, and then, as of this autumn, produce an annual Implementation Statement setting out how they acted on the principles.

None of these documents necessarily make for light reading and that doesn’t look like it will be solved anytime soon. But on a more positive note, we like that firms are being compelled to be clearer about their aims, how they intend to achieve them and, with evidence, how successful they’re being. Just as the underlying data and metrics will improve and evolve, so to we hope will the way that the vital information is presented. In the meantime, investors can know that with more of this information in the public domain, regulators and professional investors will be scrutinising firms closely.

 

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Andy Pettit  Director, Policy Research (EMEA), Morningstar