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"Green Lemons" Need to be Squeezed out From the ESG Market

By Scott Vaughan, David Uzsoki on April 18, 2023

Investments in climate change mitigation continue to grow, driving the energy transition and rapid growth in net-zero technologies. At the same time, a lack of reliable data and a loose regulatory environment have led to declining investments in environmental, social, and governance (ESG) funds, while some nervous managers are shifting assets away from ESG funds to avoid future claims of greenwashing.

The stubborn problems with ESG governance have triggered calls to either scrap ESG or reporting or replace the current framework with a narrower focus on greenhouse gas emissions. While a single indicator like carbon emissions would make reporting and governance easier, these proposals are deeply flawed, as they would ignore the need to also tackle real-world issues such as nature stewardship, pollution abatement, and climate change adaptation. More promisingly, new ESG regulations and disclosing standards proposed in the United States, the European Union, and elsewhere offer hope for curbing greenwashing and countering the credibility deficit in ESG markets.

Moreover, proposed sustainability, climate risk, and opportunities disclosure standards from the International Financial Reporting Standards (IFRS) Foundation, developed by the International Sustainability Standards Board (ISSB), could be the most important development in company reporting in a generation. The new standards are expected to be released in June 2023.

“Aggregate confusion” in sustainability reporting

Despite global financial and energy security concerns, investments in climate change mitigation and the energy transition continue to grow. Preliminary estimates show global climate finance volumes of between USD 850 billion and USD 940 billion in 2021, a 40% increase from the previous year, with the lion's share of the total going to climate change mitigation. Similarly, global investments in energy transition technologies like renewable energy and energy efficiency reached USD 1.3 trillion in 2022. Now the global community needs to turbocharge this emerging trend and quadruple annual investments in the energy transition to over USD 5 trillion to limit global warming to 1.5°C, the International Renewable Energy Agency warns.

However, climate finance is also part of the wider ESG investment space, and within the ESG space, worryingly, there is no discernible positive trend to begin with. Instead, investments in ESG funds are showing the opposite. S&P Global estimates that investment assets held by firms that factor ESG into their decisions dropped from USD 17 trillion in 2020 to USD 8.4 trillion in the United States at the beginning of 2022.

For nearly two decades, companies have made sustainability claims that were sometimes untrue, often untested, and nearly always non-comparable. The Harvard Business Review has noted that the “data underlying ESG ratings are incomplete, mostly unaudited, and often dated.” A recent report from the Massachusetts Institute of Technology (MIT), fittingly called “Aggregate Confusion,” has identified wide divergences across sustainability reporting, making it nearly impossible for investors to compare company performance and, in turn, reward higher ESG performance. Several state legislatures in the United States have called for ESG criteria to be scrubbed from markets and have even banned companies that use them.

In a less draconian proposal, The Economist has suggested jettisoning ESG frameworks altogether, instead requiring companies to report a single climate indicator: greenhouse gas emissions. While a simplified climate metric would allow financial markets to track net zero pledges against actions, it is a bad idea. A single greenhouse gas indicator would provide a static snapshot of current emissions but little information about future steps or longer-term risk scenarios. More broadly, investments are critical not only to curb emissions but also for climate change adaptation, nature conservation, nature-based infrastructure, and pollution abatement. In addition, ESG assumes these efforts must simultaneously integrate social, labour, human rights, and other standards to be truly sustainable.

Regulators looking to squeeze out the “green lemons”

The current issues with corporate sustainability disclosure standards pose a familiar problem for markets: How do we overcome information failures and allow prices to reflect the proxy value of assets?

More than half a century ago, Nobel Prize-winning economist George Akerlof identified the problem of asymmetric information stifling efficient market outcomes. Akerlof used the example of used car markets to illustrate asymmetric information: these were markets where few potential buyers possessed sufficient information to spot a defective used car, which he famously called lemons. He argued that, ultimately, regulations are needed to address information failures.

With the combination of expanding green markets and insufficient ESG data quality, the risk of “green lemons” has been growing for years, from phantom carbon offset credits to companies mismatching green pledges with daily practices.

Regulators across the world are making moves to address this. In the United States, the Securities Exchange Commission has proposed new rules setting out clear sustainability risk disclosure and reporting standards while the U.S. Federal Trade Commission has proposed new guidelines to ensure that green claims—including claims related to carbon offsets—are truthful.

In the EU, the next stage of the Sustainable Framework for Disclosure Regulations (SFDRs) entered into force at the start of this year, requiring greater transparency on how investments are classified under three categories–including “Light Green” funds, intended to promote environmental or social characteristics, and “Dark Green” funds, intended to deliver positive environmental or social impacts.

The EU is also expected to introduce new regulations to counter greenwashing in bond markets, building on the EU Taxonomy for Sustainable Activities.

In response, fund managers in Europe have moved nearly 40% of asset funds classified as “Dark Green” under the SFDRs to the lower “Light Green” level–a move representing roughly USD 100 billion. Shuffling from nervous asset managers is part of the reason ESG funds have been decreasing, and Bloomberg expects the shuffling to continue throughout 2023 as investors opt to reclassify asset funds now to avoid being accused of greenwashing when the new regulation kicks in.

Game-changing ESG and climate risk disclosure standards expected mid-year

There are promising signs that the remarkable regulatory convergence on climate finance metrics and measurement standards, which provides clarity and consistency for companies, will be replicated in the larger ESG market.

By mid-2023, the IFRS Foundation is expected to finalize its new rules on how companies disclose ESG and climate risk. These new standards, developed by the ISSB, mark the most important development in reporting in a generation.

China is among the markets to watch as the ISSB standards roll out. With climate disclosure standards already in place, China may adopt its own version of ESG standards somewhat distinct from ISSB’s. The good news is a widespread recognition among Chinese decision-makers of the importance of standards that are comparable and interoperable with other jurisdictions. Senior Chinese experts have played key roles in both the G20 Sustainable Finance Working Group and the United Nations (UN) High-Level Expert Group on the Net Zero Emissions Commitments of Non-State Entities, both of which underscore the importance of standards convergence.

Of course, with new standards forthcoming, the real test is whether better information will strengthen the business case for sustainability investments. Tim Buckley, the CEO of Vanguard, the world’s largest asset management group, recently said that they “cannot state that ESG investing is better performance-wise than broad index-based investing” as the group exited the Net Zero Asset Owner Alliance.

However, the conclusion of a recent analysis by researchers at MIT and Peking University School of Mathematical Sciences offers a vital counterpoint for sustainability investment. Based on evidence from over 200 ESG funds, the report concluded that there is a “significant positive relationship” between ESG investments and performance and that ESG funds outperformed their grey counterparts.

The new standards from the ISSB and different regulatory initiatives will allow investors to spot and crowd out “green lemons” in the critical years ahead–enabling the scaling up of investments not only for cutting emissions but also for enabling nature-positive outcomes, improving climate change adaptation, and strengthening social conditions.