Over the last decade there has been a strong growth in financial products that combine financial performance objectives with sustainability objectives in economic development. From a terminological point of view, the so-called "responsible" funds can be distinguished between: ESG funds that incorporate environmental (E), social (S) and governance (G) factors into the investment decision-making process and “impact” funds.
ESG funds and impact funds
ESG Funds aim to integrate such factors into investment decision-making and risk management, and differ from “impact funds”, which aim to achieve measurable and positive social or environmental outcomes. ESG funds may therefore not have explicit impact objectives but simply be based on exclusion criteria, i.e. excluding all companies/sectors that present a high ESG risk, such as the oil & gas sector or weapons production.
Despite the difference between impact funds and ESG funds, the two concepts are often overlapping, and we speak generically of ESG funds even for impact funds.
ESG funds therefore mean investment products that adopt a strategy aimed at combining classic financial performance objectives together with long-term environmental, social and governance objectives. The objectives of these three areas are quite different from each other: the environmental ones refer to the mitigation of climate change and adaptation to climate change. By mitigation we mean all actions, solutions and technologies capable of reducing the causes of climate change, the main one of which is the emission of climate-changing gases (greenhouse gases or GHGs). By adaptation to climate change we mean actions and solutions capable of reducing the negative consequences of climate change and therefore increasing the resilience of the production and financial system, families and infrastructure. Social objectives focus on how businesses manage relationships with employees, customers, suppliers and local communities. Social practices include diversity and inclusion policies, ethical working conditions, workplace safety and community involvement. Governance objectives refer to the management and control structure within a company; Effective governance involves transparency, accountability, business ethics and a fair decision-making structure.
ESG funds and greenwashing risk
To date, all the main financial analysis platforms (Morningstar, Bloomberg, LSEG, Facset; MSCI, S&P) provide lists of ESG funds that have different characteristics and objectives; however, in most cases it is complex to precisely identify the strategy that will be adopted, the specific environmental, social and governance objectives that will be achieved, the reference time horizon, as well as the methodologies for measuring ESG standards. This opacity, however, is not only linked to the limited information provided by fund promoters, but is also linked to the opacity of the same information that companies communicate to the market, even if they are obliged to carry out non-financial reporting. One of the major risks that investors can run into is the so-called risk of greenwashing, that deceptive practice adopted by an organisation, a company or an individual with the aim of making its activities or products appear as ecologically sustainable, respectful of the 'environmental or low environmental impact, even when this may not be the case. Greenwashing practices can include the dissemination of misleading information, the use of ambiguous labels or certifications, or the promotion of superficial green initiatives without actual concrete actions to benefit the environment.
The Sustainable Finance Disclosure Regulation
Precisely to counter the risk of greenwashing and the consequent loss of confidence of investors (institutional and retail) in Europe, the European Commission, as part of the actions undertaken to reorient capital flows towards investments and financing which also have ESG objectives, has implemented a series of directives and regulations aimed precisely at increasing the obligations and quality of disclosure of the various market players. At the level of investment product promoters, the tool implemented to counter the risk of greenwashing and encourage the dissemination of ESG financial products is the Sustainable Finance Disclosure Regulation (or SFDR), which came into force at the beginning of 2023. The SFDR defines the methods with which financial market participants, in particular fund managers, insurers and financial advisors, must disclose sustainability information and is also designed to enable retail investors to adequately assess how sustainability risks and opportunities are integrated into the decision-making process of investment. To achieve its purpose, the SFDR suggests/requires, depending on the types of funds, the use of sustainability benchmarks to evaluate and communicate performance in terms of sustainable investments and disclosure on the methodologies used to select or develop such benchmarks. The directive also requires a clear classification of the products offered to customers by dividing them between products promoted as “be sustainable"(art. 8 of the directive), products with sustainability objectives (art. 9 of the directive) e products without sustainability objectives.
An investment product that falls within the classification of Article 8 of the SFDR is a fund that specifically promotes the sustainability characteristics of its investments through the use of environmental, social and governance criteria in the selection and management of its investments. These criteria may vary, but generally reflect a broader assessment of a company's sustainability performance. The funds art. 8 are also required to disclose specific information on how the fund contributes to sustainability objectives and how it manages any conflicts of interest in relation to these objectives and make this information easily accessible to investors and the public.
Article 9 funds are designed to be investment vehicles that go beyond mere compliance with the standard ESG criteria expected in Article 8 funds. 9, actively engaging to address specific challenges and tangibly contribute to sustainability. This implies that the fund's investments must have a significant positive impact on its stated sustainability objectives, and that financial operators managing Article XNUMX funds are required to provide more detailed disclosure than other categories of funds. The disclosure must explain in depth how the fund intends to achieve its sustainability objectives and what specific measures are taken to ensure the positive contribution.
Compared to art. 8, the funds art. 9 are obliged to identify a reference benchmark for the fund. These benchmarks provide a reference to evaluate the real impact of the fund and ensure continuous monitoring and give clients an objective reference for evaluating sustainability performance.
What is defined in the SFDR directive is evolving and will be subject to further legislative and regulatory interventions in the coming years. In this process, the supervisory and control authorities of the European financial markets (ESMA, EBA and EIOPA) have developed technical regulatory standards to better specify what can be identified as financial products classified under art. 8 and 9. First, such products must present a model statement on key negative sustainability impacts, which contains quantitative sustainability indicators, such as greenhouse gas emissions and violations of key UN and OECD principles. These rules are currently undergoing further revision and this process will continue in the near future with the declared objective of increasing transparency on financial products and preventing greenwashing practices.
The performance of ESG funds
The company's attention to ESG issues leads to considerations on the return expectations of funds that include these factors in their investment strategies. One of the most relevant lines of study is connected to the performance of these funds: the relevance of these issues will lead to greater market "attention" and higher returns in the long term, or, precisely because these funds are able to reduce climate risks to which companies are subject, do they experience lower expected returns due to a lower risk profile?
There is a belief that these funds are capable of outperforming the market in the long term, but this belief is not fully confirmed in the academic literature, which has shown ambiguous results. At the basis of this is the concept of externalities: companies focused on ESG issues can generate positive externalities for society and citizens in the long term, but these externalities do not automatically translate into higher returns. The increase in environmental costs imposed by governments through increasingly stringent environmental policies can impact the cost structure and consequently on profitability. On the other hand, investor preferences could have an impact: massive disinvestment from non-ESG compliant companies could depress their market value with an increase in their cost of capital and a positive indirect effect for ESG compliant ones.
In themselves, therefore, sustainability factors do not represent a competitive advantage capable of generating value; on the contrary, they can represent a penalizing factor for all those companies that suffer the consequences of public policies and community actions aimed at countering the negative externalities linked to emission of climate-changing gases.
A second key to understanding the impact of ESG factors in investment portfolios is linked to the risk-return profile, and in particular to the ability of ESG portfolios to hedge against climate, physical and transition risks.
An ESG product may want to hold fewer companies that are exposed to climate risk and more companies that are not exposed to climate risk or that actually have some sort of solution in their business model for the climate. In general, a portfolio with low exposure to climate risk should have lower expected returns, precisely because of its lower exposure to a risk factor. This consideration is valid as long as the market's current expectations regarding the evolution of the climate and climate risks are realized in the future. However, if the climate becomes worse than the market expected, and we believe it has not been adequately priced into the market thus far, then companies prepared for climate change will increase in value while also increasing the returns of ESG compliant portfolios.
