New landscape for climate investors

Two new climate change benchmarks from the European Union should help investors identify the genuine article when it comes to green funds, but industry watchers say teething problems need to be ironed out before the benchmarks can be really effective 

How do you invest responsibly if saving the planet is your overriding concern? The European Union (EU) is in the process of changing the landscape for ‘climate investors’ with the introduction of climate change benchmarks. 

Two benchmarks are in the pipeline: the EU Climate Transition Benchmark (EU CTB) and the EU Paris-aligned Benchmark (EU PAB). Both aim to bring greater clarity to how companies focus on the climate and sustainability. 

They represent a new departure because, until now, no established framework has emerged for measuring the alignment of an investment portfolio with a temperature scenario. (The EU climate benchmarks only comprise companies that can demonstrate they comply with a global temperature increase limit of 1.5°C). But are the new benchmarks necessary? And what value do they bring? 

Growth market 

It is reasonable to argue that, given the level of growth in climate change-themed investing, there is a need to quantify what constitutes an environmentally-focused company and investment portfolio – and what doesn’t.   

Certainly, we have seen huge growth in the number of sustainability funds over the last three years. According to Morningstar, sustainable funds attracted an estimated $8.9bn in net flows in the first half of 2019, surpassing their $5.5bn in flows for the whole of 2018.

Stuart Phillips, Executive Director at BDO, believes that in general there is positive momentum for companies to take greater account of sustainability and thereby satisfy criteria to be included in a ‘climate change’ or ‘sustainability’ fund.  

“At BDO, we see a variance in demand across the global financial services landscape from the funds sector at this time. For example, environmental, social and governance (ESG) reporting has grown significantly across Asia over the past 12 months. In Hong Kong, a BDO survey among listed companies noted that 32% of responders were putting effort into formulating an ESG strategy – double the previous year.”

Phillips points out that, with regard to Guernsey in particular, the growth in demand for services such as ESG reporting is at an earlier stage.

However, through initiatives such as the new Guernsey Green Fund, The International Stock Exchange’s Green Market Segment and advisers raising awareness among clients of the options in sustainable reporting, the jurisdiction is positioning itself well for a certain upturn in demand, triggered by investors wanting to align with proven socially conscious approaches.

An end to ‘greenwashing’

There is always a danger that an investment theme, which has impetus at any given time, is exploited as a marketing opportunity. A product is labelled and sold with, at best, sketchy environmental credentials.

This fits in with the often-cited issue of greenwashing, which Rachel Whittaker, Sustainable Investing Strategist at UBS Wealth Management, describes as “calling something sustainable when there is very little substance beneath the surface”. 

She believes the EU benchmarks could help to tackle greenwashing. “In our view, standardised benchmarks can play an important role in creating transparency for investors and a common language/framework that could help non-specialists understand what is in a portfolio,” she says. “This helps reduce greenwashing, which both companies and investment managers can be guilty of.”

However, she is keen to point out that there are shortcomings to standardised frameworks – potentially, it could inhibit innovation or become a ‘crutch’ for asset managers to lean on and avoid doing their own research.

Ingrid Holmes, Head of Policy and Advocacy at Hermes Investment, agrees that there is value in the transparency and methodology the EU has used in constructing these indices. 

She argues that, from a retail investor’s perspective, an EU endorsement might provide the greater assurance they need on where their money is being invested. 

However, Holmes does have concerns over how companies will be monitored. “It is not clear at the moment who will be responsible for monitoring – whether it will be regulated on a national level or not.”

She worries that there might be an element of bandwagon jumping by product providers keen to tap into the ‘climate’ theme, but without really buying wholeheartedly into the principle. “We may see new passive funds underpinned by one of these [EU] benchmarks, where managers just say ‘job done’ and fail to take their responsibility any further.” 

The onus is on fund managers in the climate change space to take a more active approach – to prove their worth in finding and highlighting turnaround stories rather than merely focusing on which companies are ‘in’ and which companies are ‘out’ of the climate benchmark.

For active fund managers who are keen to market their fund as a ‘climate focused’ product, they will have to report what percentage of their fund complies with the taxonomy – the ‘green to brown share ratio’. The managers are clearly reliant on the transparency levels of the companies within their investment portfolio, with the green to brown ratio serving as the defined reference point. 

Devil in the detail?

There will inevitably be grey areas. For instance, the Schroder International Selection Fund Global Climate Change Equity invests in Siemens Gamesa, a leading player in the wind energy sector. However, the parent company Siemens Group also has an interest in the mining and oil and gas sectors. 

Assuming a multinational conglomerate such as Siemens is suitably transparent in its ESG reporting, it should be possible to evaluate from its disclosure if it complies or not. The green to brown share ratio comes into play in relation to where the group derives its revenues – at least equal for EU CTB companies and multiplied by at least four for EU PAB organisations.

Holmes does not think the benchmarks on their own provide a solution. “The concern is that index funds won’t monitor what companies in the index are actually doing going forward. The climate change challenge is a dynamic one, which means shareholders ideally need to be watching out to check companies are keeping to their climate change commitments – and holding them to account through effective stewardship if they don’t.” 

She adds: “This requires time and resources. It goes way beyond choosing the right benchmark. The right benchmark is only the start.”

Whittaker takes a similar line, arguing that any benchmarks of this kind are in no way a silver bullet. “A benchmark that invests in public companies has limited ‘real world’ impact,” she says. “Investing in public equities and bonds only sends a signal to companies and stakeholders that these issues are considered important by investors; it doesn’t actually channel new capital to any of these companies.” 

She suggests that investors who want to channel capital towards projects that will have a measurable impact on climate change need to be looking mainly at private market impact investments or, potentially, engagement-focused strategies.

This is a valid point but, for many investors, private market impact investing may not be something with which they are either familiar or comfortable. In this scenario, benchmarked climate change funds and impact investing could work towards the same goal but from different directions.  

The effectiveness of the EU benchmarks cannot realistically be gauged until they have been introduced – probably not until early 2021. In the meantime, supporters of the climate benchmarks will continue to expound their virtues: the fact that there are specifics regarding the ‘green to brown share ratio’ of where companies derive their revenues; and that carbon and temperature targets provide a greater degree of clarity. 

On paper, there are many positives, but the major challenge will be in the effectiveness of monitoring and analysis. Will there be sufficient buy-in? And – taking a longer-term perspective – will the benchmarks play an important role in making Europe carbon-neutral by 2050? Time will tell.