Marcus Björksten manages one of Europe’s best-performing sustainable funds. His Fondita Sustainable Europe product returned an impressive 41.6 per cent last year, while its benchmark lost around 3 per cent.

It was a standout performance during a stellar year for sustainable investing, where environmental, social and governance issues are taken into consideration. ESG investing set record after record, with investors piling unprecedented levels of cash into sustainable funds, asset managers rushing to launch new products and research suggesting such investments outperformed mainstream rivals. ESG has become one of the most important shifts in the investment industry in a generation.

Yet despite the recent fanfare about sustainable investing, Björksten says all is not what it seems. “Greenwashing is a real problem,” he warns — referring to companies’ promotion of environmental concerns as an advertising gimmick.

Speaking from a wooden cabin in northern Finland during a cross-country skiing trip, the portfolio manager says he seeks out businesses that provide products or services aimed at tackling the climate crisis. However, many of the funds that use the ESG label, he says, are not as sustainable as they appear. Several popular ESG funds, for example, invest in the world’s largest carbon emitters.

“Nowadays, every second fund is claiming it is in some way sustainable.”

As ESG becomes a part of the investment mainstream, it is reaching a critical juncture: without some way to police the way the concept is used, it runs the risk of being reduced to a marketing exercise with only modest substance.

Grouped stacked bar showing number of funds by type

With that in mind, the most rigorous effort yet to provide structure to the market begins on March 10 when the EU introduces new rules that are designed to prevent greenwashing.

Under the European rules, which are part of a wider series of green finance regulations, investment products will effectively be categorised as sustainable and non-sustainable. Any asset manager that wants to market their fund as a sustainable product will be subject to tough disclosure requirements.

“The reporting will make it very difficult to have greenwashing,” says Björksten. “It will require a lot more work from the fund managers.”

The new rules could have far-reaching consequences for asset managers — not just in Europe but around the world as investment firms are forced to demonstrate they are serious about sustainability. They will also influence the decisions of listed companies which will find themselves under pressure to focus more on ESG issues or risk losing investor capital.

“The EU wants to reorient capital to sustainable investments. If [a company] doesn’t respect certain standards, they shouldn’t be getting such easy access to capital,” says Olivier Carré, a partner at consultancy PwC in Luxembourg, where the largest chunk of Europe’s investment funds is based.

Construction workers on the Edge skyscraper building site, which will house the offices of Amazon, in Berlin, Germany. The city’s ‘high-rise model’ states that a building must meet architectural and functionally sustainable criteria

When former US vice-president Al Gore and a group of financial professionals set up Generation Investment Management in 2004, their efforts to create a long-term asset manager with a focus on sustainability were met with scepticism.

“People looked at us with pity and thought we were deluded,” says Miguel Nogales, co-chief investment officer at Generation.

At the time, ethical investing was largely the preserve of charitable foundations and religious orders. “Fast forward to 2021 and ESG has become a thing,” says Nogales.

Now investors with more than $100tn in assets, such as BlackRock, Vanguard and Amundi, have signed a commitment, the Principles for Responsible Investment, to integrate ESG information into their investment decisions, while the total assets in specialist sustainable investing mutual funds hit a record of almost $1.7tn in 2020, up 50 per cent over the year.

The industry’s interest in ESG has been driven by a combination of factors including rising client demand — with big pension funds as well as regular savers increasingly demanding sustainable investment options.

“Demographics are moving in favour of this revolution,” says Gianfranco Gianfrate, professor of finance at Edhec Business School in France. “The younger generations are really into sustainability and the environment and this translates into the products they are buying,” he says. “Covid amplified this interest.”

Beeswarm of weight of holding in portfolio (%), by fund

The sector has also benefited from regulatory changes, such as UK rules that push pension funds to weigh ESG considerations, and a growing acceptance among investors that issues such as climate change could have huge financial repercussions.

Many active investment managers — which pick investments rather than track an index — have also turned to ESG investing as a way to differentiate themselves at a time when their profit margins have come under intense pressure from the rise of passive investing.

Strong performance, particularly last year, is also driving interest. A 2020 study by Morningstar, the data provider, found that a majority of sustainable funds have performed better than equivalent conventional funds over one, three, five and 10 years. Research from BlackRock, the world’s biggest asset manager, says ESG strategies outperformed during last year’s period of intense volatility; in the first quarter 94 per cent of leading sustainable indices beating their parent benchmarks.

“The experience of 2020 will help remove investors’ worry that ESG investing means giving up returns,” says Stephen Tu, vice-president at Moody’s, the rating agency.

Asoka Woehrmann, chief executive of DWS, the €793bn asset manager, agrees that the coronavirus crisis was an “important stress test” for ESG investing. “There was a view that these products would be a good weather product,” says Woehrmann. “But the resilience of ESG products is remarkable.”

A hydro dam. From next year, funds will have to report on issues such as carbon footprint

With ESG becoming the biggest buzzword in investing, even the most cynical of asset managers have been jumping on the bandwagon. As well as launching new products, older funds have been rebadged as sustainable. Asset managers have also ramped up their hiring of specialist staff to focus on ESG and sustainability issues.

Figuring out which asset managers are talking the talk on sustainability and which are taking concrete action, however, is far from simple. Many investors have struggled to find out what funds were invested in and just how seriously asset managers were thinking about issues such as climate change.

James Alexander, chief executive of the UK Sustainable Investment and Finance Association, says: “Some [financial advisers] are saying almost every fund is marketed as sustainable now. How do they determine which are the most sustainable?”

As greenwashing by companies and fund managers has ramped up, regulators, policymakers and standard-setters have turned their attention to how investors can decipher sustainable investment products. Policymakers have also been keen to help direct cash to sustainable investments in an effort to meet countries’ targets of cutting carbon emissions.

The regional services platform at Atocha rail station in Madrid, Spain, last August. Lockdowns have witnessed a surge in eco-friendly mobility policies like bike lanes

The EU has been at the forefront of the focus on sustainable finance, planning a series of reforms, including a classification system for what counts as green corporate activities, and the new rules for the investment industry which are known as the sustainable finance disclosure regulations.

Under the first stage of the SFDR rules, all asset managers will have to publish information on their sustainability processes. They also have to put investment products into three categories recognised as dark green, light green and non-sustainable depending on their climate and social impact. As part of the second stage, expected to come into force in 2022, funds will have to report on issues such as carbon footprint, investments in companies active in fossil fuel sectors and exposure to controversial weapons such as cluster bombs.

But after heavy lobbying from the fund industry, in February the European Supervisory Authorities reduced the number of so-called indicators asset managers have to report on, dropping issues such as deforestation.

Maria van der Heide, head of EU policy at ShareAction, a responsible investment charity, says the concessions “weaken the positive impact this legislation could have made”.

Wind turbines on a hillside in Norway. The EU’s new rules and the huge demand for sustainable investments in the region are being watched around the world

Nevertheless, the new regulation is “groundbreaking”, she says. “It allows investors to compare between different products and how sustainable they are and see what asset managers are doing to integrate sustainability.”

Molly Scott Cato, a professor of green economics at the University of Roehampton and a former Green party MEP, says the significance of the SFDR cannot be overstated. “When people found there was horsemeat rather than beef in their lasagne in 2013 there was an outcry, but when the equivalent happens in the financial sector, as it has for years, customers don’t even have the right to know. SFDR will have a big impact in changing this.”

She adds: “This long-overdue regulation will finally allow people who buy pensions and investments to know what their money is being used for and provide them with a better understanding of the impact of their investments on people and the planet.”

Authorities are already warning asset managers not to exaggerate in their assessments, with some regulators, such as the Central Bank of Ireland, saying they will be keeping a close eye on how asset managers categorise their funds. Morgan Stanley, the US bank, recently warned that “funds should consider the potential negative reputational impact of categorising funds as [sustainable] incorrectly”.

Propelled by the new rules, PwC predicts that assets in sustainable investment products in Europe will jump more than threefold to reach €7.6tn by 2025. The number of ESG funds is expected to outnumber conventional funds, as asset managers rush to make their products greener to attract investors.

PwC’s Carré predicts this transformation of Europe’s investment industry will have a dramatic effect on the companies in which fund managers invest, redirecting capital into sustainable activities and forcing businesses to be transparent about everything from their environmental impact to how they treat employees.

“If an asset manager wants to promote that [it invests based on specific sustainability] criteria, that will have impact on investments and that has an impact on capital flows and available financing for companies.”

Plastic bottles and containers ready to be recycled in Switzerland. In many cases, asset managers have little choice but to embrace ESG if they want to remain competitive

Mirza Baig, global head of ESG research and stewardship at Aviva Investors, the £355bn asset manager, also believes the growing sums of money managed in ESG funds will affect share prices.

“The consequences of companies being exposed for a lack of commitment or a lack of follow through [on ESG issues] will more likely result in a shift of capital and a more direct hit to their share price,” he predicts.

But as asset managers look to become greener, there are growing concerns that some investments are becoming overpriced. Last month, Patrick Pouyanné, chief executive of energy company Total, warned there was a bubble in renewable energy assets.

Generation’s Nogales says there is a risk that some ESG asset prices are becoming inflated as the world’s energy transformation gets under way. “Industrial transitions are usually associated with bubbles — and provided society can deal with that hangover, they are not bad,” he says. But he adds: “I am not saying there is a bubble in ESG.”

Some fund managers also worry the new EU rules could have unintended consequences. Ashley Hamilton Claxton, head of responsible investment at Royal London Asset Management, says the SFDR will result in much more transparency but warned of “interesting challenges”.

She argues that investors might be incentivised to punish companies even when they are making progress on ESG issues. For example, in order to report a low carbon footprint, a fund might avoid big energy businesses that have traditionally had high emissions, even if they were working to transform their operations and developing low-carbon technologies, she argues.

Despite these concerns, the EU’s new rules and the huge demand for sustainable investments in the region are being watched closely around the world. “Europe is the centre of a lot of the regulator sustainability drive, but they are not alone,” says Jane Ambachtsheer, global head of sustainability at BNP Paribas Asset Management in France.

In the US, the Trump administration pushed back against sustainable investing, including introducing rules to make it harder for some pension funds to consider ESG issues. But Joe Biden’s arrival in the White House is expected to propel interest in ESG, particularly as the Democrat has already unveiled a series of measures around climate change, including rejoining the Paris Agreement.

“We are in the middle of that [ESG] transition globally. The change in the administration in the US is going to provide addition tail wind,” says Ambachtsheer.

In the UK, the British government is facing calls to set out its own cutting-edge disclosure rules for funds in order to stamp out greenwashing. “The UK disclosure regulations could recognise those who are really going the extra mile, rather than paying lip service,” says UKSIF’s Alexander.

Chickens roost in a shed on a free range livestock and grain farm in Netin, Czech Republic. Businesses from the US to India will need to provide information to EU fund managers on issues from climate change to labour rights

Even without other countries taking action, the impact of the EU’s new rules will be felt across the world. This is partly because European open-ended funds known as Ucits are widely sold globally. At the same time, if a non-EU fund manager wants to market a fund to European investors, they will have to comply with the rules.

Businesses from the US to India will also need to provide information to EU fund managers on issues from climate change to labour rights.

“There is certainly an extraterritorial reach with this,” says Carré.

For Europe’s investment industry, the rising regulatory pressure and growing ESG demand from clients are driving a rapid transformation of the sector. Instead of standalone ESG teams or specialist stewardship teams, sustainable investing is being “integrated” into all investment decisions, says Sacha Sadan at Legal & General Investment Management, the UK’s largest asset manager. “Asset managers are bringing ESG right into the heart of investments.”

In many cases, asset managers have little choice but to embrace ESG if they want to remain competitive: a report by Moody’s in February predicted that ESG will be the main driver of the industry’s organic growth in assets under management in 2021.

DWS’s Woehrmann says investing has changed for good, because people want to ensure their money is doing no harm. “It is not only the outperformance [that is driving demand for ESG]. It is part of the zeitgeist”.

As for Björksten, he is hopeful the new EU rules will introduce much more rigour into the industry. “The authorities have done a really great job in reducing greenwashing,” he says.

Letter in response to this article:

Europe’s disclosure rules must cover deforestation / From Alex Wijeratna, Mighty Earth UK, London W12, UK