By Shaw Mabuto, ESG Specialist and Partner at SPEAR Capital
The demand for sustainable investments has grown exponentially over the past year as the pandemic has both amplified and accelerated the need for improved social welfare, governance, and support of economic activity that enhances rather than damages the environment.
From a total of US$320 billion invested globally in the second half of 2020, a substantial number of these investments focused on sustainability and we saw record levels of investment in ESG (Environmental, Social, and Governance) factors over the past year.
With 40% of venture capital and private equity firms planning to work on improving ESG standards within their current portfolio and an increase in the number of firms starting to introduce ESG in their strategy, it is clear that ESG investment will continue to gain momentum. This is because Environmental factors such as carbon emissions, biodiversity, energy efficiency; Social factors like employment diversity, and labour standards; and Governance factors such as board structure and management incentive allow investors to incorporate long-term financial risks and opportunities into investment decision-making processes.
As non-financial factors are quickly becoming non-negotiable for investors and responsible investments continue to rise, it might seem that sustainable practices are being significantly improved.
However, there remains one area of concern. Sustainability is undeniably in vogue and, to appeal to socially-minded investors, some companies might provide misleading information or convey a false impression of being “green” or eco-friendly. This is known as greenwashing.
The investment risk in a façade of sustainability
In the long term, factors under ESG categories could introduce controversies and downside risks with the potential to erode equity value and increase credit risk over time. Therefore, it is important to combine better risk management with improved portfolio returns and to reflect both investor and beneficiary values in an investment strategy. When a beneficiary misrepresents its ESG efforts, the potential for reputational damage for both is significantly increased and will impact the long-term value of that investment.
Additionally, firms that participate in greenwashing can undermine the integrity of green or sustainability linked investments.
Greenwashing, whether intentional or not, can present itself in several ways such as making claims that are not substantiated by easily accessible information, presenting only the positive characteristics in relation to ESG factors while omitting the negative impact, vague claims purposefully meant to be easily misunderstood, or just intentionally falsified claims.
So how can investors recognise when an ESG investment is credible and authentic?
If it can’t be measured it doesn’t matter
The simplest way for investors to identify genuine ESG investments, and for companies to attract sustainability-inclined investors, is through the communication of the ESG efforts that can be measured and nothing else.
Firms must actively assess ESG efforts that are material to the company and regularly monitor their performance. Reports on ESG compliance must be clear, concise and specific in what they are saying and how they are measured. In other words, there needs to be a fully audited trail of every single ESG-related claim to avoid greenwashing.
Although credible investors are looking forward to the elimination of greenwashing, a recent S&P Global survey found that only 29% of private equity and venture capital firms intended to focus on investments with good ESG track records and only 24% were re-evaluating existing ESG diligence. Investors must prioritise ESG investments that are backed by verifiable empirical evidence and manage risk within their current portfolio by encouraging firms to correctly measure and track their ESG objectives and claims.
Confronting greenwashing through legislation
The ESG investment market is rapidly growing but is currently unregulated. There are no standardised ESG rating or assessment tools that can lend official credibility to a company’s claim. Essentially, there aren’t really any rules governing ESG reporting to determine whether investments are sustainable or environmentally friendly.
However, the European Union recently adopted the Sustainable Finance Disclosure Regulation which requires firms to report on their sustainability strategy using set rules for how and what sustainability-related information they need to disclose. Modelling legislation in sub-Saharan Africa and around the globe off of the EU’s new regulations could be extremely beneficial in helping investors avoid being deceived by greenwashing, reduce ESG investment-related risks, and assist asset managers in making green investment decisions that are fiscally responsible.
Adopting laws that target greenwashing would help to level out the playing field and ensure that companies report on what they track and measure justly.
Responsible investors are looking to make a positive long-term impact on society with their investments, but the risk of greenwashing is eroding faith in sustainable investments and could deter investors from credible opportunities if it is not addressed. Doing so calls on companies to be truthful, specific, and consistent in their reports, investors to do their due diligence when vetting an investment, and legislators to create the regulations that will set out a common framework to protect sustainable investments.