In an effort to standardize the definition of “sustainable,” the EU has introduced a common classification system for sustainable economic activities called the “EU taxonomy,” in line with the EU’s climate and energy targets for 2030. This new regulation demonstrates the need for definitions and measures of sustainability that are more aligned with sustainable development goals.
Do mutual fund investors – especially those driven by sustainable fund mandates – include information on the sustainability alignment and impact of their investments? And do they incorporate information beyond that revealed by publicly available environmental, social, and governance (ESG) ratings? In other words, is the capital of investors with preferences for sustainability channelled towards companies that are truly sustainable? Answering these questions will help us elucidate whether greenwashing is still alive in the mutual fund industry.
SDG Rather Than ESG
During the organization of a conference on sustainable financial intermediation, I recently encountered a paper by my colleague Denitsa Stefanova, who is also Professor at the Finance Department of the University of Luxembourg. Her work is closely related to the role of financial intermediaries in promoting sustainable economic activities. In one of her papers, she employs alternative measures to assess the sustainable footprint of mutual fund holdings. She argues that relying solely on ESG ratings to evaluate a company’s sustainability impact may be problematic for several reasons: the methodologies employed by rating agencies to derive ESG scores lack standardization and transparency, aggregating multiple pieces of information into a single score is challenging, and most of the information used to derive ESG scores is self-reported by the companies under assessment.
“Greenwashing is not rewarded by the markets, as institutional investors incorporate information about the sustainability alignment of mutual funds beyond their ESG ratings.”
Diane Pierret, assistant professor at the Department of Finance at the University of Luxembourg
Instead of relying on ESG ratings, the paper uses a metric of companies’ sustainability reflected in the impact of their products and services on the 17 UN Sustainable Development Goals (SDGs). The impact metric leverages natural language processing algorithms to determine a product’s impact on the SDGs, sourcing it from a vast pool of millions of academic research articles. The approach provides an objective assessment of the sustainability footprint of a company through the portfolio of its products and services and abstracts from any self-reported information about the company’s sustainable policies.
When Greenwashing Does Not Mean Performing
Analyzing the flows of retail and institutional investors’ capital in mutual funds, Denitsa’s paper documents increased investor capital allocations to funds that are marketed as sustainable. However, market segmentation is amplified when considering investor capital flows through the lens of the SDG impact measure. Funds with a clear sustainability mandate see higher investor inflows associated with better alignment of their portfolios with SDGs. When mutual funds are not marketed as sustainable, however, their higher SDG alignment scores are associated with outflows from investors.
Similarly, while funds with a sustainability mandate generally have lower returns than non-sustainable funds, an increase in the alignment of their portfolios with SDGs correlates with improved performance.
Interestingly, she finds that the correction in investor flows in sustainable funds is driven by outflows from “sustainable” funds with low SDG alignment scores. Hence, it seems that investors do not get “greenwashed.” Investors can accurately assess the sustainability of the holdings of funds that are negatively aligned with SDGs despite their “sustainable” label, and they divest from those greenwashing funds.
While investors seem to exhibit a preference for sustainability, their investment decisions primarily bear on excluding funds that hinder the advancement of SDGs. Thus, divestment rather than an active increase in flows towards funds with high SDG scores dominates the reallocation of sustainability-driven capital.
To summarize, greenwashing is not rewarded by the markets, as institutional investors incorporate information about the sustainability alignment of mutual funds beyond their ESG ratings. Denitsa’s paper even goes further by showing that greenwashing is penalized, with investors divesting from the falsely labelled sustainable funds.
Professor Diane Pierret is assistant professor at the Department of Finance at the University of Luxembourg. Her research in the field of empirical banking focuses on the regulatory stress testing practices, consequences of unconventional central bank interventions, sovereign-bank linkages, bank profitability and monetary policy, and the interaction between solvency and liquidity regulations. Diane Pierret is also research affiliate of the Centre for Economic Policy Research (CEPR).
