ESG investing is broken. This is how fintechs can help fix it.

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Nick Miller Senior Ventures Strategist
4min read

‘Green’ funds aren't solving climate change, they’re facilitating it.

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The well-intentioned ESG investing movement has ballooned in the past few years. Assets invested into ‘green’ funds reached over $200bn in 2021, up from approximately $25bn in 2018. But this isn’t good news for those who care about combating climate change or solving inequality, because ESG investing is broken. It’s leading us to believe that we’re addressing these issues, when instead we’re sleepwalking into inaction.

It’s leading us to believe that we’re addressing these issues, when instead we’re sleepwalking into inaction.

ESG-focused investing isn’t delivering what it promises

‘ESG investing’ can mean a number of different things to different people. There’s no single definition or any universally agreed framework to classify every product, making it open to interpretation. This opaqueness has led companies and leaders to preach its importance, while their actions go unaccounted for.

These ambiguities also mean that ‘social’, ‘green’ or ‘low-carbon’ products are mismarketed to investors. Investments are not ‘green’ when asset managers like State Street and Blackrock launch ‘fossil fuel-free’ indices holding refining companies. Product impact is being overstated by top-tier institutions such as DWS and Deutsche Bank. ESG indices are highly questionable if Standard & Poor can include oil giant Exxon Mobil, but not Tesla.

Fintechs are also at fault. Money management and investing apps like Plum don’t even explain what their ‘green’ or ‘ethical’ fund contains on their product page. From the customer’s perspective, they see the product label and trust the impact promised is being delivered. The issue is, it’s often exaggerated or just pure bullshit.

The labelling issue also extends to the ESG ratings. They don’t work because companies only need to tick one of the ‘E’, ‘S’ or ‘G’ boxes to be classified as ‘ESG compliant’, irrelevant of other criteria. For instance, tobacco companies have been classified as ‘ESG-compliant’ because they meet environmental and governance benchmarks, despite their terrible social impact on people’s health.

These scandals are happening partly because regulators are behind the curve. The SEC only voted in May to extend the rule governing fund naming conventions, to ESG funds. Until now, a ‘US Clean Climate Equities Fund’ would need to hold at least 80% US stocks, but could still have 50% of the equity allocation in oil and gas.

These scandals are happening partly because regulators are behind the curve.

Customers are also being hoodwinked when they believe they’re ‘offsetting’ their portfolio’s carbon footprint using Voluntary Carbon Markets. These have incurred countless scenarios of fraud, where offset projects are sold multiple times over or not even implemented in the first instance. A mechanism like blockchain is needed to verify their authenticity, so that customers don’t continue polluting under a false impression that their ecological impact is being neutralised.

The torrent of greenwashing surrounding ESG investing proves that the industry can’t rely on self-governance. Instead of positive action, ESG investing has caused an epidemic of virtue signalling and window dressing. Retail investors have been misled. Our attempts to conquer our biggest challenges, such as climate change, are being derailed.

The torrent of greenwashing surrounding ESG investing proves that the industry can’t rely on self-governance.

Why we’re being greenwashed

So why do leaders consciously set unrealistic net carbon zero targets or exaggerate the positive impact their companies and products are really having? It’s primarily a marketing tactic. In an attempt to improve reputations, many practitioners are under pressure to promote themselves as ‘do-gooders’ to an increasingly socially-conscious customer base.

Unfortunately, this marketing propaganda is supported by academia. Until recently, academics were arguing a strong correlation between high ESG scoring investments and outperformance, despite contested evidence. But as former Blackrock CIO Tariq Fancy highlights in his essay on ESG investing, academics are incentivised to find connections: “There’s always money to be made from telling people what they want to hear.” Advising the investment industry that it could help solve climate change through selling so-called ‘green funds’ was exactly what finance leaders wanted to hear. Scholars aren't neutral in the discussion.

Commercial drivers are also influencing industry leaders. There’s an obvious comparison to be made with the subprime mortgage crisis, where poor performing loans were chucked into the CDO ‘bucket’ and sold to the market. Now a mix of investments are being grouped together, painted green and tagged with an ESG sticker before being flogged to investors. The products may be different, but the principle is the same.

Product competition is also a factor, with actively managed funds losing out to low-cost, passively invested indices. The introduction of ETFs meant that asset managers needed to justify their vastly more expensive products and the added value of ESG-friendly investments provided a convenient excuse.

The ESG pretext is evidenced by the now former head of HSBC Asset Management’s sustainable investing business, Stuart Kirk, who was forced to resign after a highly controversial presentation titled: ‘Why investors need not worry about climate risk’. At the event Kirk stated that because the average HSBC loan term was six years, “what happens to the planet in year seven is actually irrelevant to our loan book.” Bank execs like Kirk will continue to prioritise short-term shareholder returns over long-term environmental risks whilst their bonuses are dependent on a few year’s revenue performance.

My unfiltered opinion

While there are some ESG products which genuinely create positive social outcomes, the result of self-regulation puts them firmly in the minority. To address the issues mentioned above, governments and industry need to work collaboratively to stop greenwashing. The distributed, auditable and immutable characteristics of blockchain would enable innovative use cases for ESG investing, especially as the technology’s energy efficiency improves.

While there are some ESG products which genuinely create positive social outcomes, the result of self-regulation puts them firmly in the minority.

There’s an increased need to transparently validate the real impacts that products are having, and blockchain technology could be the solution. Fintechs like Cleartrace, which JPMorgan has partnered with to track its energy output, are clear proof that this tech works. Further use cases can be introduced for improved data sharing and disclosure by open source platforms like OS-Climate.

Pricing carbon is critical to fighting climate change and fintechs can improve the uncertainty with voluntary carbon markets. Web3-based fintechs like Veritee are leveraging blockchain to provide their customers with more transparency and separate sham projects from legitimate ones. Alternatively, companies such as Sparkchange allow investors to access more trustworthy and regulated carbon credit products.

Fintechs can help restore investors’ faith in the industry. If ESG investing is to be truly fixed, we need to leverage innovations such as blockchain, as well as a continued high degree of healthy scrutiny from all stakeholders, to ensure that greenwashing becomes a thing of the past.

Disclosure: the opinions expressed in this article are not intended to be financial advice or recommendations for any specific security, company or investment product. You should only seek advice from an authorised financial professional before investing.

 Nick Miller
About the author

Nick Miller

Nick is a Senior Strategist in the Ventures team, helping to create new, disruptive propositions and providing research on fintech to forward-looking organisations.