Funds industry becoming greener

Investment funds are getting greener. According to a report from the European Central Bank (ECB) last year, assets under management of global Environmental, Social and Governance (ESG) funds increased rapidly in recent years, jumping from €0.5 trillion in 2015 to €1.3 trillion in June 2021. Not only are these investments ethically and environmentally sound, the ECB insists they are showing greater resilience than “browner” traditional options.

That said, much of this demand is driven by increasing regulation in this area. James McKnight, partner in the investment funds practice at Simmons & Simmons, says investors are increasingly curious about green credentials, since the introduction of the Sustainable Finance Disclosure Regulation (SFDR). This EU regulation has prompted managers to look at how they invest and consider whether sustainability and ESG more broadly should be embedded within their investment processes.

“Some have made significant changes, but many fund managers are looking for the approach with minimal impact on existing operations, whilst also keeping investors happy,” says McKnight.

The years ahead will be interesting, says McKnight, as regulators voice concerns around so-called “greenwashing”; he points out that the European Securities and Markets Authority (ESMA) have launched a consultation into the validity of the use of ESG or sustainability-related terms in the names of funds. Some managers are classifying funds as “light green”, or Article 8, which are those which promote environmental or social characteristics, while “dark green” funds (Article 9 classification) are those that have sustainable investment as their core objective.

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“We have seen many so-called ‘dark green’ funds opting down to ‘light green’ once regulatory expectations for dark green funds became more clear,” he says, adding that there is a risk going forward of nearly every fund being classified as light green, “which would defeat at least part of the purpose of SFDR”.

McKnight and other experts agree that the implementation of the SFDR has been poor, leading to confusion among market participants as to what exactly is required. “ESG and sustainability will remain as key regulatory priorities for many years to come, but it will take a while to figure out what the best approach is. For now, managers should think very carefully about how they classify and name their investment products so as to minimise the risk of regulatory sanction,” he says.

Optimism

Andrew Farmer, director of KPMG Sustainable Futures, agrees that the investment management industry is still getting to grips with these regulatory requirements but is optimistic that once “level setting” has taken place, the future looks even greener.

“As we look to the next decade, the transparency promoted by European regulation is likely to add fuel to a transition of funds towards a greener future as investors can easily identify greener funds and interrogate the authenticity of a fund’s ESG characteristics,” he says. “Funds will likely be held to account with these regulatory mechanisms and, as a result, become greener.”

Farmer recalls a similar shift in the market with the advent of Socially Responsible Investing (SRI) back in the 1980s. “This is now a mainstream practice of restricting investments based on the values of the investor and I believe that the market is at a similar inflexion point today as SRI was nearly 50 years ago.”

Richard Kelly, head of client business with Legal & General Investment Management, has also noted significant demand for green investments from both individual and institutional investors. “Many investors want to see their money making a difference, helping to deliver the clean power we need to achieve the energy transition, and the regulatory agenda reflects and supports that investor interest.”

In terms of returns, investors should approach green investments as they would any other, advises Kelly. “Investors need to balance the risk and reward, as well as ensuring they are properly diversified across both assets and geographies,” he says. “We’re seeing a lot of interest in clean power infrastructure projects such as wind, solar and energy storage, for example, because these assets can offer reliable yields and a degree of inflation sensitivity, which is potentially helpful in a higher interest rate environment.”

Farmer says he has spent a material portion of his career as a participant and observer of the debate “green versus brown” funds’ ability to drive financial returns. “My conclusion is that it all depends on who is making the argument as the debate can be easily manipulated based on asset class, time horizon, sample set, definitions and a myriad of other factors,” he says.

Instead, he believes the returns differential between “brown” and “green” funds is the “non-financial” implication of the investment. “Whilst there will always be a place and necessity for financial returns, investors have reshaped their expectations to include a measurement of the impact, positive or negative, that their investment is making in our world. By that measure, I believe that green funds will always have a returns advantage.”