By Roselina Petkova
Everything at this stage suggests that the future for ESG funds should be rosy. Europe’s strict rules and efforts to achieve business sustainability support this expectation. But 2024 began with not so rosy data for ESG funds and the reasons are the lack of confidence in the green paradigm.
At the beginning of this year, data came out about the first in history of the ESG funds global capital outflow. According to Morningstar Inc. US fund clients withdrew 5,1 billion dollars net in the last three months of 2023. ESG scepticism is strong in the US, and it follows years of attacks by Republicans, with lawmakers in New Hampshire even trying to criminalize this practice. At the same time, investors began to question the sustainability of the strategy after a prolonged period of poor financial returns.
The reasons for the ESG funds net outflow are many, but first and foremost is peoples’ doubts that goes into the ESG paradigm is meaningful. “There is still no good enough homogeneity for ESG criteria and for which companies are considered green, and which not,” explains Dimitar Georgiev, head of Financial markets at ELANA Trading. He also adds that all ESG ratings that agencies give are written in different ways and they are not comparable with each other. “This is precisely what leads to the lack of interest in the funds themselves,” explains Georgiev.
In his report, Hortense Bioy, global director of sustainability research for Morningstar, writes that the active managers have once again failed to prevent the buybacks in the corner of the market where it is easier for them to prove their value. “In contrast, passive funds demonstrated consequent sustainability,” adds Bioy.
Greenwashing problem
Greenwashing is one of the main problems of the European green package. Why? Because many companies that want to respond to the new, green criteria are cleverly disguising their real politics, repainting them in “green”. For example, putting a “green label” on certain policy would mislead the investors about the actual practice – a problem that is in its infancy and difficult to grasp, as the EU is in the process of constantly renewing regulations aimed at limiting or exposing greenwashing. But the question is, what will investors be watching for? According to Dimitar Georgiev, investor interest will be directed to stocks and bonds, specifically to companies that claim to be green and adhere to ESG principles. “At this point, the so-called 'greenwashing' occurs very easily and to a large extent, where companies and projects claim to be green in order to attract a certain financial resource. But it is not invested in ESG projects,” explains Georgiev.
Factors that will drive the market
Another problem facing investors is the incomparable criteria for whether a company is green or not. Different rating agencies take different criteria into consideration. According to Dimitar Georgiev it is key to change this and make ESG ratings comparable. “It must be homogenized and clearly stated that a company is exactly as green as it presents itself," explains Georgiev. Another important factor, he says, is what science will continue to say about carbon emissions. Because every scientific conclusion that confirms or denies that human actions contribute to global warming can have a very drastic effect. “In the financial markets many are not convinced in the fact that we have to limit carbon emission and that they are relevant to climate change. And this is a central issue in the entire ESG paradigm," explains Georgiev. He also adds that the main thing that still drives the interest of investors continues to be the maximization of financial profit, the maximization of financial benefit without taking into account the sustainability of the management.
What do companies do?
A recent KPMG survey conducted among American companies also showed the sentiment among companies. Despite the protests against ESG in the US, many companies – approximately 90% in KPMG’s survey – plan to devote more more financial resources for ESG in the following three years. 43% of those surveyed want to add employees to deal with environmental, social and governance factors. Another 40% plan to invest in ESG-specific software, and 38% want to train or educate their employees. The sentiment among the major companies is to continue with their plans to improve ESG capabilities. According to Maura Hodge, KPMG’s ESG audit leader, the main reason now is regulatory pressure. Regulations are forcing companies to "bring the same level of rigour into their sustainability reporting that is required of financial statements", she said. Just over three-quarters of the 550 board members, CEOs and managers surveyed by KPMG globally say their organizations plan to restructure their teams with an ESG focus. Some companies – around 24% - even plan significantly to increase ESG inclusion within "non-ESG" roles, while 59% expect a moderate increase in ESG within these roles. Hodge also explains that historically, reporting on sustainable development has been the work of a very small group of people with insufficient resources. And now that the requirements are evolving, "the amount of effort and rigour that needs to go into reporting has changed significantly," she says.
Another report of Jefferies Financial Group shows that in Europe the number of job postings that include the term ESG has risen. Although ESG reporting is becoming more common, almost half of the companies surveyed said they still rely on outdated spreadsheets to manage their data, KPMG said. This can change, because most major companies plan to increase their investments in sustainability software and workforce capabilities over the next few years. In addition to meeting compliance requirements, the survey finds that many companies view establishing ESG capabilities as a key tool to improve organizational performance.
Dimitar Georgiev explains that in Europe ESG rules are really strict. And from the companies' point of view, this is another administrative burden that requires the creation of new departments and structuring of teams. “The costs of true ESG reporting are significant. Because every single company will have to start doing activities it has not done until now," explains Georgiev. And according to the KPMG report, improving ESG data management and reporting capabilities is seen as the best way to strengthen integration of sustainability objectives with overall business objectives.
Despite the outflow of capital from ESG funds, financial analysts are not rushing to negative conclusions. According to Dimitar Georgiev, their future should be rosy. The reason is that Europe has big enough consensus that the continent should develop in a sustainable way, respecting the basic ESG principles. At the same time, it is likely to slow Europe's competitiveness, he predicts. "The growth of the ESG industry is expected, but it will be smooth and less aggressive than initially predicted," he adds.
Morningstar’s analyst Hortens Bioy explains that the picture of the global streams of ESG funds in the last trimester maybe seemed bleak, but ESG funds in Europe continued to behave better than the rest part of the fund universe. She also noted that the global asset value of ESG funds continued to rise, increasing by 8% to a total of 3 trillion dollars. “The retreat from ESG came at a time when the “broader open-end and exchange-traded fund market was also experiencing buybacks amid a continued challenging macroeconomic and geopolitical context," Morningstar said.
THE BOTTOM LINE Greenwashing is one of the major problems of the European Green Deal, because many companies that want to meet the new green criteria are cleverly disguising their real policies to look “green”.