Managing the Associated Risks of Growing ESG Investments

Rating agencies, both local and international, are responsible for producing ESG grades for companies. However, the rating criteria for ESG investments are very broad and vary widely by agency and industry, leading to inconsistent grading. Thus, it is not advisable for investors to use only the composite ESG grade in making an investment decision. The investment portfolio of so-called ESG funds could also be misleading. An example is Vanguard, which has performed excellently like many ESG funds. Yet market-leading tech stocks like Apple, Microsoft, Amazon, Facebook, Google, and Tesla make up a big chunk of its portfolio, which does not necessarily mean that ESG is driving growth.

That is why there is a growing demand for deterring greenwashing⁠—or misleading investors to think that a particular development project is environmentally sound—and strengthening investor protection.

In the United States, the Securities and Exchange Commission (SEC) noted that some investment companies fail to assess ESG elements before making investment decisions, and it is looking into strengthening regulations over the naming of investment funds to help investors make informed decisions. The SEC inspects compliance with the “Names Rule,” which requires that 80% or more of a fund’s asset match what its name implies. It is considering whether to extend this rule to funds that treat ESG as an investment strategy. Investors might experience great confusion if an investment advisory firm or fund fails to provide a specific definition of ESG and its application when there is no standard definition in the marketplace. Identified problems include

·        a mismatch between a fund’s claim to using the ESG approach and actual management of its investment portfolio,

·        the lack of internal control over compliance with investment guidance and monitoring,

·        a potential risk of misrepresentation of the ESG approach, and

·        a mismatch between ESG disclosure and marketing materials and actual activities.

Meanwhile, efforts are underway to introduce regulations or guidelines for ESG rating agencies. The European Securities and Markets Authority (ESMA) sees the need for adequate regulations to ensure the quality of investment given the growing importance of producing trustworthy grades and rating amid risks of greenwashing, misallocation of resources, and mis-selling. The Netherland Authority for the Financial Markets (AFM) and France’s Autorité des Marchés Financiers (AMF) have supported ESMA supervision of ESG rating. In the Republic of Korea (ROK), the Ministry of Trade, Industry and Energy unveiled a plan to establish K-ESG to address confusion stemming from inconsistent rating.

Regulations on ESG rating should focus on establishing disclosure criteria and enhancing transparency. SEC Commissioner Hester Peirce has said that ESG factors are complex and not readily comparable across issuers and industries. She expressed concern over providing common ESG disclosure metrics for fear of driving and homogenizing capital allocation decisions and undermining the people-centered objectives of the ESG movement by displacing the insights of the people making and consuming products and services. For ratings to be meaningful, it is important to expand the scope of corporate disclosure, make disclosure mandatory for information selected through a rigorous significance test, and establish a regulatory and supervisory framework that enables investors to fully understand the method of ESG rating.

Efforts to define and categorize ESG-related activities need to be carefully done as well. The European Union and other major economies are putting together a green taxonomy to further promote green financing and investment. The Korean government is also developing its own K-taxonomy. This needs to be done in a clear-cut and rigorous manner to prevent greenwashing and should be well aligned with global practice.

Consumer protection measures must be established. In the US, the SEC examines whether investment firms disclose activities related to ESG investment. They employ policy, procedure, and strategies that match the disclosed information, focusing on portfolio management, advertisement of fund performance, marketing, and compliance program. In the ROK, the supervisory authority’s monitoring should step up to ensure that investment firms clearly demonstrate how they consider each ESG factor and perform due diligence.

H. Lim. 2021. Mobilizing Green Finance through K-taxonomy. Development Asia. 28 June.

Korea Institute of Finance website

R. Armstrong. 2020. The Fallacy of ESG Investing. Financial Times. 23 October.