Responsible investing is a key factor in driving the transition to a more sustainable society. ESG ratings and reporting regulations such as SFDR are meant to guide private and professional investors, but the sheer abundance and complexity of scores and methodologies can be overwhelming.
Remember when the weather was just a topic for small talk over coffee or between business meetings? Now it’s all we talk about. Hurricanes, flooding and burning forests have put the need for a rapid transition to a carbon-free world on top of everyone’s agenda.
Steering capital toward sustainable investment is crucial for the transition to succeed. But what is sustainable investment? One indication is offered by measuring how well a company performs on environmental, social and governance-related (ESG) issues.
Needless to say, trying to cover such a wide range as represented by the ESG spectrum is a difficult task. Petra Hakamo, Head of Sustainability at Evli points out that the ratings jungle may prove impenetrable to some observers: “The more ratings there are, the more difficult it becomes. Sustainable investing is hard because there are so many and sometimes conflicting issues to take into consideration. A company may, for example, perform well on emission reductions but poorly on social issues. It’s rarely black and white.”
According to a paper from March 2023 by Morningstar about $2.7tn of assets are currently managed in more than 2,900 ESG funds. In the fourth quarter of last year alone, there were about $142.5bn of inflows into the sector.
Not the whole story
Rating agencies have been criticized for not giving the whole picture, says Hakamo. “A single score doesn’t tell the whole story and risks portfolio managers simply conducting a ticking-the-box exercise when it comes to ESG ratings.”
Who gets to decide which methodologies are used to produce ESG ratings and index scores? What’s to prevent companies from highlighting some achievements and downplaying others? Not much, according to critical voices that warn of “greenwashing” to seduce investors and consumers. Green is sometimes painted onto products and services that are frankly quite pale from a sustainability perspective.
To prevent greenwashing and increase transparency in the ESG reporting jungle, the EU has introduced the Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy. These regulations aim to ensure that “asset managers, institutional investors, insurance distributors and investment advisors include ESG factors in their investment decisions and advisory processes” according to the European Commission.
The EU Taxonomy is a classification system for environmentally sustainable economic activities and is integrated into the SFDR – specifically Article 8 or 9 as these cover environmentally and or socially sustainable investments.
As of 2023, level 2 of SFDR is implemented, which requires asset managers to disclose more information on the methodology used and the sustainability risks involved. As a result, many fund managers appear to have chosen a path of caution and reclassified their funds from Article 9 to Article 8.
Article 9 covers products that target a sustainable investment primary objective, whereas Article 8 products promote investments or projects with positive environment or social characteristics and with good governance principles, alongside other non-ESG traits. While sustainable investment is not an objective of the product, it remains an aspect of the investment process. Article 8 products need to disclose the degree (if any) to which they invest in environmentally sustainable investments or in investments with a social objective.
“The voluntary downgrade wave probably reflects a realization among fund managers that funds may have been too hasty in arriving at a classification and decided to step down a notch ahead of the regulatory inspection of sustainability classifications,” says Hakamo and adds, “Merely tracking ESG metrics such as the carbon footprint doesn’t automatically place the company in category 9.”
307 funds downgraded
In all, some 420 products have changed their SFDR status since September 2022, of which 307 were downgraded from Article 9 to 8. This equals 170 billion euro in assets and the total share of Article 9 funds in the EU fund market fell to 3.3% by the end of December, from 5.2% three months earlier.
To an investor, does this imply that a large number of companies have suddenly become less sustainable? Certainly not, say Evli’s experts. “Article 9 funds only include companies with a pure impact focus, whereas Article 8 funds can invest in companies that are still in a transitional phase. Investing in Article 8 funds may actually have a wider impact simply because they are larger and may have a bigger impact on society,” says Hakamo.
She points out that Evli always tries to see the bigger picture. “We want all of our funds – not just a handful of specialized impact players – to have a strong ESG process in place and the underlying companies to have a positive impact on the world.”
Juhamatti Pukka, Portfolio Manager of the Evli Green Corporate Bond fund, believes that the narrower scope of Article 9 is good since it prevents greenwashing: “In selecting an Article 9 fund, institutional and retail investors can rest assured that there is a high standard and benchmark in terms of ESG performance. The whole purpose of SFDR is to increase clarity as to which instruments are sustainable and which are not.”
Pukka points out that issuer level ESG is only one dimension of the analysis behind Evli’s Green Corporate Bond fund. “Instrument level selection – which bonds to invest in – is important to fulfil the requirements set out for Article 9 funds. The Fund’s objective is to make sustainable investments in a way that achieves a positive and measurable social and environmental impact.”
In addition, issuing a green bond doesn’t necessarily imply that the issuer is a top sustainability performer across the board. There are 50 shades of green and one should analyze the green bond framework closely to see if the projects financed with green bonds really make enough positive impact. In many cases issuers have large amount of bonds outstanding while only some of these are green bonds. “Looking at issuer level ESG only takes you so far. You need to analyze the green bond framework to complete the sustainability analysis,” Pukka notes.
SFDR is not a rating, but a way to streamline ESG reporting. As for actual ratings, two of the most widely used are MSCI and ISS. MSCI has recently introduced a change in fund rating methodology that will lead to a downgrade of many funds and companies.
Strive to see the bigger picture
The reason behind the change is that MSCI wanted to adjust for what might be seen as a “too rosy” picture by assigning new weight to factors such as the number of “very bad” performers in the underlying portfolio or the rate of change in positive ESG development. The outcome will be that fund ratings and index ratings will decline broadly, an effect that incidentally echoes the change following SFDR level 2.
Again, this does not necessarily imply that sustainability performance in general has gone down the drain, merely that methodology changes behind the rating produce one-off shifts in the charts. At Evli, experts welcome the change: “The goal is to raise the requirements for triple As and provide meaningful differentiation between funds and arrive at a less perfect and more realistic picture of ESG risks and opportunities, and to provide an incentive for companies to work harder on ESG issues,” says Noora Lakkonen, a credit analyst at Evli.
As for ratings and indices, they are a good start but private as well as institutional investors alike should always strive to see the bigger picture, adds Pukka: “At Evli, we monitor our investments regularly and strive to influence the way companies operate. If we observe that a company is violating the principles of human rights, labour standards, the environment or anti-corruption as set out in the UN Global Compact, we seek to influence the company's operations or exclude it from our investments.”
Lakkonen adds, “Single figures and scores do not reveal the balance and possible tradeoffs. Just looking at the scores doesn’t really tell you much about the complexity of underlying issues.“
Finally, sustainability is not a new concern, even if the focus has shifted over time. In 1990, when MSCI began publishing its index, socially conscious investors considered pollution, ozone-depleting chemicals, fossil fuels, and other environmental risks.
Today, with climate change widely recognized as the greatest challenge we face, the investor focus has shifted to climate solutions at the portfolio-level. ESG concerns have triggered a dramatic and continuing shift in the asset and wealth management, driving a huge redistribution of investment. According to PwC’s Asset and Wealth Management Revolution 2022 report, asset managers globally are expected to increase their ESG-related assets under management (AuM) to US$33.9tn by 2026, from US$18.4tn in 2021. With a projected compound annual growth rate (CAGR) of 12.9%, ESG assets are on pace to constitute 21.5% of total global AuM in less than 5 years.
ESG-oriented AuM is set to grow at a much faster pace than the AWM market as a whole. Under PwC’s base-case growth scenario, ESG-oriented AUM in the US (the largest AWM market) would more than double from US$4.5tn in 2021 to US$10.5 tn in 2026; in Europe (already up 172% in 2021 alone) it would increase 53% to US$19.6tn. Investors in other regions outside the USA and Europe are also growing their allocations.
Responsible investing at Evli
Over the years, Evli's work on ESG integration has naturally evolved and developed, and so have its organizational capabilities. Today, over 50 portfolio managers and analysts are working actively on ESG integration, supported by a centralized responsible investing team and an ESG executive committee.
Investors are rightly concerned about greenwashing and elevated regulatory scrutiny. But how do investors find a fund that’s best aligned with their green aspirations? The answer lies in finding a fund manager that uses a systematic approach and has the capabilities to analyse ESG on a wide range.
Our methodology leverages ESG data on 13,900 issuers integrated into our own internal database with ESG ratings and analysis from external providers, to form a solid foundation for issuer level analysis, monitoring and engagement, exclusion, and reporting. At Evli ESG is widely integrated across the investment process and investment decisions are based on our own analysis, not solely the work of others.
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