ESG stands for integrating environmental, social and governance aspects in the capital allocation strategy of investment funds. In essence, most ESG funds take conventional mutual funds as their baseline and then alter the capital allocation according to environmental, social and governance factors. ESG funds buy equity or debt securities that have been issued in the past (what is called the secondary markets). The fact that ESG funds are not active on the primary markets, where new capital is raised through the issuance of shares or bonds means that ESG funds are not able to directly achieve 'additionality,' a term which captures capital flows to 'green' or 'sustainable' projects that would otherwise not have been financed.
In principle, there are two main transmission mechanisms through which ESG funds could potentially create sustainability impact, which can be defined as when ESG funds have significant positive effects on companies in their portfolio. Put differently, sustainability impact is a change in the business practices of firms and real-world outcomes caused by ESG funds.
The second potential mechanism for the sustainability impact of ESG funds is their capital allocation. In our recently published paper , we have provided a novel market analysis of ESG funds and their capital allocation. We distinguish between 'Broad ESG' (or 'ESG integration') funds, 'Light Green' funds and 'Dark Green' ESG funds. In their capital allocation strategy, most 'Broad ESG' funds only deviate marginally from conventional funds (and the benchmark stock indices which they track). On the one hand, this makes these funds prone to greenwashing as recent regulatory shake-ups have demonstrated. On the other hand, this means that the likelihood of them creating sustainability impact is extremely low as they still invest billions into fossil fuel stocks and other decidedly non-sustainable investments.
'Light Green' and 'Dark Green' ESG funds do not track their respective benchmark stock indices as closely and thus the plausibility that they are able to create a sustainability impact via their capital allocation is much higher. However, in our dataset of all index-tracking ESG funds among the 500 largest recorded on the Bloomberg Terminal, 88% are Broad ESG funds while Light Green and Dark Green funds only had market shares of 7% and 5%, respectively.
Building on these findings, our research suggests two potential ways for regulators to enhance the sustainability impact of ESG funds (and reduce obvious litigation risks that arise from greenwashing). First, regulators should develop credible minimum standards for all ESG funds concerning their proxy voting behaviour and private engagements. Second, the vague category of Broad ESG funds should be made much more precise, including clear criteria on how their capital allocation deviates from conventional funds.
If we are to use financial markets for a green transition, they need to be regulated in ways that facilitate sustainable investment outcomes. Without clear standards for ESG, marked greenwashing concerns are likely to create a lose-lose situation for investors, asset managers, and, above all, the environment.
