Understanding how and why ESG data communication rules have led to widespread “green window dressing” of ESG funds in the U.S., according to academic research.

A critical discussion has unfolded around the classification of ESG funds following the SFDR standards. A seminar held by the European Commission on October 10, 2023, highlighted that many experts and industry players are concerned that SFDR communication may be promoting greenwashing rather than enhancing true transparency. This concern is echoed by leading figures, including the Chair of ESMA and the Director of Financial Markets at FISMA.

The intent behind these regulations is to support ecological transition by preventing greenwashing. However, certain current practices in sustainable finance seem to undermine these goals. I draw upon research, such as that by Professors G. Parise and M. Rubin from Edhec, which exposed the prevalent “Green Window Dressing” tactic (link in comments).

Some managers may artificially spruce up their portfolio just before the quarterly “official” snapshot to appear more environmentally friendly.

This has become a reality for numerous ESG funds in the United States. The study mentioned earlier uncovered large-scale manipulation of ESG fund inventories from 2016 to 2021 to appear more committed to ESG. The scheme? Selling off low ESG score stocks just before quarter-end and repurchasing them shortly after. The discrepancies between pre- and post-inventory positions are stark. Moreover, these funds outperform their genuinely ESG-committed counterparts because they face fewer constraints! Not to mention, they attract more capital than their more ‘ethical’ rivals.

Europe should take heed, as sustainability indicators operate similarly here as in the U.S. Consider this: a manager anticipating a rise in oil prices may temporarily shift to fossil fuels, then switch back to a greener portfolio just before an assessment. The outcome? A misleadingly low PAI emissions score despite a carbon-heavy investment strategy.

What if I told you there’s more to the story? Shockingly, within the PAI (Principal Adverse Impact) system, the carbon footprint of an equity fluctuates with its stock price (!), unfairly penalizing ESG stocks. But that’s a scandal I’ll delve into in another article.

Sustainable finance deserves better than these ill-suited and even counterproductive indicators. It’s time to rethink sustainability KPIs like SFDR “PAIs” to truly reflect the ESG impact of investments.

For instance, the carbon footprint of a fund should be as dependable as its daily Net Asset Value (NAV). There are viable alternatives, and they warrant swift exploration and trial within a regulatory sandbox for instance.

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