An equity portfolio where climate considerations represent less than 50% of the determinants of the weight of the stocks should not be permitted to claim that it is climate-friendly or aligned with net-zero ambitions, according to the authors of an EDHEC-Scientific Beta study.

In the study, ‘Doing Good or Feeling Good? Detecting Greenwashing in Climate Investing’, Noël Amenc, Felix Goltz and Victor Liu set out how they tested stylised climate investing strategies in developed equity markets to find that popular climate strategies are inconsistent with the objective of influencing firms to reduce their emissions.

In a webinar yesterday, Goltz, who is associate researcher at EDHEC Business School and research director at index provider Scientific Beta, said climate investing was different from standard investing because it also pursued non-financial objectives. Investor initiatives such as the Paris-Aligned Investment Initiative clearly stated contributing to limiting global warming as an objective, he said.

In their analysis, Goltz, Amenc and Liu found three key shortcomings that introduce greenwashing risks in climate strategies.

One is that stock weights in the stylised strategies were mainly driven by market capitalisation, with climate scores only accounting for 12% of differences in weights across stocks.

The trio also said the climate investing strategies were “relatively insensitive in their allocation decisions to the dynamics of corporate climate performance”, with on average around 35% of stocks with a deteriorating climate score over time being rewarded with an increase in weight.

According to the authors, firm-level weighting decisions need to send clear signals to companies’ management to motivate them to improve their climate performance.

“Such clear signals are also important for engagement strategies to be effective,” they wrote.

Language in a separate EDHEC statement about the study was stronger, describing inconsistency between companies’ climate performance and weights in investors’ portfolios as “remov[ing] any credibility from the engagement actions that investors conduct with these same companies”.

Another finding pointed out in the study paper is that climate strategies “underweight essential sectors such as electricity in a drastic way, by up to 91%”.

“While this allows good portfolio green scores to be displayed, it will be less easy to greenify the economy by doing away with electricity,” the authors wrote.

Don’t mix

According to the study, all popular climate-aligned indices and funds are exposed to the portfolio greenwashing risk they identified, “and unfortunately the recent EU regulation on Paris-Aligned Benchmarks (PABs) does not protect against this risk”.

Speaking during a webinar, Goltz, who is associate researcher at EDHEC Business School and research director at Scientific Beta, said a constraint imposed by the PAB regulation was too broad to prevent the underweighting or even complete exclusion of sectors that are crucial for reducing fossil fuel consumption.

In their paper, Goltz and his co-authors recommended that institutional investors and their consultants pay attention to the risks they identified when conducting due diligence, but also said “we think it is time for collective consideration of the necessary paradigm shift in climate investing”.

“It is not possible to achieve a climate revolution by continuing to stick to traditional benchmarks,” they wrote.

“It is only by freeing climate investment from tracking error minimisation constraints and objectives that we can hope to have benchmarks that are consistent with climate alignment objectives.”

“Mixing financial objectives and climate objectives is not the right thing to do”

Noël Amenc, associate professor of finance at EDHEC and founding CEO of Scientific Beta

Regulators should draw up clear rules for the fight against portfolio greenwashing, they continued, and “avoid promoting green labels based on regulations that in no way protect investors against greenwashing risks, as is the case with the likes of the EU PAB regulation”.

A concrete suggestion on their part was for a threshold for qualifying “true green strategies”, and for this to be that at least 50% of the weight of constituents be determined by climate metrics. Where this criterion is not met, “the strategy should not be marketed as a genuine climate strategy”, they wrote.

Speaking during the webinar, Amenc, who is associate professor of finance at EDHEC and founding CEO of Scientific Beta, said he wanted to underline that the objective of the study was not to put the spotlight on a particular fund or index, but “to question the methodology”.

“Our idea is also not to say that investors or asset managers are willing to do the wrong things,” he added. “We strongly believe that investors are really honest with the climate question. We strongly believe that asset managers want to have an impact, but they are not using the proper methodology.

“Mixing financial objectives and climate objectives is not the right thing to do.”

The study in question was produced as part of the EDHEC-Scientific Beta research chair for “Advanced ESG and Climate Investing” research chair, which is co-financed by Scientific Beta.

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