The Rise of Sustainable Investing: The Challenges of ESG and Green Bonds for an Investor

Sustainable finance has recently emerged as a key area of interest for modern investors and market participants.

The term sustainable finance more broadly encompasses environmental, social, and governance (ESG) investing, socially responsible investing, and impact investing. While many investors debate whether the trend is sustainable and if it ultimately provides the promised social return (positive externality), this article focuses on how an investor should assess investments through the lens of sustainability.

Acknowledging the Paris Climate Agreement goals, retail investor demand for sustainability in the investment process has steadily grown. To put things into perspective, more than $30 trillion is invested globally in sustainable investing assets, according to the Global Sustainable Investment Alliance. In Europe, large government investment initiatives, such as the Next Generation EU a result of the Green Deal, primarily focus on green investments. While investing is mainly driven by the goal of increasing wealth, the methods through which wealth is created by public companies have always been challenged by active investors. Ethical investing was a trend 20 years ago, but faced a similar problem we face today with ESG: what is ethical for person A may not be ethical for person B. This meant that a framework to categorize companies and their activities needed to be developed, and the EU pioneered this field with the EU Taxonomy. With many regulatory frameworks emerging over the years, investors have become accustomed to a new era of investing with ESG criteria, scores, and ratings, which provide crucial information for interested investors. The main aim of these regulatory requirements is to mandate more disclosure from both public and private entities, requiring them to report their practices and receive a scoring system that guides more funding toward businesses that are better aligned with sustainable goals.

All well and good then? Not exactly. Beyond the significant costs associated with all the reporting and compliance requirements, as mentioned in Mario Draghi’s recent report, the compliance burden is substantial and needs to be lightened. The problem lies in the false claims made by companies, a phenomenon known as greenwashing. Greenwashing refers to the practice of companies or investment funds misleading about their sustainability achievements. This usually occurs when market participants use deceptive claims, marketing, and communication strategies that promote a positive image of the company, while in reality, its environmental performance may be inferior, with the ulterior motive of capitalizing on fundraising opportunities. This usually occurs when market participants rush to capitalize on a new trend or opportunity to raise funds.

The responsibility then falls on to the investor to conduct enhanced due diligence on their investments, leading to an additional issue: complexity. Assessing the actual ESG impact of a company may require hours of research, report reading, and claim verification, making the process genuinely time-consuming. Furthermore, the differences in the approaches of rating agencies providing guidance is varied, as their methods vary. While classifying by defined categories of activities is the future, there are currently many inconsistencies in the markets, particularly in emerging markets where reporting is less mature. Despite these challenges, data from LSEG indicates that over the past five years, Green Bonds have gained traction.

Green bonds are investment instruments that fall under the category of fixed income. Their issuers are either governments or companies that issue debt aimed at financing investments that contribute to addressing climate and environmental issues. Here are some key figures to better illustrate the landscape:

• Europe is the Wall Street of the Green Bond Market.
• Since 2019, approximately $2.5 trillion USD of financing has been issued.
• Green bonds fund a wide range of projects, but Clean Transport, Energy Efficiency, and Climate Change Adaptation cover 80% of the amount mentioned.
• China, Germany, and France are the top three issuers, in that order.
• Of the amount raised, three categories of ESG bonds are included: Climate Bonds Initiative (CBI) Aligned, Self-Labeled, and CBI Certified. The differences are as follows: CBI Aligned bonds are structured to follow the standards for climate projects set by the CBI. Self-Labeled bonds are based on the issuer's own criteria without any third-party verification. CBI Certified is the only category that undergoes rigorous third-party verification to ensure it meets CBI standards. Only 5% of the issued bonds are CBI Certified, 15% are Self-Labeled, and 80% are CBI Aligned.

For issuers raising capital, green bonds have been a valuable source of funding. Furthermore, the appeal of raising capital via ESG-related sources reinforces the potential benefits to a company's brand and reputation for considering these factors.

For investors, a recent and insightful study by Desislava Vladimirova and Jieyan Fang-Klingler (Bonds with Benefits: Impact Investing in Corporate Debt, November ’23), which compares the performance of ESG investment funds, provides significant clarity. They argue that "credit investors seeking to construct portfolios based solely on green bonds or bonds issued by low-carbon/high-SDG (Sustainable Development Goals) companies should expect portfolio performance close to that of the benchmark." This means that investors can expect similar returns to those of the benchmark index, and the results also suggest that this may be relevant for equity investing.

In an effort to mitigate greenwashing risks, new regulations set to take effect throughout 2024 will place further requirements on funds marketing themselves as sustainable. These funds will be required to clearly disclose their environmental, social, and governance (ESG) credentials. Additionally, the new rules aim to ensure that any sustainability-related claims are fair, clear, and not misleading. Funds must provide evidence to support their sustainability claims, and failure to comply with these rules could result in the loss of their "sustainable" label. This new framework is designed to help investors make better-informed decisions by providing clearer criteria for evaluating sustainable financial products.

Practically, however, a fund will weigh the additional cost of providing this evidence against the benefits. If it loses its sustainable identity, how many investors will it lose? At the same time, if it cannot provide the required evidence, it will be forced to divest from investments that do not meet the stringent new requirements and proceed with liquidations. Attention is increasingly shifting toward allowing a sustainable identity only when it is directly linked to an investment or project, rather than the general revenues of a company, even if that company undertakes some ESG projects. This approach makes sense but could cause disruption.

The Global Investor Week 2024 focuses our attention on these issues, highlighting awareness of sustainable finance. As more sustainable financial products enter the market, it becomes increasingly important for investors to understand how to evaluate the sustainability of these options. This means not only understanding the fundamental principles of the new era of ESG investing but also knowing how to assess whether a specific investment product aligns with personal values and financial goals.

I encourage investors to enhance their knowledge and to ask their advisors about:

• Areas of research
• Relevant experience
• Ability to contribute to analysis.

Whether your focus is on ESG, sustainability, or an ethical approach, remember that when investing with others (financial advisors, wealth managers, intermediaries), it is important to have shared perspectives. Otherwise, your paths may diverge. With the right knowledge and understanding, investors can make more informed and proactive decisions, thus contributing to a more sustainable global economy, should they wish to do so.

*Alexandros Clappas CFA, Chair of Financial Literacy Committee, CFA Society Cyprus, Head of Investment Advice, One Plus Capital Ltd