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Hedge funds game the system to cash in on net zero targets

·6 min read
green pound coin net zero hedge funds ethical investing esg
green pound coin net zero hedge funds ethical investing esg

Boris Johnson took umbrage with Kermit the Frog as he addressed world leaders at the United National in September: “It is easy being green.”

Whether Prime Minister or puppet is correct may be a question of approach. As socially conscious investing surges, dodgy metrics and dirty tricks abound.

Consultancy PwC says the expansion of investing on environmental, social and corporate governance (ESG) principles makes 2022 the “growth opportunity of the century”, labelling it a potentially epoch-defining moment “not only for Europe’s asset-management industry, but in Europe as a whole”.

It predicts ESG will account for more than half Europe’s funds under management by 2025, reflecting a “staggering” compound growth rate of 28.8pc.

“What was probably going to be a relatively slow, long-term transition in the capital markets has suddenly become the immediate term, and it has exploded,” says Luke Sussams at Jefferies, the investment bank.

Recently, “net zero”, which is linked to but distinct from ESG, has become the defining buzzword. Mark Carney, the former Bank of England governor, announced last month that he had formed a $130 trillion “alliance” of companies investing for carbon neutrality.

Being able to label a fund as net zero is a marketing coup for fund managers, and has prompted some to try some classic financial engineering.

One of the most egregious ways to go net zero is to “short” high emitters, a technique that Barclays analyst Charlotte Edwards says several hedge funds have employed.

In this process, a fund manager places a bet against a big polluter, such as an an oil and gas giant, and then counts their emissions as offsetting the rest of a portfolio. Such positioning can have an outsized impact because a small, targeted short against one company can offset the emissions of hundreds of others.

“Theoretically, by shorting a few high-emitting companies an investor could make a dramatic reduction in portfolio emissions, or even make it to net zero, but there would be little to no impact in the real world,” says Edwards.

'No standardisation'

With the sector rapidly developing and growing demand for ethical investment options, both the sector as well as regulators are struggling to keep up.

Many fund managers rely on data services such as Morningstar’s Sustainalytics platform, but City insiders say these too often provide data that covers the past and present, but not the future.

The limited data that is available can also be pretty questionable. Simultaneous attempts to develop labelling by companies have created a standards Wild West, in which the connection between a good ratings and actual ESG performance can be tenuous.

For instance, some ratings services offer intra-sector ratings, creating the possibility a company could be green-lit for green investment simply because it is the best of a bad bunch.

“This is just the inherent problem with ESG,” says Sussams. “What is considered good and what is considered bad has always depended on who you asked. There is no universality, there is no standardisation.”

So-called green bonds suffer a similar problem. “Current labels for green bonds do not necessarily signal that issuers have a lower or decreasing carbon intensity,” said a report by analysts at the Bank for International Settlements released last year.

Sometimes, funds do not even need to adjust to claim green credentials.

“The badges don't reflect what's in the product at all, when you look under the bonnet,” says Gina Miller, the investment manager who rose to fame for the legal challenges she brought against the Government during the Brexit process.

With her husband and business partner Alan, she is calling for the Financial Conduct Authority to take urgent action to clamp down on funds that falsely bill themselves as ESG or socially responsible.

“It's a bit like being able to park your car on a double-yellow line and know you'll never get a ticket,” says Alan Miller.

Mislabelled funds

They save special frustration for Legal & General’s “ESG China CNY Bond ETF”, an exchange-traded fund that bills itself as ESG despite being nearly entirely invested in Chinese government bonds.

China is the world’s biggest polluter and has been accused of crimes against humanity by human rights group Amnesty for its treatment of the Uyghur population in Xinjiang.

But other examples are almost as egregious. The Millers point to Vanguard’s SRI European Fund, which says it “promotes environmental and social characteristics by excluding companies from its portfolio based on the impact of their conduct or products on society and/or the environment”.

But its holdings, which include four gambling stocks, nine oil and gas stocks, and the company that supplied cladding for Grenfell Tower, are nearly identical to another Vanguard fund, the FTSE Developed Europe ETF, which does not make the same ethical claims.

Gina Miller says fund managers are preying on “naive” customers who want their money to go to ethical companies but lack financial expertise.

“They're not just taking advantage of the trend, they're taking advantage of new investors,” she says. “They need to make some examples, I think, because that will encourage other companies to behave better.”

Regulators, for their part, know they face a big task. Financial Conduct Authority ESG director Sacha Sadan, formerly of L&G, told the Inside FCA podcast earlier this year that labelling problems are “one of those things that happens when an industry grows very quickly”.

“I think it’s really important we start putting these sort of labels and protections in place as early as possible,” he added.

Nikhil Rathi, the regulator’s chief executive, told the Cop26 climate conference that the FCA aims to put ESG considerations in “everything we do”.

This pressure could prove counterproductive, warns Sussams, who says funds need to be able to decide whether they want to go net zero now, or to invest in the companies including miners and energy companies that will be crucial for a net-zero future. Doing so can make for tough conversations with investors.

“The level of intervention and scrutiny from financial regulators on to [asset managers] is so intense that it's actually starting to impact their stock selection,” he says, adding: “Ultimately, if all asset managers just hold pure-play renewables names, you don't get to net zero.”

Mandeep Jagpal, an analyst at Royal Bank of Canada, concurs that managers face a “difficult, difficult balancing act” as they weigh up which approach to take.

““The transition in ESG investing going forward is likely to evolve hugely from its current state, becoming more sophisticated,” he says. “The journey is not done yet.”