Navigating environmental, social and governance (ESG) considerations can be challenging for investors. Over the years, the need to incorporate these considerations into investment decisions has accelerated, driven by changing stakeholder expectations and regulatory influence. With ESG quickly gaining traction in the private markets, there is often a misunderstanding of topics, which can result in miscommunication, mismanaging sustainability initiatives, and accusations of greenwashing.
Investing Philosophies and Greenwashing
Private market investors adopt different approaches to incorporating ESG considerations into investment decisions. According to PitchBook analyst note, a firm’s understanding of greenwashing is often dependent on its philosophy on ESG and sustainability, which can vary from one individual to another. The report explored three sustainable investing philosophies held by investors:
- ESG Purists tend to steer clear of sectors like oil and gas, opting instead for companies in the classic “green” space—think alternative energy, sustainable agriculture, and more. If they do consider other sectors, those companies need to excel in each category of E, S, and G.
- ESG Pragmatists would likely invest in industries such as food production, manufacturing, or retail, which neither harm nor contribute to a more sustainable economy. However, they understand the exposure to certain risks in their investment.
- ESG Pluralists are likely to be risk-takers, willing to take a chance with companies with unmanageable ESG risks, or as the report puts it, “unmanaged manageable risk.”
Based on these investing philosophies, investors will have different interpretations of what constitutes greenwashing:
- ESG purists would label it greenwashing when any firm claiming to practice ESG invests in socially or environmentally harmful industries or in companies that don’t contribute to sustainability. However, accepting this claim as an absolute truth for penalty is unrealistic, given the nature of the world’s financial structure.
- Both ESG pragmatists and ESG pluralists share a common view on greenwashing: it occurs when managers claim to practice ESG but fail to mitigate a company’s manageable ESG risks.
While the threshold differs for these philosophies, misrepresenting outcomes and practices is the underlying similarity contributing to greenwashing. With sustainability practices coming under increasing scrutiny and stakeholders — including investors, consumers, and regulatory bodies — concerned about the accuracy of corporate sustainability information, it is prudent for investors to take steps to avoid greenwashing.
Mitigating Risks of Greenwashing
Regardless of a firm’s investing philosophy, mitigating the risk of greenwashing begins with building a strong foundation. As the Pitchbook report highlights, it is important for firms to have policies in place outlining what ESG means, with materiality defined and the steps taken to achieve established sustainability goals. These policies act as a guide in the investment process, help to allocate strategies, and lead to a shared understanding of how to set communications around sustainability practices within and outside the organization.
Another effective strategy in avoiding greenwashing is to adopt a clear and distinct product approach, which transparently communicates the investment strategy and outlook. Take, for instance, a portfolio that uses a negative screening approach. This approach involves the exclusion of certain companies or sectors based on predefined criteria. In reporting, disclosures, and marketing materials for this portfolio, it is crucial to explicitly outline these exclusion criteria upfront and align them with specific goals. For example, if the aim is to combat climate change, excluding all fossil fuel companies from the portfolio becomes paramount. By being upfront and transparent about these decisions, investors are empowered to make informed choices, ensuring authenticity and accountability in their reporting and communications.
Finally, high-quality data and a reliable ESG management system to track data and performance can also help managers prevent the risks of greenwashing accusations. Such systems can help track portfolio companies’ ESG data to provide comprehensive insight into the performance of these investments. These insights can help create projections to set long-term goals and ambitious yet realistic expectations based on previous performance.
Transparency is key in ESG and sustainable investing, and it is up to managers to be accurate in their sustainability claims to better inform the decision-making of their stakeholders.
In the intricate world of ESG complexities, Novata is committed to making ESG uncomplicated for the private markets. Learn more about how Novata can help you simplify ESG data management and streamline your sustainability journey.
