Companies’ ESG performance is increasingly influencing investment decisions. Yet, poor data disclosure indicates several fundamental problems with the transparency and reliability of ESG funds. To address greenwashing issues, mushrooming start-ups are creating platforms to organise massive amounts of raw ESG data, increasing businesses’ transparency and accountability.
The rising demand for ESG data
ESG investing is becoming a popular trend in finance, as investors have increasingly shown interest in protecting their financial commitments from global warming and global justice related risks. Indeed, the acronym ‘ESG’ refers to (E)nvironmental, (S)ocial and Corporate (G)overnance, indicating to market participants, stakeholders and regulators how a company performs in terms of environmental practices, social impacts and governance factors of decision-making.
ESG reports help attenuate investment risks. As McKinsey notes: “As evidence mounts that the financial performance of companies corresponds to how well they contend with environmental, social, governance (ESG), and other non-financial matters, more investors are seeking to determine whether executives are running their businesses with such issues in mind”. ESG scores and risk ratings, built against ESG data, thus indicate to investors which investments may yield the greatest financial returns. Moreover, investors will be able to avoid companies that are involved with ESG controversies, which can have long-term effects on the valuation of a company.
Therefore, data disclosure is a precondition to meet stakeholders’ expectations, who want to properly inform their decisions.
ESG data: lack of transparency and reliability
However, ESG data disclosure practices present numerous defaults regarding transparency and data reliability, making the integration of ESG factors into investment decisions a challenge. First, ESG ratings are based on non-standardised data reporting: companies publish immense amounts of specialised data through either annual reports, sustainability reports or their own websites. Chitra S De Silva Lokuwaduge and Keshara De Silva, from Victoria University and the University of Melbourne, argue that the inconsistency of reporting creates the “opportunity for potentially misleading disclosures” aimed at exaggerating and misrepresenting green credentials. Not only may information be outdated, but also ‘cherry picked’ by the firm to raise its attractiveness to investors. Second, if companies do not publish ESG reports, ESG rating providers may also rely on third-party sources to construct the scores. These “estimates” may easily be far from precise or correct.
These conditions create the potential for Greenwashing: when businesses represent themselves as sustainable by providing false or misleading information.
Greenwashing
Greenwashing is a pervasive problem for ESG investing. First, it leads investors to focus on funds that do not take the meaningful actions they claim to take. Second, greenwashing increases investment risks, as investors’ decisions are not based on truthful information. According to Schroders Institutional Investor’s study, 59% of investors “cite greenwashing as the major challenge to sustainable investing”.
A most recent example is the fast fashion company Boohoo. The company had already been subject to an investigation by the Sunday Times in 2019, which claimed that factory workers were paid below the minimum working wage - as low as £3.50 or $4.37 per hour. Then, in September 2022, Boohoo faced claims for misleading customers into believing they are environmentally friendly.
The public argues that Boohoo’s collaboration with Kourtney Kardashian as the new ‘sustainability ambassador’ is just an attempt to distract from the unethical practices involved in the fast-fashion industry. Moreover, the ‘sustainable’ pieces make up a very small fraction of all Boohoo’s collections, making the collaboration a branding strategy.
How is FinTech mitigating the issue?
Transparency and greenwashing issues, triggering scepticism among investors, are likely to cause a decrease in money flows and slower economic returns for ESG funds. To alleviate the problem, ESG rating agencies and investors should track and store raw ESG data provided by the firms, and allocate resources into reviewing and analysing its reliability. Moreover, organisations should manage data more effectively to avoid unintentional greenwashing within their supply chains.
Over the past years, the internet has seen an increasing number of sustainability reporting start-ups. Worldfavor is one of them.
Worldfavor, a sustainability management and reporting platform, aims to make ESG monitoring easy and transparent. For example, Venture Capital investors can invite portfolio companies to report ESG data in Worldfavor for free, so that they can easily track all sustainability developments and make informed decisions. Through automated analysis and data aggregation, Worldfavor creates neat dashboards that give actionable insights, thus benefiting investors that need to do sustainability due diligence.
The platform also helps companies to prevent unintended greenwashing. Filtering and breaking down data, Wordfavor allows one to track ESG progresses in a user-friendly way. Additionally, the platform automatically compares companies’ activities with standardised industry benchmarks or regulatory standards, such as The Sustainable Finance Disclosure Regulation (SFDR).
Start-ups such as Wordfavor do not solve the issue of greenwashing. However, they allow organisations to back their sustainability claims with clear insights or Venture Capital to track the performance of their portfolio companies. Preventing that lack of transparency disincentives ESG investing and reducing unintended greenwashing, FinTech is taking important steps in mitigating greenwashing's negative effects.
Opinion: ESG as ethical finance or secure finance?
Some argue that ESG aims to increase secure investing, rather than ethical finance. A major proponent of this argument is Tariq Fancy, an ex-chief investment officer for sustainable investing at BlackRock, who is now a chief green investing whistleblower. He claims, “if you’re looking to climate change, that’s not where you should be spending your time. Protecting a portfolio from climate change risks is not the same thing as stopping climate change in the first place”.
In a few words, ESG ratings point to the E, S and G risks that may negatively influence assets. They are important from a financial strategy perspective, but should not be conflated with stopping climate change. For example, most ESG ratings do not account for scope 3 emissions - those that the company is indirectly responsible for. This is part of the reason why many oil and gas companies can receive high ESG scores.
If investors want to contribute to social and environmental improvements, investing in ‘sustainable’ funds will not be enough. Capital should rather be channelled in companies that actively battle to mitigate global climate and address global injustice concerns.