‘Dark Green’ indices could have an impact on sustainability but broad environmental, social, and governance indices, which dominate ESG investing do not meaningfully facilitate sustainability, according to new academic research.
Jan Fichtner at Deutsche Bundesbank, and Robin Jaspert and Johannes Petry at the Institute for Political Science, Goethe University Frankfurt, said in a report that there is an ESG capital allocation gap. They wrote: “This has important implications, because effective transmission mechanisms are crucial for ESG funds to achieve sustainability impact in the real economy.”
Their research paper, ‘Mind the ESG capital allocation gap: The role of index providers, standard-setting, and “green” indices for the creation of sustainability impact’ was published in the journal Research & Governance (2023). Governance through ESG is characterized by three potential transmission mechanisms- ratings, shareholder engagement, and capital allocation according to the paper. These mechanisms can either create sustainability impact or constitute “ESG gaps” if they are ineffective or unutilised. The research analysed the standard-setting role of index providers, due to the lack of public regulation which precisely defines ESG, although regulatory frameworks are emerging.
“In our research, we identify the pivotal role of a highly concentrated group of index providers, such as MSCI, and their ESG indices in setting the standards of what is generally accepted as “sustainable” investing and for steering investment toward more (or less) sustainable capital allocation,” said the paper.
The researchers compiled a dataset of existing ESG funds by extracting the data of all investment funds that were classified as ESG in the Bloomberg Terminal. The dataset consisted of 1,110 ESG funds with total assets under management of $793.21bn as of 10 February 2022. They analysed the largest 250 funds in detail, which also made up 84.3% of the total assets in the sample.
They found that active managers hardly deviate from their non-ESG benchmarks as the weighted average tracking error between active ESG funds and their non ESG benchmarks was just 4.88%.
“Overall, our data suggest that asset managers on their own are unlikely to impact ESG capital allocation directly and meaningfully” said the paper. “Their activities will thus probably not translate into effective sustainability impact. Instead, they are to a large extent relying on ESG indices for their investment decisions.”
In addition, they argued that only funds that replicate/follow Dark Green indices can be considered as (mostly) holding genuinely sustainable assets in their portfolio. The paper said: “Dark Green indices could therefore potentially mitigate the ESG capital allocation gap and create substantial sustainability impact (output ESG).”
Dark Green indices are defined as those geared to facilitate the transition toward a low carbon economy and are designed to exceed the minimum requirements of the EU Climate Transition Benchmark or EU Paris Aligned Benchmark.
“However, contemporary ESG investing is heavily skewed toward Broad ESG indices (88% of total AUM), with only three Dark Green funds in the 250 largest ESG funds of our dataset (4.9%),” said the paper. “Thus, while ESG indices could potentially have a sustainability impact, most currently do not fully facilitate sustainability—we call this the ESG capital allocation gap.”
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