Green window dressing

Jean-Baptiste Vaujour is a Professor of Practice at emlyon business school where he teaches about consulting and green finance. He is an energy economist and a registered expert at the EU Commission and for the World Energy Council. He has recently published a book on the decarbonisation of the economy.

 

I recently read a paper by Gianpaolo Parise and Mirco Rubin called Green Window Dressing in which they present evidence of optimising behaviour from investment managers. This is part of a wider trope of unintended consequences of the current ESG reporting framework. We will discuss a few of these in the present article.

Optimising timing

There is a fundamental issue with the ESG disclosure framework as it is currently defined in the SFDR (Sustainable Finance Disclosure Regulation). The frequency of reporting for the SFDR and EU taxonomy alignment is yearly. Fund ESG performances are reported quarterly to asset managers. On the other hand, the financial performance of portfolios is reported daily. This reporting frequency mismatch creates a situation in which financial incentives are not aligned with environmental incentives.

It also opens the door to optimisation behaviour that Parise and Rubin describe in detail. For example, they highlight anomalous purchase and sell operations around ESG reporting dates. They infer that portfolio managers optimise financial performance most of the time and that they reallocate assets prior to reporting to maximise the displayed environmental performance at the moment of reporting – thus providing a green snapshot to investors while maintaining a return-driven allocation strategy the rest of the time. Once the reporting phase is over, they proceed to sell the ESG assets to refocus on performance.

This kind of behaviour leads to pricing anomalies on markets and misleads investors and asset managers. It remains extremely difficult to prove on a case-by-case basis as investors and asset managers do not have access to daily portfolio compositions. It also highlights one of the key issues with environmental regulation: people will try to game the system.

Disposing of brown assets

Another issue that is pregnant with the EU taxonomy and the whole ESG reporting framework is the incentive it provides to companies to dispose of their dirty assets. A company that wants to increase its ESG standing and reduce its environmental risk has two options. Either it invests massively to decarbonise its polluting assets, which is a risky long-term endeavour that may or may not prove profitable, or it can simply sell them to someone who is willing to purchase them. This second option provides an immediate return (albeit arguably diminished) and disposes of the issue.

The problem is that this easy way out raises the question of the identity of the company that is willing to purchase these assets and of its strategic intentions. Sometimes, this may be the result of a deliberate policy to create a “dirty” company whose sole purpose will be take on the transition risk and to decarbonise the portfolio without spreading this risk to other “green” assets. This is for example the rationale behind the Uniper carve out from German energy giant E.On. Uniper kept all the coal-related assets while E.On focused on renewables and networks. Both companies have distinct risk profiles and trajectories. In this example, the split of the assets made sense, both from a financial and an environmental standpoint.

The issue becomes murkier when for example oil and gas companies are selling their polluting offshore assets to anonymous consortiums whose intents and purposes remain unknown. It becomes a way for them to transfer the responsibility of the pollution to actors that are subject to less stringent environmental regulations and that are less concerned with activist pressures. These assets then escape the perimeter covered by environmental regulations and instead of being decarbonised, they still contribute to global pollution.

What is the way forward?

A key trope in these examples is that there is a synchronicity issue with regulations. Synchronicity between markets and reporting obligations, synchronicity between regulations in different jurisdictions. Climate change and other environmental challenges are global, systemic issues and what we are facing is the consequence of our inability to come up with a global, standardised response. As long as coordination issues remain, there will be friction at the interface and people will try and exploit them.