Schleswig-Holstein is already going ahead with it, and Baden-Württemberg, Brandenburg, Hessen, and North Rhine-Westphalia are planning to follow suit. These German federal states are intending to introduce legislation that will require their own pension funds to invest only in sustainable businesses. In other words, they will only hold shares in companies that are climate-friendly and have high standards of social responsibility and corporate governance. The investments made by the federal states must be based on ESG criteria (environmental, social, governance). The ESG label is intended to guarantee that the companies in the investment portfolio do business sustainably, in other words, meet high standards in terms of the environment, climate action, human rights, health and safety, and leadership for their employees.
Investments in sustainable ESG funds are rapidly increasing in importance. According to the Sustainable Investment Forum (FNG), they hit a new record high in 2021. The total amount invested in funds of this kind in Germany reached 501.4 billion euros and the sector’s share in the overall investment market grew from three to 9.4 percent. Public funds in particular saw considerable growth and even overtook the special sustainable funds. These changes were driven primarily by private investors whose investment volume tripled to 131.2 billion euros.
Lack of ESG standards
The label “ESG” has become almost synonymous with the concept of sustainability. The term “ESG” was first used in 2006 when the United Nations launched its “Principles for Responsible Investment” initiative in collaboration with an international group of institutional investors, who voluntarily committed to incorporating environmental, social, and governance factors into their investment decisions. But the problem was that no standards were introduced, and not even minimum requirements were imposed. As a result, anyone can interpret ESG however they want. Deutsche Bank, for example, defines ESG rather vaguely as “a statement of ambition for the world as it should be when finance can be used to support the broad long-term objectives of society.”
Another problem is that issuers of ESG funds often take a best-in-class approach, which means that they automatically select the most sustainable companies. “Depending on the bandwidth of the selection, this can include businesses that have not completely given up using fossil fuels, that do not fully comply with labor law standards or that have corporate governance systems which leave much to be desired,” explains Nadine Bold, sustainability management expert at UmweltBank AG, who specializes in sustainable investments. “Many funds also apply tolerance limits, which means that they allow investments if a company’s involvement in the arms industry amounts to a maximum of ten percent of its business, for example.”
A team of reporters from the German television channel SWR has lifted the lid on practices of this kind. These involved the inclusion of companies such as TotalEnergies, Hensoldt, and Coca-Cola in a sustainable ETF (exchange traded fund) that tracks an index and bundles the shares of different businesses in the index. Rating agencies had confirmed the sustainability of the organizations referred to above.
Human rights organizations and environmental activists refer to this as greenwashing. In order to prevent it from happening, many investment funds apply exclusion criteria. This means avoiding incorporating specific industries or firms into their portfolios if the companies have committed breaches of human rights or international labor standards or are involved in bribery and corruption. According to the FNG, around 82 percent of the funds considered to be “sustainable” use exclusion criteria.
The dispute about the “taxonomy” on a European level has highlighted how much ESG criteria can vary. The EU uses the term taxonomy to describe a mandatory definition of sustainability that is aimed at boosting the climate-friendly financial markets, among other things. According to the EU, 180 billion euros need to be invested in “green” funds every year if the Paris climate targets are to be met. Currently the figure is much lower. The taxonomy is intended to be an important part of the Green Deal, which will help the EU to achieve its target of reducing its carbon footprint by 55 percent compared with 1990 levels by 2030. But here there is also a dispute underway about the formulation of the criteria.
In the current version of the taxonomy, investments in nuclear power and gas-fired power stations are considered to be sustainable. The German government has expressed its opposition to this definition over a long period and environmental organizations describe the EU taxonomy as greenwashing. Martin Kaiser, Executive Director of Greenpeace Germany, explains: “With this taxonomy, the EU is betraying its own self-imposed environmental and climate goals from the Green Deal.” He announced that his organization would be taking legal action in the European Court of Justice.
No reduction in returns
But how profitable are ESG investments? More than half of investors expect normal market returns from their sustainable investments, according to a market study carried out in 2020 by the “Federal Initiative for Impact Investing.” But a growing proportion are also hoping that the sustainability criteria will bring them above-average returns. Only 18 percent of the people who invest their money in this way would accept a reduction in yields in return for sustainability.
Lars Hornuf, Professor of Business Administration at the University of Bremen and specialist in financial services, warns that long-term ESG investments can lead to a drop in returns or an increase in risk, at least in the expected value. He refers to modern portfolio theory, which states that an efficient portfolio is as diversified as possible and therefore on the capital market line. Portfolios on the line offer the ideal combination of risk and return. “If you only want to optimize risks and returns over a long period, you should not invest in a portfolio below the capital market line,” says Hornuf. “As soon as you exclude too many arms manufacturers, cannabis producers, or whatever from your portfolio, you reduce the potential for diversification, and this has a negative impact on portfolio optimization.” To put it simply, investing only in selected segments is always associated with a higher risk.
Tax relief for ESG investments
On the other hand, the costs of ESG portfolios could begin to fall in the future. The Sustainable Finance Advisory Committee of the German government has proposed that earnings from investments in products “which are rated as sustainable in accordance with the Sustainable Finance Disclosure Regulation” should be exempt from tax up to a specific maximum amount. The expert committee, which has members from the real economy and the financial sector, including fund managers, hopes that this will increase the demand for sustainable financial market products. The best example in this respect is the Netherlands, where investments in sustainable funds already receive tax incentives.
Another consideration is the “E” for environment, which involves a political requirement to decarbonize the economy and bring about a green transition. From the perspective of profitability, it could make sense to invest in certain companies that offer financial benefits because of their particularly strict decarbonization strategy, which could include avoiding emissions and reducing the amount of carbon tax they have to pay.
In the case of the criteria for social (“S”) responsibility and good governance (“G”), investors may be hoping that companies with a strong sense of social responsibility will be able to plan more reliably for the future because they will be involved less often in labor disputes or may be less likely to become the target of boycotts by human rights organizations.
With regard to governance, the increased satisfaction of employees in companies with good governance should lead to less employee churn and, therefore, to greater expertise and a better working climate. These companies could also perform better than others in the long term.
Increasing disclosure for financial products
However, all of this is speculation and hardly compensates for the vagueness of the ESG concept. The Sustainable Investment Forum (FNG) is hoping for a self-regulatory effect to emerge in the future: “The financial sector will increasingly have to disclose the social and environmental footprint of its products,” says Dr. Helge Wulsdorf, member of the Executive Board of the FNG. However, it is important to consider which sustainable quality requirements need to be met by products that are intended to have an environmental or social impact in order to ensure that investors are not misled.
The German states are basing their choice of ESG products on the criteria formulated by the United Nations. In addition, they will exclude companies that have an involvement in nuclear power or fossil fuels. This conflicts with the EU taxonomy, which rates nuclear power and gas as being sustainable. Only one thing is certain: the debate about the ESG criteria is far from over.