Now worth more than $10trn, the success of the US sustainable fund market is a testament to the growing realisation that factoring environmental, social or governance (ESG) considerations into financial decision-making is a sensible way to protect investments from social controversies or environmental breakdown. Given that limiting exposure to fossil fuel assets is a focus of ESG investing, you would be forgiven for assuming that most if not all ESG funds are fossil fuel-free.

However, the opposite is true. A total of 82.8% of sustainable funds contain at least some exposure to companies producing fossil fuels, reveals an Energy Monitor analysis of more than 300 US equity mutual funds and exchange-traded funds (ETFs) classed as having a “sustainable mandate” by data provider Morningstar. This is roughly the same proportion as in a sample of 2,600 non-sustainable funds (83.6%). All this data comes from investment non-profit As You Sow’s Fossil Free Funds platform, which in turn takes its sample of individual US funds and their respective fossil fuel exposures from Morningstar.

ESG funds' fossil fuel assets include the 200 largest owners of publicly traded coal, oil and gas reserves globally, ranked by the potential carbon emissions of these reserves, as well as companies designated by Morningstar’s industry classifications as thermal coal; coking coal; oil and gas drilling, production and extraction; oil and gas equipment and services; and oil and gas refining and marketing. In addition, assets include companies flagged by German non-profit Urgewald in its coal, and oil and gas “exit lists”, which are large public databases with information on the expansion plans of the world's largest fossil fuel companies.

Energy Monitor’s analysis reveals that, across As You Sow’s sample of nearly 3,000 funds, more than two-thirds of the 300-plus sustainable funds (69.7%) are exposed to oil and gas while just over a quarter (26.3%) are exposed to the 30 largest public-company owners of coal-fired power plants in developed markets, plus China and India. Compared with ‘regular’ funds, however, on average, individual ESG funds displayed a lower exposure to these fossil fuel assets as a percentage of total fund holdings.

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For example, ESG funds are on average 5% exposed to fossil fuel assets compared with 10% for their non-ESG counterparts. Fewer than 0.5% of sustainable funds are exposed to the world’s largest public producers of coal-fired power, compared with just under 1% of regular funds.

Over the past two years, a mismatch in expectations around what should constitute a ‘sustainable fund’ has resulted in a number of complications, ranging from investor confusion and frustration, to the more serious issue of greenwashing litigation.

While, as in the above data, funds can be broadly categorised by Morningstar or other data providers as either ESG or not ESG, in practice, that does not necessarily reflect the reality of sustainable investing.

ESG funds in fossil fuels: higher carbon means higher potential emissions reductions

“Of course, the word ‘sustainable’ is far too much of a binary definition to account for the myriad of different intentions within companies and investors,” Emily Pierce, associate general counsel and vice-president of global regulatory climate disclosure at Persefoni, a climate data disclosure and management company, tells Energy Monitor.

Analysis of the top ten sustainable funds in As You Sow’s database with the highest exposure to fossil fuels highlights this diversity of intention. At the top of the list is First Trust EIP Carbon Impact ETF with more than two-thirds of fossil fuel-exposed assets but this is intentional. Its strategy is to invest at least 80% of its net assets in companies “having or seeking to have a positive carbon impact” across sectors including utilities, natural gas pipelines and renewable energy. The fund aims to promote investment in companies that either “currently” or “have plans to” reduce their carbon emissions.

Some experts argue that investment in carbon-intensive companies with plans to transition is in fact more important than excluding them altogether. “All the heavy polluters need to either change their business model or go out of business, but you are not achieving that by opening a portfolio that consists of tech stocks and financials,” Tom Steffen, a researcher at sustainable investment management company Osmosis, told Energy Monitor last November.

Another reason a sustainable fund may have a high exposure to fossil fuel assets is that some of the world’s largest owners of fossil fuel assets are large, diversified companies that are also developing renewable energy assets.

Goldman Sachs’ Clean Energy Income Fund, for example, has the highest exposure in cash terms – $900m – to fossil fuels of all the sustainable funds in As You Sow’s database, in part due to exposure to companies like German energy giant RWE, in which it has a $7.5m stake. RWE is one of the world’s largest providers of renewable energy, while continuing to engage in coal mining activities.

The Goldman Sachs fund also has a $23.2m stake in US energy company NextEra Energy, whose activities, according to the company, include “transforming older, less-efficient fossil plants into state-of-the-art natural gas facilities”, while also being “the world’s largest producer of wind and solar energy”.

There is no simple answer to the question of whether fossil fuel companies that have plans to decarbonise, either through setting emission reduction targets, diversifying into renewables – or even to natural gas – count as ‘sustainable’ in a US context.

SEC rules could bring investors much-needed clarity

The most pressing issue for the US Securities and Exchange Commission (SEC) is that investors are not misled by a sustainable or ESG fund label into thinking they are investing in something that they are not.

Aside from the label itself, the lack of existing regulation around fund disclosures in the US means that existing disclosures are often not detailed, or consistent, enough to provide this sort of clarity.

In its assessment of the sustainability credentials of the First Trust EIP Carbon Impact ETF, Morningstar warns that while the fund’s prospectus states that it “aims to avoid, or limit its exposure to, companies associated with thermal coal”, the fund “struggles to fulfill this goal, as it exhibits 31.18% exposure to such companies”.

In May 2022, the SEC proposed an “enhanced” disclosure regime for companies and investors touting sustainable credentials, with the aim of protecting investors from greenwashing accusations, allowing them to “drill down to see what’s under the hood of these strategies”. The SEC’s proposal, which is still under review, will require funds and advisers to provide more specific disclosures in their fund prospectuses, annual reports and adviser brochures based on the ESG strategies they pursue, where funds following a sustainable strategy will disclose according to one of three categories: ESG “Integration Funds”, which integrate ESG factors alongside non-ESG factors in investment decisions, “ESG-Focused”, where ESG factors are a significant consideration, or ESG “Impact Funds”, which seek to achieve a particular ESG impact and therefore are required to disclose exactly how they measure progress on this objective.

There will also be a separate rule around fund labels, which will require funds to have at least 80% of their assets matching the characteristics described in their name. This will apply not just to ESG-related terms but financial fund descriptors too, like “growth” or “value” funds.

Investors and asset owners broadly welcome these forthcoming disclosure rules, although many have also expressed concern with the categories. In a consultation response to the SEC’s rules published in August 2022 by the Principles for Responsible Investment, for example, investors expressed concern that the ESG Integration Fund category “could potentially increase greenwashing, by allowing funds with limited ESG considerations to disclose minimal information to the Commission, yet market their fund, appropriately, as an ‘ESG Integration Fund’”.

The SEC’s three proposed categories can be loosely mapped onto existing categories for funds domiciled in the EU under the Sustainable Finance Disclosure Regulation (SFDR), or proposed rules in the UK under Sustainability Disclosure Requirements (SDR). However, while many wish to draw comparisons to existing EU rules, Pierce notes that there is an “important distinction” to be made between US and EU markets. Namely, “The EU has a taxonomy, which leads to a clearer definition of what ‘sustainable’ means – you have to meet certain criteria,” she says.

In the EU, “SFDR is perceived as more of a labelling regime,” Pierce says, while in the US, “the fund or advisor will have a greater role in defining how they think about sustainability and disclosing that”. She sums up: “[In the US] it is really up to the market, the funds and investors to define sustainability – how they are thinking about it and how they want to define different types of investments.”

Given the market-neutral approach taken by the US, the SEC rules are less likely to be caught up in the ongoing backlash against ESG investing spreading throughout the country. “Quite frankly, the disclosure rules are as valuable to an anti-ESG investor as they are to an ESG investor,” says Pierce. “If you are truly anti-ESG, you need information as well to make your decisions.”