Life cycle assessment of investment funds

While sustainable finance is a subject of current regulatory developments worldwide, there is yet no commonly agreed upon standard for measuring the sustainability performance of investment products. The aim of this thesis is to adapt best practice scientific methods for sustainability assessment stemming from the industrial ecology field, namely input-output life cycle assessment (IOLCA) for the quantification of the environmental and social impacts associated with equity investment funds, contributing thus to mitigating greenwashing risk and supporting policy makers and financial market participants. A model based on IOLCA is developed to estimate impacts for companies and investment funds in a robust way. In essence, country-sector life-cycle-based monetary impact factors are derived using IOLCA and then attributed to companies and investment funds, using revenue, and holding information to proportionally attribute impacts. To prove the usability of the model and resulted estimates, it is applied in a suite of case studies.
In a first case study, the carbon footprints of a sample of 670 Europe-domiciled self-labelled socially responsible investment (SRI) funds are estimated and compared to the carbon footprints of an equivalent sample of funds without an SRI-themed investment mandate. We find that SRI funds are not consistently less carbon intensive than conventional funds and many SRI funds still hold investments in carbon intensive companies. In a following case study, we linked mandatory and voluntary indicators from the EU Sustainable Finance Disclosure Regulation (SFDR) with life-cycle-based indicators that are ready to use and can be adapted to estimate impact at investment fund level. We estimated 13 environmental and 13 social indicators for a sample of 230 SFDR self labelled funds, listed on the Luxembourg Green Exchange (LGX). These sampled funds are exposed to significant direct and indirect impacts that have not been previously assessed at investment fund level, such as water stress and human toxicity, or social impacts, such as exposure to child labor in the supply chains of invested companies. Finally, in a last study the novel dataset of IOLCA-estimated company-level impacts are used to construct independent variables representing sustainability characteristics of stocks, in order to study a debated research question in the asset pricing literature: “Are sustainability characteristics of companies positively correlated with their stock market returns?” A cross-sectional regression is run for the time period from 2012 to 2021, for over 25,000 unique companies.
This research has implications for financial institutions and policy makers alike. Estimating impact by means of IOLCA uncovers the large indirect exposure that funds have via their holdings and their respective supply chains. These impacts could not be measured using company proprietary data, given the lack of capability to retrieve, assess and verify supplier data. As a methodological contribution, this thesis helps towards the systematization of sustainability assessment of equity investment funds by providing a science-based method to estimate impacts on a wide array of life-cycle-based indicators. Through case studies we show that the identification of best investment alternative from a sustainability point of view is not straightforward. Depending on the scope considered (direct or life cycle), the metric (weighted average intensity or relative footprint) and impact categories (environmental, such as GHG emissions, water stress, and/or social, such as vulnerable employment), the ranking of funds varies.
As implication for portfolio allocation strategies, investors should be cautious in choosing funds that reduce their carbon footprint by tilting their portfolios towards companies from industries that are by-default low carbon, without having a direct contribution to decarbonization. Moreover, the indirect carbon footprint may reveal large exposures to high-intensive industries that are overlooked when only assessing direct exposure. This indirect carbon exposure poses additional risks for investors, as in the future supply chain responsibility may be mandated. Additional caution should be taken when assessing
funds that finance the low-carbon transition. Some funds may hold investments in companies that are highly carbon intensive, but that are nonetheless key for the low carbon transition, such as manufacturing of parts for installation of low-carbon electricity.