Environmental funds A profile of green financial products

Truly sustainable and profitable? What investors should look for in environmental funds.

Green, organic, sustainable, ethical, environmental: these terms have now become mainstream and no longer only refer to products in the supermarket, but also in the financial market. No matter how positive they sound, for many investors, sustainable investing is a new type of challenge to keep track of and understand what such “green” financial products actually involve.

One of these products is the environmental fund. As its name suggests, environmental protection is promoted – literally. Sometimes providers just label their financial products with this designation without actually pursuing sustainable goals. As the term is not protected and does not require specific criteria to be met, it is too often used for greenwashed marketing purposes.

But with the right research, investors can actually find sustainable products and, on top of that, get promising potential returns, especially with regard to the growing collective awareness of factors such as environmental or climate protection.

But what are the specific advantages and disadvantages of environmental funds? What risks do you need to watch out for? And how sustainable are these funds really? This is where we get to the heart of green investments and give you an overview of the most important facts to support you in your investment decision.

Environmental funds are sustainable thematic funds which aim to combine environmental protection and returns in one product. In line with their focus, the selection of suitable investment projects and companies is based on environmentally sustainable criteria.    

Environmental funds often invest in renewable raw materials such as wood or water, green real estate, energy efficiency or companies that are particularly committed to ecology and the environment.

An important feature is the distinction between open-end and closed-end environmental funds:

• Open-end environmental funds are characterised by the fact that shares can be purchased and redeemed at any time, so they have an indefinite term. Here, the fund assets usually flow into company shares, bonds or a mix of both. An important principle is risk diversification, which is achieved through a portfolio that is as diversified as possible.
  
• Closed-end environmental funds only allow a limited investment period, as these are usually concrete projects, such as a specific solar plant. After a certain fixed amount has been invested, the investment is closed. In most cases, such funds work with higher minimum maturities, meaning that investors cannot access their money over a longer period of time than with open-end environmental funds. Although the focus on certain projects increases the potential returns for investors, the lack of diversification also means that the risk of losses is correspondingly higher.

Both closed-end and open-end environmental funds invest in environmental sustainability. This largely excludes economic and social sustainability aspects when selecting investment projects.

With a focus on the environment, environmental funds primarily focus on the reduction of carbon emissions and the production of renewable energy. With regard to the ESG criteria (environmental, social and governance) for sustainable financial products, environmental funds pay attention to criterion E.

With the focus on environmental sustainability, it is not a given that social and economic aspects categorically play a role. Nevertheless, it is important to be aware of what the different priorities mean.  

An example to illustrate the distinction: when researching, you come across an environmental fund that invests in equities with a focus on sustainability. You can therefore be sure that the companies represented in them have an eye on the environment and, for example, attach importance to sustainable electricity generation.

Nevertheless, the selection does not pay much attention to whether the companies included in the fund protect employees’ rights or are even involved in corruption transactions

In answering this question, a distinction must again be made between open-end and closed-end environmental funds: 

• The returns of open-end environmental funds are usually achieved by rising share prices or, in the case of corporate or government bonds, by fixed-interest securities.
  
• The returns on closed-end environmental funds are primarily generated by selling, for example, the energy generated, which is fed into the electricity grid. Furthermore, investment properties of closed environmental funds can also be rented, sold or leased, for example in the case of green real estate. Closed-end environmental funds also make profits with emission credits in the event of CO₂ reductions.

In order to be able to make a differentiated assessment of the advantages and disadvantages of environmental funds, it is important whether the fund is open-end or closed-end and which investment properties are included in the fund.

If, for example, a solar power plant is located in a developing or emerging country, other political or social factors must be taken into account than in a European country, for example.

Use this table to get an overview:

While the intentions of environmental investments are undoubtedly good and can have a positive impact on our society, our climate and our future, there are a few things that must be considered. For inexperienced investors in particular, such investments can entail certain risks: 

for closed-end environmental funds that do not diversify, but only invest in one or two projects, there is a significantly higher risk of total loss. Above all, with this product it must be noted that social and political influences can vary at different project locations and also affect the risks for investors. 

In addition, there are uncontrollable natural risks to which sustainable financial products are particularly exposed. Solar parks, waterworks or wind turbines rely on elementary resources for generating energy, which can suffer considerable damage in the event of floods, storms or droughts.  

In the past, projects of this type failed because, for example, all the solar parks were located in a single Spanish coastal region and the risk was therefore concentrated in one location.  

The steady increase in supposedly green financial products, which initially appears to be positive, also poses risks for potential investors. Some suppliers are taking advantage of greenwashing in order not to lose touch with the current trend towards sustainability.  

This is simply a marketing strategy that makes a product out to be as green as possible without really being able to prove a positive impact on the environment, society or the economy. This can quickly make it difficult for interested parties to pave the way through the supposedly green jungle of sustainable financial products. 

The lack of sustainability requirements of environmental funds in particular must also be mentioned in this context. Names such as green ETFs, sustainable funds or ESG equities are not regulated or protected and therefore do not have any specific criteria that need to be met for their use.  

To clarify, let’s take a look at the exclusion principle. This principle is used by funds to categorically exclude certain sectors such as the tobacco or weapons industry from their portfolio. This step is already sufficient to declare a provider’s own fund as sustainable. 

At the same time, however, it is possible that one of the companies in the fund portfolio consumes an enormous amount of resources and thus does not operate sustainably. Investors wanting to invest in an open-end environmental fund, for example, are therefore at risk of promoting non-sustainable companies with their units at the same time as sustainable projects.

First and foremost, the difference is the focus, which is set by the respective fund.  

Environmental funds focus primarily on the environmental factor. Corresponding further forms of sustainable funds can be identified based on the ESG criteria, which take environmental, social and economic sustainability aspects into account. 

Unlike environmental funds, social investments pay particular attention to social and societal sustainability, while environmental and economic aspects take a back seat. 

ESG investments, for example ESG funds, include all three criteria in roughly equal proportions in the design of their portfolio. 

Another category of sustainable funds are the impact funds. The focus here is on transparency and measurability, which are not regulated or controlled in almost any other sustainable investment product. Impact investments, on the other hand, define one or more qualitative goals, such as the reduction of CO₂ emissions, and make the means and ways to achieve these objectives identifiable and measurable.

 It is therefore not incorrect to refer to impact funds as a form of environmental fund – only that they go one step further in their claim and thus create a separate class.