Environmental, Social and Governance (ESG) investing has become a pillar of modern capital allocation. Yet behind the glossy reports and sustainability claims, a growing number of sophisticated investors are exploiting regulatory mismatches across jurisdictions to gain a marketing edge. Welcome to the world of ESG arbitrage!

 

This is a largely under-the-radar strategy, where asset managers and issuers navigate to the most lenient rulebook that still allows them to call themselves “green”. While not illegal, many question whether it is ethical, but one thing is sure, it’s increasingly problematic.

 

A patchwork of ESG rulebooks

 

The ESG landscape remains highly fragmented and will take some time to come together. In the EU, fund managers must comply with the Sustainable Finance Disclosure Regulation (SFDR). This means categorising funds under strict Article 6, 8, or 9 labels, with detailed disclosures on sustainability risks and principal adverse impacts.

 

Meanwhile, the US still operates without a formal ESG labelling regime, relying more on voluntary disclosures and SEC guidance. However, there is a growing focus on anti-greenwashing enforcement rather than structural compliance.

 

Asia, by contrast, is even more varied - Hong Kong, Singapore, and Japan have begun implementing their own ESG frameworks. However, disclosure depth and verification standards still trail the EU's more rigorous approach. That leaves room for issuers and fund platforms to market ESG products under looser definitions, depending on where they domicile the fund or issue the securities.

 

How ESG arbitrage works

 

Here’s how the strategy plays out:

 

· A fund structured in a lenient jurisdiction (e.g., Cayman, Luxembourg, or Hong Kong) uses a loose ESG screen or labels a strategy as "climate-aligned" without binding investment criteria.

· It is then distributed into stricter ESG-conscious markets - such as the EU under SFDR, or the UK, which is rolling out its Sustainable Disclosure Requirements (SDR) - where retail or institutional investors may assume compliance based on branding alone.

· These funds attract inflows from ESG-mandated portfolios, even though their underlying assets may fail stricter sustainability filters.

 

The result is superficially “green” portfolios that fall short on substance, instead, riding the regulatory gap to scale AUM and boost performance via broader investable markets.

 

Risk on the horizon: Harmonisation and enforcement

 

However, this regulatory shopping spree has a shelf life with regulators now more aware of the strategy. The International Sustainability Standards Board (ISSB) is gaining traction, and global frameworks like the Task Force on Climate-related Financial Disclosures (TCFD) and TNFD (for nature-related risk) are pushing toward harmonisation.

 

The European Securities and Markets Authority (ESMA) is already cracking down on misleading ESG claims, and the US SEC has proposed climate disclosure rules and increased enforcement activity. Asia is not far behind, with Hong Kong's SFC now requiring fund-level ESG disclosures, and we also have Singapore regulators tightening sustainable fund criteria.

 

As a consequence, investors relying on ESG arbitrage today may find themselves on the wrong side of tomorrow’s rulebook. Looking at this from a business angle, the reputational damage from greenwashing accusations can be swift and severe, particularly in a post-2023 environment where ESG scrutiny is more intense than ever.

 

Conclusion: Greenwashing as a strategic liability

 

ESG arbitrage may offer a short-term capital advantage but it carries long-term brand, legal, and compliance risks. The key takeaway for professional investors and allocators is clear - don't just read the label, interrogate the framework.

 

As global standards converge, funds built on loose definitions may face forced reclassification, outflows, or regulatory intervention. The window to arbitrage the ESG system is closing, and for forward-thinking capital, authenticity and alignment will soon outweigh ambiguity and arbitrage.

Back to News