ESG: Addressing greenwashing in financial services

In 2022, financial services firms expect increased scrutiny of ESG credentials from regulators, shareholders and customers, as well as other stakeholders. Firms should be proactive in mitigating the risk of allegations of misleading statements or greenwashing to avoid enforcement action and complaints, particularly regulatory investigation and censure, civil litigation and the negative financial impacts arising from reputational risk.

This article will explain what greenwashing is, how it can be a reputational risk, and the steps you can take to avoid it.

The term greenwashing was first used by Jay Westerveld, an environmental activist, in the 1980s and it implies any dishonest practices used by businesses to represent themselves as more sustainable either by giving a false impression or providing misleading information as to the sustainability of a product/service.

As emphasised in the UK’s Financial Conduct Authority (FCA) ESG strategy, the increase in demand for private sector products with sustainable credentials is increasing, with $35 trillion of assets under management (AUM) now in ESG-labelled funds. With this in mind, it is in everyone’s interest that the markets for sustainable financial products are robust and trusted.

Greenwashing is a priority issue for the financial services sector in most jurisdictions. The risk of greenwashing – and consequently the focus by regulators, consumers, and environmental groups – has increased exponentially as consumers/investors proactively seek ‘sustainable’, ‘green’, and ‘planet friendly’ products/investments. They are also challenging greenwashing via regulatory complaints, lawsuits and other actions; for example, the critical media attention experienced by producers and funders of single-use plastics.

The asset management sector is proactively marketing ESG funds. However, such ESG funds may misrepresent their ESG criteria, and regulators worldwide are clamping down on these incidents of greenwashing. Last year, the UK’s Competition and Markets Authority (CMA) published generic guidance on sustainability goals.

Additionally, the CMA’s Green Claims Code aims to protect consumers from misleading environmental claims/greenwashing. It also provides six key principles that serve as a valuable tool to help businesses avoid greenwashing. In 2022, the CMA may well propose legal changes to bolster its anti-greenwashing campaign, as the CMA builds on its Green Claims Code by announcing an investigation of corporate sustainability claims.

Similarly, the US Securities and Exchange Commission (SEC) is focusing on ESG issues. Its newly formed ESG Task Force will prioritise the investigation of climate- and ESG-related misconduct (greenwashing) this year.

The FCA recognises that over the past few years, the financial services sector has had a dramatic increase in ESG and sustainable investments, which has also led to increasing concerns about firms confusing or even misleading consumers about the nature of some of these investments.

There are no specific UK sanctions for those found guilty of greenwashing, although traditional sanctions for fraudulent misrepresentation or contractual claims may apply. Reputational risk is a significant reason as to why greenwashing matters; even accusations or suspicions of greenwashing could be damaging.

The anticipated increase in litigation in 2022 based on greenwashing claims is another reason why organisations should focus on tackling this issue. ESG commitments contained in public statements, decarbonisation pledges, corporate social responsibility (CSR) claims, etc should translate into real action to avoid vulnerability to accusations of greenwashing, not only against the corporates themselves but increasingly also brought against ‘facilitators’ such as financiers, insurers, advisors, and PR agencies.

Motivations for caring about greenwashing are not all about minimising potential negative impacts; there are also financial incentives for funders. For example, the EU is considering lowering capital requirements for sustainable finance. Helpfully, the industry has promoted voluntary guidelines. The Loan Syndications and Trading Association has released its Green Loan Principles and its Sustainability Linked Principles to assist lenders and borrowers in understanding the scope of sustainable, or green, finance.

Although greenwashing is not easy to avoid, you can take certain steps to mitigate the risk of greenwashing claims.

The implementation of programmes to upskill the board and employees on the fundamentals of ESG and the risk of greenwashing is a critical starting point.

Embed ESG criteria in existing risk management procedures and controls. Consider introducing a bespoke ESG policy. ESG governance can assist the business to follow, and have evidence of, robust processes to make accurate public statements and claims about how ‘green’ or sustainable their products and services are.

Regulations will likely help avoid the risk of greenwashing. The European Commission (EC) is seeking to strengthen national authorities’ ability to deal with greenwashing in a coordinated manner.

The EC’s motivation to get this right was demonstrated by its announcement that the implementation of the level two requirement of the Sustainable Financial Disclosure Regulation (SFDR) would be delayed by six months to July 1 2022 in order to address concerns raised by national regulators about greenwashing. For example, the risk of firms incorrectly self-certifying products as meeting enhanced ESG characteristics described in Articles 8 and 9 of the SFDR (the SFDR will require fund managers to disclose the ESG characteristics of their financial products, with Article 8 funds proactively promoting ESG characteristics, while the main objective of Article 9 funds is sustainable investments).

Fortunately, the SFDR’s delay did not affect the Taxonomy Regulation, part of the EU’s Green Deal, providing a list of green activities, coming into effect on January 1 2022.

Rather than transposing the SFDR into national law, the UK has encouraged businesses to comply with the SFDR, while also opting to apply the Financial Stability Board’s Task Force for Climate-related Financial Disclosures. Rishi Sunak, the chancellor at the time, announced that the UK Taxonomy intended to help address concerns about, and avoid accusations of, greenwashing using technical screening criteria. The UK Taxonomy may be based on the EU Taxonomy’s scientific metrics to the extent that they are deemed appropriate for the UK market.

The US SEC is expected to issue a proposal targeting funds that market themselves as green or sustainable. This proposal could require fund managers to disclose the criteria and underlying data used. It is also likely that the SEC will review the Names Rule. The Names Rule requires funds to invest at least 80% of their assets in the investment type their names infer.

Organisations should be mindful to help ensure that any green or sustainable claims comply with the CMA’s Green Claims Code principles, as well as any guidance released by industry; for example, guidance by advertising standards agencies on misleading advertisements.

Ideally, the voluntary – as well as the anticipated mandatory – corporate disclosure regime should enable asset managers, financial advisors, and investors to access “reliable, comparable and verifiable information” to determine what is sustainable/green to assess their portfolio’s carbon footprint. The SEC takes a different approach to greenwashing by enforcing existing rules rather than introducing new ones. Time will tell which is the most effective approach. Unfortunately, from an ESG point of view, time is another resource that is quickly running out.

If you would like to discuss the risks of greenwashing and how to avoid it, please reach out.