Greenwashing lessons for investment managers

Legislation and guidelines set by the EU in respect of ESG, like the Corporate Sustainability Reporting Directive (CSRD), the Taxonomy Regulation and the Sustainable Finance Disclosure Regulation (SFRD) are open to greenwashing risks.

On 31 May 2023, the three European Supervisory Authorities (ESAs) for banks, insurance and pensions and securities markets published progress reports on greenwashing as a response to the request from the European Commission for input on “greenwashing risks and the supervision of sustainable finance policies”. The ESAs consider greenwashing as “a practice where sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services”.

In other words, the term ‘greenwashing’ describes activities or campaigns which present individual financial products, whole companies, or investment strategies in a ‘green’ light, to give the impression that the parties or their investment vehicles are operating in a particularly environmentally friendly, ethical and fair way even if this is factually incorrect. Whether or not greenwashing practices are imposed or voluntary, they are subject to regulatory risks and may lead to sanctions that may severely affect the reputation of the market player being accused of a violation.

While greenwashing is conventionally seen as an act of deliberate misconduct, it can also inadvertently arise from incomplete data or new and unfamiliar terminology. Investment managers must incorporate controls against this into their overall risk management frameworks – a fact made clear by ESMA’s findings.

ESMA assesses which areas of the sustainable value investment chain are more exposed to greenwashing risks. For investment managers, the high-risk areas are found in respect of sustainability topics such as impact claims, statements about engagements with investee companies, ESG strategy of the fund manager and the ESG credentials, misleading fund names and misleading claims about ESG governance.

The frequent use of the term “sustainable” in fund names is considered to be a major issue, as this term is not specifically limited to ESG and rather is a more general qualification. Even funds that do not disclose under articles 8 and 9 SFDR have terms as “sustainable” or “sustainable growth” in their name.

The reason for this is that customers, especially institutional investors, are demanding sustainable products in the purest sense. But if the financial market participants cannot provide these, there are concerns that they could indulge in greenwashing to meet investor expectations and stand out from their competitors. Numerous studies by the Global Sustainable Investment Alliance show that there has been a huge increase in the number of financial products claiming to be sustainable.

This has also been identified by the Luxembourg financial supervisory authority, the CSSF, as a major issue. In March, the CSSF released an updated FAQ on the SFDR reminding financial market participants that information required should be easily accessible, simple, fair, clear and not misleading which also applies to fund names. Consequently, funds’ names should not be misleading, and disclosure of sustainability characteristics should be commensurate with the effective application of those characteristics to the fund. Terms such as ‘ESG’, ‘green’, ‘sustainable’, ‘impact’ and other ESG–related terms should only be used when supported in a material way by evidence of sustainability characteristics.

In terms of strategy-related claims – such as claiming that a fund aims at sustainable objectives – the ESMA report further states that there is “a lack of commitment and specificity regarding the sustainable characteristics or objectives of SFDR financial products”. Pre-contractual disclosures contain references to an “excessive number of sustainable objectives or characteristics promoted by a given fund without a specified commitment to them”.

At the same time, ESMA identifies that certain SFDR provisions are perceived as drivers for greenwashing, such as the lack of clarity of certain concepts – in particular the SFDR’s ‘do no significant harm’ test, for which the criteria are not sufficiently clear. Furthermore, the high level of flexibility and the absence of a threshold in the definition of “contribution to a sustainable objective” in SFDR may, in ESMA’s view, lead to “varying degrees of ambition” for sustainable investments that fall within the ambit of article 9 SFDR. Currently, SFDR, meant to be a disclosure regulation, turns out to function as a labelling regime built around articles 6, 8 and 9 SFDR. The use of terms such as ‘brown products’, ‘light green’ products and ‘dark green’ products must be discouraged as this is considered to be misuse of SFDR classifications.

The ESMA report suggests as preliminary remediation action that market participants across the sustainable value investment chain take their responsibility for substantiated claims and must communicate on sustainability in a balanced manner without exaggerating green standards. Sustainability disclosures to retail investors must be improved in order to be more understandable.

Based on the findings in the ESMA report and the corresponding reports from the two other ESAs, the EU will certainly take action to make the regulatory framework greenwashing-proof. It is inevitable that this will lay a huge additional administrative and technical burden on investment managers. On the other hand, both the financial sector and consumers will benefit from a more level playing field for fair competition. Essential to mitigating greenwashing risk is a diligent oversight of the investment managers over a thorough fund documentation that draws explicit links between fund names, objectives and strategies, backed by clearly written and comprehensive firm-wide policies.

First significant efforts in this regard can already be observed in certain EU jurisdictions – such as Luxembourg, which leads the way when it comes to ESG investing – with governmental bodies spearheading initiatives, including the Sustainable Finance Agenda that led to the foundation of the Luxembourg Sustainable Finance Initiative. This initiative intends to guide the financial sector towards sustainability – which includes fighting deceitful behaviours, such as greenwashing.

The Dutch supervisor, the AFM, has also expressed interest in introducing European regulation for providers of ESG ratings, data and related services and has called for minimum requirements and supervision at a European level. On the other hand, the AFM has highlighted the risk that strict reporting requirements may end up in information overload that impedes the addressee to distinguish between main and minor points. Moreover, complex regulations make it harder for auditors and regulatory authorities to audit and to enforce. In that scenario, the greenwashing risk will only increase. 

Co-written by Lous Vervuurt of Pinsent Masons.