Greenwashing Regulation

This edito by Frédéric Ducoulombier, Director of EDHEC-Risk Climate, has been originally published in the February newsletter of the Institute. To subscribe to this complimentary newsletter, please contact: [email protected].

The demand for investments integrating Environmental, Social, and Governance (ESG) dimensions has increased significantly in the past decade and the assets that financial intermediaries claim to manage responsibly and sustainably have close to trebled, reportedly growing to represent a third of overall assets under management.[1]

However, the industry-accepted definition of sustainable and responsible investing is nothing if not inclusive (Ducoulombier, 2023). As incorporating ESG issues into investment management now suffices to claim the responsible investment badge, the industry welcomes a dazzling array of strategies with heterogeneous objectives, potential sustainability contributions, and methodologies.

Furthermore, there remains considerable disagreement in respect of basic terminology across jurisdictions, voluntary standard setting bodies, and industry associations.

Regulating sustainability claims and mandating appropriate disclosures is required to protect investors from confusing or misleading claims and to facilitate the matching of investment products with sustainability preferences. Beyond investor protection, such regulation could accompany the integration of sustainability concerns by businesses through better capital allocation and stewardship.

For more than five years, the European Union has led the development of such regulation. In the wake of the climate and development commitments made by the international community in 2015, the European Commission embarked on developing a sustainable finance masterplan. Published in March 2018, the Action Plan on Financing Sustainable Growth aimed to redirect capital flows toward sustainable investments, manage financial risks related to environmental and social issues, and promote long-term economic sustainability.

The European Union swiftly implemented three major components of its sustainable financial framework. These include a classification system for sustainable activities, known as the Taxonomy Regulation (“TR”); sustainability disclosure frameworks for both financial market participants and large companies–the Sustainable Finance Disclosure Regulation (“SFDR”) and the Corporate Sustainability Reporting Directive (“CSRD”), respectively; and investment tools, including climate benchmarks, a green bond standard, and specific expectations and disclosures for financial products promoting environmental or social characteristics or with sustainable investment as objective (SFDR Article 8 and 9 products, respectively).

In a 2021 update to its sustainable finance strategy,[2] the European Commission highlighted the issue of greenwashing, defined as “the use of marketing to portray an organisation’s products, activities or policies as environmentally friendly when they are not.” The Commission warned that greenwashing risks, could not only involve reputational risks for those involved but may also undermine trust in sustainable finance products and the financial system as a whole.

The Commission asserted that the legislator had established a sufficient framework of definitions, disclosures, and tools to inform investment decisions adequately. It emphasised the need to shift focus towards supervision and enforcement to protect investors and consumers against “unsubstantiated sustainability claims.” In this regard, the Commission announced its intention to assess and review the powers, capabilities, and obligations of competent authorities to ensure they are fit for combatting greenwashing (a practice for which the legislator has yet to provide a generally applicable and binding definition).

In 2022, the International Organisation of Securities Commissions (IOSCO), representing 130 member jurisdictions regulating over 95% of the world’s securities markets, elevated the fight against greenwashing as a priority for regulators and policymakers. This year marked a record number of greenwashing allegations[3] and witnessed the first greenwashing-related enforcement actions against financial institutions in several key jurisdictions. 

In May 2022, the European Commission approached the authorities supervising the bloc’s financial sector for advice on greenwashing, its associated risks, supervision and enforcement, and possible adjustments to the regulatory framework. Initial findings were expected after a year and final conclusions requested for May 2024.

To support their efforts, the European Supervisory Authorities (ESAs) sought input from stakeholders, including through a Call for Evidence (CfE) to which EDHEC-Risk Climate Impact Institute responded in early 2023.

The interim reports produced by the ESAs jointly define greenwashing[4] as any communication or action that could mislead market participants regarding the true sustainability profile of a product, service, or entity. They note that greenwashing may occur at any stage of the product or service lifecycle and throughout the value chain and that it need not be intentional.[5] The reports discuss possible financial risks associated with greenwashing and agree with the academic literature that the financial standing of entities may be affected by greenwashing allegations.  While current risks appear limited,[6] they are expected to rise over time. 

The ESAs suggest that greenwashing arises in a context of mismatch between high demand for sustainability themed financial products and services and scarcity of underlying assets with undisputable sustainability credentials.[7] They represent that greenwashing risks are driven by a convergence of factors, including market dynamics, regulatory and supervisory frameworks,[8] data and methodological issues, which may exacerbate conduct issues.

Significantly, the reports do not shy away from attributing a significant part of the problem to existing legislation and reflect an understanding of some of the pitfalls of financial regulation.  We appreciate the ESA’s consideration of our feedback on these and other high-risk areas.

The report by the European Securities and Markets Authority (ESMA) goes as far as acknowledging that certain provisions and omissions of the SFDR contribute to greenwashing. Specifically, it highlights the lack of clarity in central aspects of the regulation, such as the definition of “sustainable investment”, and the assessment of contributions–as well as harms–to environmental or social objectives. Without predefined and binding criteria and thresholds to assess the said contributions (or harms), it would indeed be relatively easy to select criteria and benchmarks to design Article 9 products with very low ambitions. The latter would not be as much of a problem, if (large swathes of) the market had not repurposed this disclosure regulation as a labelling regime (on the value of this labelling, refer to Scherer and Hasaj, 2023 and our October 2023 newsletter).  

The report also points to a lack of mandated disclosures for investor impact and engagement,[9] which contributes to the proliferation of unsubstantiated or ambiguous claims in their respect.[10] It also takes home our remarks about the risks of confusion between a claim about an ESG process being implemented and actual progress being achieved.

Finally, the report highlights inconsistencies in Do No Significant Harm expectations across the sustainable finance package leading to confusion and contributing to greenwashing. For instance, newcomers to European sustainable finance regulation may be surprised to learn that funds tracking climate benchmarks designed to comply with the minimum standards of the Benchmark Regulation (“BMR”) may include holdings that do not qualify as sustainable under SFDR.[11] Conversely, tobacco is excluded from the EU Climate Benchmarks but not covered by the SFDR mandatory Principal Adverse Indicators.  

The ESA reports also emphasise the importance of recognising transition finance to address the gap between demand for ESG-themed products and the scarcity of EU taxonomy-aligned investment opportunities. We agree and remark that this is not only important to mitigate greenwashing risks but that is also crucial for channelling funds towards the transition. Naturally, this must be accompanied with appropriate rules to mitigate the risks of pledges remaining pledges. The implementation of the CSRD (see our discussion of sustainability disclosures in the previous newsletter) should greatly increase the supply of credible forward-looking ESG information, e.g., emissions reduction targets and transition plans.[12]

It is encouraging to see the ESMA incorporate many of our criticisms of the minimum standards of BMR in its report.[13] This increases the likelihood of an update to BMR that will realign the minimum standards of the EU Climate Benchmarks with the objective of channeling funds towards the transition.[14] It also draws attention to the dangers of institutionalising greenwashing through improperly designed labelling schemes.

Regarding BMR and focusing on EU Climate Benchmarks, there are several key issues. The choice of metric to steer the construction of the EU Climate Transition and Paris-aligned Benchmarks is inconsistent with the promotion of real-world changes. One reason is that the (numerator of the) Commission’s carbon intensity metric naively incorporates value chain emissions data that are unfit for the intended purpose of cross-constituent comparisons (see Scope for Divergence contribution in this Newsletter and Ducoulombier, 2021). Another reason is that it scales emissions by a financial indicator that is dominated by capital market volatility (see Ducoulombier and Liu, 2021). In addition, the regulation’s sectoral allocation constraints, which were presented as protection against greenwashing, lack the granularity to prevent the meeting of minimum standards by mere reallocation from higher to lower intensity assets irrespective of their decarbonisation trajectories or importance for the transition (see Amenc, Goltz, and Liu, 2022).[15]

Regarding the labelling system, we consider that it should be evolved from SFDR for economic efficiency and political expediency. Indeed, the very material investments made to establish and maintain SFDR compliance systems should be leveraged upon rather than remised. And the understandable fatigue with (everchanging) sustainability disclosure regulation should be acknowledged.

A labelling scheme for sustainable financial products could increase retail investor participation. A proper scheme would allow for clear identification of objectives, ambitions and strategies and be underpinned by coherent minimum criteria and corresponding disclosure requirements.[16]

For such a scheme to not only mitigate greenwashing risks but also foster the transition to an environmentally sustainable economy, it should be grounded in science-based minimum standards,[17] constrain investment management to be consistent with the promotion of real-world impact, and mandate clear disclosures documenting processes and outcomes.[18] Proper recognition of transitional activities, in line with the EU Taxonomy, is crucial.

The Commission has an opportunity to rectify its BMR mistakes, correct its SFDR oversights, and put forward a more comprehensive and effective system to combat greenwashing, steer funds towards sustainability enhancing investments, and promote alignment of investee companies with required transition pathways and high standards of sustainability performance.

Footnotes

[1] See, inter alia, the figures published in November 2023 by the Global Sustainable Investment Alliance.

[2] Strategy for Financing the Transition to a Sustainable Economy, Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, COM(2021) 390 final, 6 July 2021.

[3] See the figures cited in EBA Progress Report on Greenwashing Monitoring and Supervision, European Banking Authority, EBA/REP/2023/16, 31 May 2023.

[4] The ESAs define greenwashing as a practice where sustainability-related communications and/or actions potentially mislead market participants by failing to clearly and fairly reflect the actual sustainability profile of an entity, a product, or a service.

They identify eight core characteristics to help understand the scope of greenwashing:
i. The potential to mislead may result from sins of omission and/or commission: decision-relevant information may be withheld, and/or information may be provided that is false, deceives, or is likely to deceive; relevant to consumers, investors or other markets participants’ decisions
ii. it may not only concern claims but also actions, e.g., insufficient consideration of client sustainability preferences;
iii. it need not be intentional, e.g., it may occur or spread because of negligence, or due to (due diligence) processes lacking in robustness and/or appropriateness.
iv. it may occur at the level of (i) an entity; (ii) financial product; and/or (iii) financial service;
v. it may occur “at any point where sustainability-related statements, declarations, actions or communications are made” and thus at any stage of a product/service business cycle (e.g., manufacturing, delivery, marketing, sales, monitoring) and throughout the sustainable finance value chain;
vi. it may occur in relation to mandated sustainable finance disclosures and/or to general principles (and concern entities outside the current remit of EU sustainable finance regulation);
vii. it may be triggered by the entity to which the sustainability communications relate, by the entity responsible for the product or that providing advice or information on the product, or it by third parties, e.g., data providers or auditors;
viii. it need not result in immediate harm to individual investors or in the gain of an unfair competitive advantage (as its proliferation may undermine trust in sustainable finance markets and policies).

[5] Naturally, some market participants had advocated for a more restrictive characterisation of greenwashing requiring intentionality and evidence of harm.

[6] Characterising greenwashing indirectly through divergence between ex-ante data provider controversy scores and ex-post sanctions (and alternatively through ESG rating divergence in the spirit of Avramov et al., 2022), Ghitti et al. (2023) find evidence of negative impact on firm value for large U.S. companies between 2012 and 2017.  A staff paper by ESMA looks at the market impact of greenwashing controversies in Europe over 2021 and 2022 and find no evidence of impact (Mazzacurati et al., 2023).

[7] With respect to this gap, refer to: The Proposed Extension of the EU Ecolabel for Retail Funds Needs a Rethink, Frédéric Ducoulombier, EDHEC Risk Climate Impact Institute Newsletter, Issue 1, May 2023.

[8] Insufficient oversight of sustainability-related claims and actions lead to limited sanctions for greenwashing, which may disincentivise investments in greenwashing risk prevention.

[9] Engagement and voting are forms of stewardship that may be targeted towards sustainability issues. However, a diversity of practices have been described as engagement and measuring intensity, quality of engagement, as well as engagement outcomes, is fraught with problems that have yet to be properly addressed. Against this backdrop, it is not directly obvious how engagement activity could be disclosed in a concise and informative manner. However, detailed disclosure of engagement and voting commitments, strategy, and metrics should be required of products making engagement-related sustainability claims.

[10] Disclosures are required from funds mentioning engagement as a binding characteristic or objective (see Article 4).

[11] While the ESMA remarks that DNSH testing under SFDR affords a lot of discretion to providers and that it may be calibrated in bad faith to be rendered ineffective, this is not the remedy it suggests to align BMR and SFDR compliance.

[12] The ESAs also acknowledge that putting the SFDR cart before the CSRD horse has contributed to data access issues, excessive reliance on ESG data providers, and heightened greenwashing risks.

[13] See notably paragraphs 126 and 127 and footnote 118 as well as paragraphs 133 to 136.  Paragraph 126 reads: “EU Climate Benchmarks are not seen by certain CfE respondents as ambitious enough in terms of design, reduction in GHG emission and broader real-world environmental impact. These benchmarks have minimum technical standards that allow the use of portfolio construction techniques considered by some CfE respondents to have little, or even negative, climate impacts as they fail to bring about real world GHG emission cuts. Sectoral constraints (…) are considered to be insufficiently granular and allow the decarbonisation requirements to be met by divestment of high-climate-impact issuers irrespective of their importance for the climate transition. (…) Thus, it can be argued that the carbon reductions may result from a reallocation of capital across sectors and regions, i.e., the minimum standard on the 7% yearly decarbonisation can be met by simply rebalancing the portfolio across companies, sectors and countries.
”Paragraph 127 reads: “In addition to this, at a more granular level, the calculation formulas for some of the ESG metrics (…) including climate benchmarks under BMR lack standardisation and are seen to lead to greenwashing based on CfE input. One such metric is the GHG intensity formula which uses Enterprise Value Including Cash (EVIC) in BMR,  but can also be computed by using a revenue metric in other disclosures. The use of EVIC as a denominator instead of revenues has certain failings which may lead to greenwashing; emissions trajectories should arguably be calculated using real economic outputs, yet EVIC introduces volatility in the measurement and rewards issuer market performance over its decarbonisation performance.” Footnote 118 reads: “Indeed, another shortcoming of these EU Paris-Aligned Benchmarks is perceived to be Article 12(1g) of BMR which excludes companies whose majority revenues are from high intensity electricity generation with no consideration for their revenues from low-intensity electricity generation, their related CaPex, or transition plans.”

[14] Paragraph 135 reads: “Increase the level of ambition of EU Climate Benchmarks by revising the minimum standards for climate benchmarks.”

[15] Adding insult to injury, the minimum standards for EU Paris-aligned Benchmark require the exclusion of companies that derive 50% or more of their revenues from electricity generation with a GHG intensity of more than 100g CO2e/kWh with no consideration for their revenues from low intensity electricity generation or for their transition commitments or plans. It follows inter alia that a diversified company producing electricity from unabated fossil fuels and deriving slightly less than 50% of its revenue from such power generation activities may be included while a pure power generation company producing half of its electricity from low carbon sources will be excluded.  Note that all of these issues were brought to the attention of the European Commission before finalisation of the BMR.

[16] As we wrote in our advice in respect of SFDR review: “The Commission should seek to ensure that (i) minimum standards are fit for the purpose of encouraging the offering of products that promote capital allocation to sustainability enhancing investments and alignment of investee companies with required transition pathways and high standards of sustainability performance; (ii) disclosures are fit for the purposes of demonstrating process and documenting outcomes and assessing performance across peer group and time.”

[17] Pioneering studies find that investors are more emotional than calculative in their valuation of impact (see Heeb et al., 2023) – if high impact is sought by the regulator, it should be mandated by minimum standards.  The endorsement of a labelling scheme by the regulator creates multiple moral hazards, including a (false) sense of security that leads to reduced due diligence by investors.

[18] Disclosure should combine uniform information, scheme-category specific information, and additional information supporting idiosyncratic product claims.

References

Amenc, N., F. Goltz, and V. Liu (2022). Doing Good or Feeling Good? Detecting Greenwashing in Climate Investing, The Journal of Impact and ESG Investing, 2(4), pp. 57–68.
Avramov, D., S. Cheng, A. Lioui, and A. Tarelli (2022). Sustainable investing with ESG rating uncertainty, Journal of Financial Economics, 145(2), pp. 642–664.
Heeb, F., J. Kölbel, F. Paetzold, and S. Zeisberger (2023). Do Investors Care about Impact?, The Review of Financial Studies, 36(5), pp. 1737–1787.
Ducoulombier, F. and V. Liu (2021). Carbon Intensity Bumps on the Way to Net Zero, The Journal of Impact and ESG Investing, 1(3), pp. 59–73.
Ducoulombier, F. (2021). Understanding the Importance of Scope 3 Emissions and the Implications of Data Limitations, The Journal of Impact and ESG Investing, 1(4), pp. 63–71.
Ducoulombier, F. (2023). EDHEC-Risk Climate Impact Institute’s Response to the European Supervisory Authorities’ Call for Evidence on Greenwashing, EDHEC-Risk Climate Impact Institute Policy Contribution.
Mazzacurati, J., S. Balitzky, and F. Piazza (2023). The financial impact of greenwashing controversies, ESMA TRV Risk Analysis, European Securities and Markets Authority (19 December).
Ghitti, M., G. Gianfrate, and L. Palma (2023). The agency of greenwashing, Journal of Management Governance.
Scherer, B. and M. Hasaj (2023). Greenlabelling: How valuable is the SFDR Art 9 label?, Journal of Asset Management, 24(7), pp. 541–546.

To explore further:

While the article discusses the European Union's efforts to regulate greenwashing and enhance transparency in sustainable finance, how do stakeholders perceive the effectiveness of these regulations in addressing the complexities of ESG integration and combating greenwashing practices globally, especially outside the EU?

The effectiveness of sustainability regulations, particularly those aimed at combating greenwashing and promoting transparency in sustainable finance, is subject to ongoing evaluation by stakeholders across the financial industry. While the European Union has made significant strides in implementing regulatory frameworks such as the Taxonomy Regulation, SFDR, and CSRD, the effectiveness of these regulations outside the EU and in addressing global challenges remains a topic of debate. Stakeholders may question the extent to which these regulations adequately address the complexities of ESG integration and provide sufficient protection against greenwashing practices on a global scale.

The article highlights the disagreements over terminology and standards in sustainable investing across jurisdictions and industry bodies. How do these ongoing challenges in standardization impact investors' ability to make informed decisions and hold financial intermediaries accountable for their sustainability claims on a global scale?

The article highlights the persistent challenges in standardizing terminology and standards within sustainable investing, both across jurisdictions and among industry associations. These disagreements can significantly impact investors' ability to make informed decisions and hold financial intermediaries accountable for their sustainability claims. The lack of standardized definitions and criteria may lead to confusion among investors and hinder the comparability of sustainable investment products across different markets and regions.

Given the identified shortcomings in current regulatory frameworks, what are the key recommendations or potential next steps proposed by experts and stakeholders to further enhance transparency, mitigate greenwashing risks, and foster genuine sustainability in investment practices? How can regulatory bodies adapt to emerging trends and challenges in sustainable finance while ensuring alignment with broader environmental and social goals beyond the EU's jurisdiction?

Looking forward, stakeholders may seek clarity on the future direction of sustainability regulations and the potential steps to address identified shortcomings. Experts and stakeholders may propose recommendations aimed at enhancing transparency, mitigating greenwashing risks, and fostering genuine sustainability in investment practices. This could involve refining existing regulatory frameworks, improving data quality and accessibility, and promoting international collaboration to harmonize standards and enhance regulatory effectiveness beyond the EU's jurisdiction. Additionally, stakeholders may advocate for ongoing dialogue and engagement between regulators, industry participants, and civil society to adapt to emerging trends and challenges in sustainable finance while aligning with broader environmental and social goals.