Green finance insiders have recently delivered two painful jolts to the self-image of the booming environmental, social and governance (ESG) investment sector. In March Tariq Fancy, the former chief investment officer for sustainable investing at BlackRock, the world’s largest asset manager, penned an essay dismissing the entire ESG project as being about profit-hungry firms that are incapable of delivering a better, greener world.

Five months later more damaging specific claims revealed that German and US regulators had opened investigations into the huge asset manager DWS, which is part of Deutsche Bank. This followed claims made by a whistleblower, its former global head of sustainability, Desiree Fixler, who was sacked from her role as global head of sustainability. She alleged that DWS’s 2020 annual report misrepresented how the firm used ESG metrics, thereby allowing it to claim that more than half of its $900bn assets were invested using ESG criteria. DWS rejects the allegations.

“This case has been very strongly noticed by the industry and there is a feeling that ‘it could have been us’,” says one London-based asset manager.

ESG confusion abounds

It has been apparent for some time that all the ingredients for a potential wave of mis-selling are in place. The current mantra is that “green sells”; consumers’ urge to make the world a better place has driven an avalanche of money into ESG-labelled investments with sustainable investment currently the fastest-growing segment of the European funds market. At the same time, consumers’ expectations about ethical investment are high yet there is a dearth of companies that “do good and no harm”. In addition, even the established ratings agencies have had to acknowledge there is serious confusion over what their ESG scores mean.

The wider fear, of course, is that consumers will have their confidence in ESG-badged products dented, thereby thwarting the fundamental objective of directing capital to a green transition.

Regulators may be playing catch-up, but around the world firms are now acutely conscious of greenwashing risk and have taken active steps to introduce more robust requirements.

Tamara Cizeika, regulatory finance counsel at law firm Allen & Overy, says: “It has been clear for some time that regulators are on the war path as regards greenwashing, and some at least are taking the view that standards are not what they should be. No one wants a big greenwashing scandal: not the government, not regulators like the Financial Conduct Authority, not the firms. So it is in everyone’s interest to take a collaborative approach. The UK Financial Conduct Authority [FCA] has been pretty open in saying it has concerns – the ball is now squarely in the industry’s court.”

So how widespread is greenwashing? In November regulators in France, the UK, Sweden, the Netherlands and Switzerland told the Reuters news agency that they had found a number of instances where ESG claims were not backed up. The asset managers were asked to provide more information to support those claims, or forced to drop sustainability labels.

In one example, French finance regulator Autorité des marchés financiers forced managers to drop ESG labels after finding “completely unacceptable” cases of greenwashing, including funds that justified ESG names by excluding stocks that were anyway proscribed under French law.

Sweden’s Finansinspektionen found that around 5% of 400 funds it examined made claims that did not stack up. The Swiss Financial Market Supervisory Authority (FINMA) says it is dedicating more resources to tackling the problem and has “immediately eliminated” cases of greenwashing it has found, by forcing asset managers to drop ESG claims, or amend relevant disclosures. 

This was echoed in the UK by the FCA, which said that weak fund disclosures were common. Often the quality of the information is not sufficient for the regulator to begin considering the fund application; there were also questions about whether managers met value-for-money regulations given that ESG funds often charge higher fees.

Greenwashing causes harm

James Alexander, chief executive of the UK Sustainable Investment and Finance Association (UKSIF), a body with more than 40 leading financial institutions as members, identifies greenwashing as a real problem for the industry. “Specifically, we think greenwashing harms those that are actually leading the way when it comes to sustainability,” he says. “If you’re going the extra mile you will have in place an analysts team, you’ve got the staff, you’re spending a lot of time and resources making your fund as green as possible. And when you come to market someone else can also say they’re doing all those things. They put a nice picture of wind farms and solar panels on their brochure, and you as customer and end-user can’t tell the difference.” 

Regulators are taking a two-pronged approach for the short and long terms; they are tackling the immediate problem with enforcement action plus use of soft levers while hurrying to put in place tougher new ESG standards at a national and global level. 

One oft-cited problem is that definitions of what counts as ‘green’ are for the moment vague, hence taking action under the current regulatory framework can be difficult. But regulators do not necessarily need to rely on bespoke anti-greenwashing rules, according to Jonathan Cavill, partner at lawy firm Pinsent Masons. “Regulators have a lot of tools in their toolbox,” he says. “They can start with soft ‘informal’ levers and there are many other more formal steps they could resort to if necessary, such as enforcement action in the UK for breaches of the Conduct of Business Sourcebook. And there is also the option for customers to take civil action under existing common law that could be pursued.”

The risk that asset managers fall into a greenwashing trap is heightened by consumers’ sometimes unrealistically lofty expectations. MSCI, one of the leading green ratings firms, recently admitted that some people think ESG ratings are like credit ratings, while others think they should be focused on the climate crisis or rejuvenating the planet. “Both interpretations misconstrue their true purpose,” the firm said in a LinkedIn article: ratings are not about “corporate goodness” but instead measure a company’s resilience to financially material ESG risk.

One consequence is that how products are marketed has become pivotal. Mr Alexander warns: “The marketing department may be saying, ‘why can’t we just say that this is green?’ There’s always that internal tension in any firm to create something that maybe looks better than it is. There’s a lack of skills inside the industry, and there are people in the industry talking about sustainability in a way which creates this risk of mis-selling.”

Relying on big agencies

Robert Eccles, visiting professor at Saïd Business School, has been working with Ms Fixler, the DWS whistleblower, to define some key principles. He comments: “The weakness up until now is the reliance on ESG ratings from big ratings agencies like MSCI. The ratings agencies are not responsible for what asset managers do with their findings. But these ratings are only proxies and it’s clearly really simplistic if an ESG asset fund decides to invest in, say, the companies that make it into the top 25% of a table.

“But there is a lot of momentum now behind ESG. The EU is trying really hard with its green taxonomy, for example. The [IFRS’s] International Sustainability Standards Board is up and running. What’s needed is to establish some principles for asset managers that are manufacturing ESG products. All we need is for a few of the largest asset managers to take these principles to heart and some real progress can be made since the rest will have to follow suit.

“Then the regulators need to deliver a wake-up call like what we have seen with DWS. Find some people who have violated those principles and beat them up. Get people a bit scared. That could bring about a transformation, in my view.”

Yet the message coming from regulators is that they do not want simply to catch out companies through short-term enforcement action. The FCA, for example, has been giving firms a heads-up about their concerns and flagging what they will be looking for in the coming year, according to Ms Cizeika. “Hopefully that gives firms time to double check their internal approach and ensure everything is in line with regulatory expectations,” she says. 

Stewardship challenges  

Another part of the equation is stewardship. In the UK this entails adhering to the Financial Reporting Council’s voluntary Stewardship Code 2020, billed as “world-leading”. Corporate signatories must report against some quite general principles relating to stewardship and how financial institutions take into account stewardship for clients in the investment process. UKSIF says some of its members failed to meet the strict standards to become code signatories in the first wave earlier last year. Others were let in but told they need to sharpen up their act in specific ways if they want to remain. 

As they embark on longer-term fixes at national and global level, regulators are conducting formal industry consultations on new requirements.

In Germany BaFin, the Federal Financial Supervisory Authority, published draft guidelines on sustainability-oriented investment funds in August. Chief executive director Thorsten Pötzsch declared: “A fund that uses the ESG label must deliver on its promise of sustainability.” 

BaFin plans in future only to approve funds marketed with the “sustainable” label if the fund rules comply with one of three separate approaches. One option is compliance with a minimum investment ratio in sustainable assets; the draft proposals set out a minimum investment ratio in sustainable assets of 75%. These assets must contribute substantially to achieving environmental or social goals. Maximum limits will also apply, such as a maximum of 10% on energy generation from fossil fuels. 

The BaFin guidelines supplement the EU regulations. Notable is the Sustainable Finance Disclosure Regulation (SFDR), which is currently being phased in. This requires firms to make detailed disclosures in relation to relevant products and services that have environmental or social characteristics, or a sustainable investment objective. The intention is to make clear what the product or service is actually promising and what it actually delivers. This regulation applies to products and services such as funds, managed portfolios and fund-linked insurance policies; it does not apply to structured products, derivatives or bank accounts. 

Defining ‘green’ 

Then there is the so-called EU green taxonomy. Due to come into force from this month, this is a classification framework, intended to provide a common language for deciding what is “green” and what is not. 

The post-Brexit UK is developing a parallel green taxonomy. Meanwhile, a couple of months ago the FCA launched a paper entitled “Sustainability Disclosure Requirements and investment labels” subject to a consultation ending on January 7. Its starting point is that labels are an important driver of consumers’ choices of sustainable investment products and that as a regulator the FCA has an important role in building trust. 

The FCA’s initial proposal on a product labelling and disclosure system proposes a two-tier approach. The first would provide key product-level information for consumers. The second would be aimed at institutional investors, and other stakeholders would require detailed disclosures at product and entity level on sustainability risk, opportunities and impacts. The FCA is also proposing that the labelling should use objective criteria and descriptive labels, referencing for example the proportion of sustainable investments. “Subjective markers, such as ‘medals’, or ‘traffic lights’ would not seem appropriate… and may be more difficult to supervise effectively.”

Another idea is a three-way categorisation on sustainability products. “Transitioning” products would offer low allocation to the UK’s new green taxonomy, and “aligned” would offer high allocation. “Impact”, the highest ranking, would offer the objective of delivering positive environmental or social impact. The whole thing would be mapped to the EU’s SFDR: the FCA acknowledges that the SFDR categorisation has become a de facto classification and labelling system for sustainability-related investments. 

In the UK, regulators such as the FCA follow an outcomes-based approach grounded on key principles. Academic studies support the efficacy of this type of system based on trust rather than expensive and prescriptive rules. But lawyers point out this approach does allow the regulator a certain degree of “regulatory hindsight”, essentially being able to tell a financial institution after the event which principles and outcomes were those that mattered and not followed. 

By August amendments to MiFID II will come into play within the EU. These will insist that clients are asked about their sustainability preferences and that they be found suitable investment products. One unresolved conundrum is what remedies might be sought for customers mis-sold products: a purely financial recompense would seem out of place for an investment chosen with the goal of making the world a better place.