Sustainable finance has become increasingly trendy among investors. Asset managers are responding to this by coming up with more and more funds and sustainable investment products that are classified as ‘ESG’ or ‘sustainable’. Nowadays, the majority of financial institutions, investors, and asset managers extensively display and communicate their pursue of climate goals and sustainable investments.
Growing concerns
With increasing supply and demand for sustainable investments, there are also increasing concerns of so-called ‘greenwashing’ in the financial markets. Recent reports show that the world’s 60 largest banks have pumped over $3.8 trillion into the fossil fuel industry in the five years since the Paris Agreement. These banks still increased their financing in 2020 to the 100 companies most responsible for fossil fuel expansion by over 10%. These same banks have mission statements as “Play a leading role in driving the transitions to a low carbon economy” or “Do The Right Thing”. Even more remarkable, an analysis of the world’s 20 biggest ESG funds show that on average, each of them holds investments in 17 fossil-fuel producers. All of this raises questions regarding greenwashing and if it is potentially becoming a widespread reality in sustainable finance. Greenwashing in the financial market is the practice of convincing investors – as well as the general public – that a company, fund or sustainable investment is doing more to adopt sustainability than it actually is. It is the process of conveying a false impression or providing misleading information about how a company’s practices are environmentally sound.
With the risk of greenwashing and a lack of full, transparent and sufficient information concerning the sustainable or social impact of an investment, several problems arise. Investors must be able to make decisions on sustainable investments based on sufficient information on the sustainability claims of the investment. Unfortunately, sustainable finance and in particular the green bond markets is still unstandardized and fragmented across issuer types and regions, with too little standard for information disclosures. According to a report published by the Climate Bonds Initiative in early 2021, only 77% of issuers of green bonds published on the allocation of proceeds, and only 59% quantified the environmental impact of the projects financed. The lack of uniformity in impact data makes it even more difficult to evaluate the performance of the sustainable investment reliably, which in turn makes it more difficult for investors to make their investment decisions. But probably most important, control mechanisms to get and keep funds and investments ‘green’ are insufficient due to a lack of accountability. This absents of accountability is a result of underdeveloped universal processes and policies with regards to such control mechanisms.
The importance of reporting on sustainability
While reporting on sustainable investments have been niche for a long time, it is now becoming mainstream to communicate about the impact of long-term investments and social importance. It is worth noting that sustainable financing involves various groups and stakeholders including investors, financial institutions, public and private issuing companies, regulators, supervising authorities, and other market players. These different groups are all subject to different social responsibilities and accountability regarding the impact of these sustainable investments.
Governments
Government bodies start to become increasingly aware of the need to act on the problem of greenwashing. However, policies and sanctions to combat greenwashing are mostly focused on the consumer markets. The UK government is designing a framework, “The Call for Evidence”, to urge providers of energy products to be more transparent about green energy claims. In April this year, the French government were the first to introduce legal sanctions against greenwashing companies. These sanctions mean that organizations accused of greenwashing could be fined up to 80% of the cost of the false promotional campaigns. Furthermore, the penalty for greenwashing will be published on the website of the convicted legal person for thirty days. It remains doubtful whether these measures will result in stopping greenwashing from happening. It increases the risk of a slightly higher price tag, but it doesn’t make it impossible or even more difficult.
Taking a global leading role, the EU has designed green taxonomies and frameworks about sustainable finance as the EU Taxonomy Regulation and the EU Green Bond Standard. These guidelines cover over 70 activities and aim to guide investors through sustainability criteria, which are closely in line with the International Capital Markets Association’s (ICMA) Green Bond Principles. However, they are still voluntarily and companies may choose for themselves what to disclose, and also what not to disclose. An effective method against greenwashing could be to force issuing companies to give full disclosure about their carbon emissions and their sustainability commitments. This would eliminate the possibility of omitting environmental unfriendly activities when opting for positive ESG labels.
Issuing companies
Issuers of green financial products are subject to the same voluntarily principle of providing data and transparency. Labelling an investment fund or corporate bond as ‘green’ is possible without full disclosure. When these issuing companies would be held more accountable for the sustainability claims they make with their green-labelled investment products, and especially for the use of the proceeds, this would lead to an increase in transparency and accessibility in their reporting. However, many public companies are critical about the workload and the required resources due to the large number of different standards on sustainability reporting. A key challenge here lies in the harmonisation of these standards, so that public and private companies can incorporate the required sustainability disclosures more easily.
Investors and asset managers
From an investor perspective, the most important tool for managing the risk of potential greenwashing, and making sure that issuing companies are held accountable for their sustainability commitments, is full, transparent, and correct information. This implies that investors must also be able to understand and to scrutinise the sustainability metrics and understand the factors that are most material to them from a sustainability perspective. In recent years, an increasing number of investors and asset managers are gearing up their investment criteria and improving their investment processes to prevent investments that are subject to greenwashing.
Harmonization and increasing disclosure
As standards and taxonomies for sustainable finance become more and more developed, the key challenge will be to harmonize these standards across regions and practice areas. For this harmonization of standards, all stakeholders and groups in the market must continue to work together and strive towards common goals; increasing standardization, and increasing the knowledge and tools for all market players to evaluate the sustainability metrics.
As reporting and disclosure standards get more harmonized over time, investors and regulators will be able to increase their scrutiny on sustainability statements. Pushing companies to give full disclosure with regards to their sustainability commitments gives rise to a new challenge; which controlling mechanisms will be in place and which market players are going to be responsible for these actions. The risk of bad publicity, sanctions or fines will create an incentive for issuing companies to prevent mistakes and to hire players in the market such as sustainability consultants or accountants. This market push may lead to an increase in such businesses and thereby resolve the problem of a lack of resources.
Harmonizing the standards and increasing the pressure on full disclosure on sustainability commitments, will result in the markets’ ability to better evaluate the sustainable impact of an investment. This way hopefully in the coming years, the impact of an investment can be evaluated at individual financial instrument level, at an issuing entity level, and most preferably at the underlying asset level. As companies will become increasingly forced to disclose their sustainability commitments, the risk of greenwashing will decrease. All of this will support the fundamental common goal of sustainable finance; accelerating the transition towards a sustainable future.
Max Terheggen & Paul Roelandschap