ESAs report on greenwashing

What has happened?

On 31 May 2023, each of the European Supervisory Authorities (ESAs)¹ published their preliminary responses to the European Commission's May 2022 Request for input from the ESAs related to greenwashing risks and supervision of sustainable finance policies. The EC request sought input from the ESAs on (i) the definition of greenwashing in the financial sector (and in particular their respective sectors), (ii) risks posed by greenwashing, (iii) the implementation of sustainable finance policies to prevent greenwashing, and (iv) potential improvements to the EU's current regulatory framework. The ESAs' reports draw heavily on market responses to their Call for Evidence launched in November 2022.

The ESAs' review process is still ongoing but we expect it to ultimately give rise to significant changes to the EU's ESG framework, including changes to the EU SFDR and the EU BMR.  A final report from each of the respective ESAs is due next year (scheduled for May 2024 publication) which will include recommendations on those changes. 

What is greenwashing?

In the reports, the ESAs put forward a common understanding of the term "greenwashing", being:

"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 service, [which] practice may be misleading to consumers, investors, or other market participants"

The ESAs also agree that (i) for greenwashing to occur, investors do not need to be harmed, and (ii) greenwashing can occur at both entity and product level, within or outside the EU regulatory framework. Some of the reports refer to different roles that financial market participants may play in greenwashing being trigger, spreader and/or receiver of a misleading claim².

What do the reports conclude?

The key themes of the Reports are:

• there is a mismatch between a growing investor demand for "ESG products" and investment products that are genuinely sustainable;
• the EU's current legislative framework is not holistic and the various pieces of relevant legislation (including the EU SFDR, the EU Taxonomy Regulation, the EU BMR and the EU CSDR) are not joined up, particularly with respect to greenwashing;
• there is a lack of supervisory oversight of and enforcement against entities suspected of greenwashing;
• market education is needed across the board – from investment advisers to retail investors – to ensure that market participants are sufficiently well informed about the risk of greenwashing and the applicable regulation;
• the most common forms of greenwashing are (i) highlighting positive aspects of an entity or product while failing to mention less ESG-friendly aspects (referred to as "cherry-picking"), (ii) omitting key information from claims, (iii) making ambiguous claims, (iv) making empty or exaggerated claims, and (v) using ESG terminology in a misleading manner (examples of each of these are given in the respective reports);
• names and labels applied to products and vehicles are often misleading. For example, articles 6, 8 and 9 of the EU SFDR are frequently erroneously used as labelling conventions, rather than as indicators of the required level of disclosure;
• regulatory documents such as prospectuses are generally less prone to greenwashing than marketing materials, labels and voluntary reporting; and
• greenwashing occurs at all stages of product development and across all sectors, and although may not in itself result in immediate damage to individual consumers or investors, will undermine trust in sustainable finance markets and policies.

The ESAs are particularly concerned about the "mismatch between growing demand for ESG products and the limited pool of assets that are deemed sustainable", in particular those in line with the high standard of the EU Taxonomy Regulation, which creates a competitive drive for market participants to gain market share and revenue through bolstering their sustainability profiles, which may in some cases be misleading. 

What are the roles of different types of market participant?

The reports focus on four types of market participants, or "sectors": issuers, investment managers, benchmarks, and investment service providers. For each sector, the reports identify (i) "high-risk" greenwashing areas, (ii) the underlying drivers of greenwashing, and (iii) possible remediation actions.

For issuers, the key greenwashing risks identified relate to forward-looking information and pledges about future ESG performance, with the risk of cherry-picking (discussed below) being particularly high for this sector.

For investment managers, areas of risk include (i) claims about a fund’s or the manager’s engagement with investee companies, (ii) ESG strategy, policies and credentials, (iii) ESG governance, and (iv) claims on sustainability impact. The naming of funds is also identified as a problematic area, with misleading terminology often being used in fund names.

For banks, areas of risk include at entity level, risks relating to business strategy such as (i) selectively promoting sustainable initiatives while intentionally omitting information about financing non-sustainable activities and/or avoiding any mention of negative impacts on sustainability, (ii) making public commitments to decarbonise their overall investments and lending activities (Scope 3) and/or reach net zero emissions but the transition plan at entity level being neither evidenced nor credible, (iii) failures of due diligence for engaging in business with individuals and corporations involved in various crimes, and (iv) conveying misleading communications on the extent to which ESG is embedded in the governance structure, management culture and staff policies. 

For benchmarks, misleading names are also a problem, as well as impact claims related to specific climate and ESG benchmarks.

For investment service providers, areas of risk include (i) claims about the extent to which advice offered to retail investors takes sustainability into account and (ii) insufficient knowledge and expertise.

Examples of greenwashing

Cherry picking

This could include naming issues in investment products or benchmarks where there is lack of clarity of the definition of sustainable investment.  This could also include selective disclosures or hidden trade-offs, for example where a product is marketed as sustainable based on a very narrow set of attributes without paying attention to other major issues.  A practical example of this is the use of positive alignment of a product to the UN Sustainable Development Goals as a way of identifying it as sustainable. 

Empty or exaggerated claims 

This could include a product which states achievements that reflect compliance with legislation if these are presented as an overachievement.  These can often be accompanied by omission and vagueness. 

Labels 

To the extent that they enhance comprehensibility and comparability, reliable labelling schemes can help to mitigate greenwashing. At the same time, their misuse represents potential sources of misleading sustainability claims. This is concerning given that retail investors with limited financial and ESG literacy rely on them to make informed investment decisions. Moreover, there is fragmentation of the labelling landscape, with most labels only catering to national or intra-EU regional markets and a very wide array of design and governance schemes

Omission

Omission is also seen as a source of greenwashing risk in relation to underlying ESG data used and ESG metrics in general. The lack of clearly outlined data limitations and/or disclaimers in documentation on underlying methodologies poses a high risk to investor protection and deters comparisons across products and firms. 

Green bonds in focus 

The ESMA report notes that the risk of greenwashing appears particularly high for green bonds, due to the occasional excessive leeway in use of proceeds, which are sometimes referenced in the bonds’ prospectuses in a non-commital way such as “The use of proceeds for this security might include […]”.

In terms of the disclosures published in relation to the offering of securities to the public and/or admitting securities to trading on a regulated market, several ongoing legislative initiatives are also expected to enhance the quality of the information disclosed. The EU Green Bond Standard (EU GBS) Regulation aims to create a high-quality voluntary standard for the green bonds market. The EU GBS will also provide investors with a benchmark against which to compare other sustainable bonds segments, although it is not expected to lay out requirements regarding the use of ESG- or sustainability-related terms in the names of financial instruments falling within and outside its scope. In this context, to support transparency and comparability, extending the development of naming conventions (that is already being considered regarding funds) to financial instruments might be beneficial and could be considered in the future. 

This could lead to possible future legislation in this area. 

What next?

Regulators of financial markets face expectations from stakeholders to step up in ensuring investor protection and market integrity and maintain a trusted environment for sustainable investments. Greenwashing allegations have been growing in numbers, targeting both financial and non-financial entities, which has also attracted the attention of regulators. Professional investors and other industry players also seem to share the concern that greenwashing risks have increased.

The ESA responses are described as "progress reports" only, with final reports to follow in May 2024. However, they give a good indication of possible future developments in the EU ESG space, even going so far as to include high-level preliminary remediation actions, which will be adjusted and finalised for inclusion in the final reports. The recommendations include:

• clarifying central concepts, such as "sustainable investment";
• aligning central concepts, such as the "do no significant harm" principle and how it is interpreted under different pieces of EU legislation;
• developing a labelling scheme for sustainable financial products; 
• further consideration of how the impact of social factors should be measured;
• encouraging market participants to invest in capacity, expertise and IT systems, and to adapt governance structures to better manage the challenges of a transition to sustainable finance;
• encouraging increased due diligence of ESG data; and
• addressing retail investors' financial and sustainability literacy gaps.

We expect this review process to give rise to significant changes to the EU's ESG regulatory framework, including through changes to the EU BMR, which was last reviewed in 2019 – before the Taxonomy Regulation was adopted - but is due to be reviewed again later this month, and to the EU SFDR, which is also due to undergo a suitability assessment soon.

^{1 European Securities and Markets Authority (ESMA); European Banking Authority (EBA); and European Insurance and Occupational Pensions Authority (EIOPA)}

^{2 an end investor will always fall into the "receiver" category}