Can sustainability legislation prevent greenwashing?

Adviser-Hub in association with Ninety One.

It is over a year since the Sustainable Finance Disclosure Regulation (SFDR) was introduced in Europe. The UK’s Sustainable Disclosure Requirements (SDRs) came into effect at the start of this year and US regulators are also working on a new disclosure regime. These rules have been introduced with the promise of standardising disclosure on key environmental issues. This should prevent greenwashing and deliver better environmental outcomes, but is this happening in practice?

Greenwashing is a significant threat to the development of sustainable finance. If investors do not trust the labels put on funds, or fund managers seek green status without pushing companies to change, it imperils the ability of the financial sector to bring about environmental improvements. Regulators and the fund industry recognise the risks. 

Greenwashing is certainly still happening. There have been some egregious examples of fund groups putting ‘ESG’ labels on funds with no material change in the underlying investment approach. At the same time, some major global companies also appear to be gaming the system. A recent report from the NewClimate institute and Carbon Market Watch found that high profile companies were using loopholes, cherry-picking data and using flattering date ranges to improve their scores.1  It also criticised them for having ‘low integrity’ climate ambitions, omitting large chunks of their business from their targets. 

The EU’s SFDR was designed to address some of these problems. By introducing fund labels – 8 for ‘ESG’ funds and 9 for ‘pure’ sustainability funds, fund managers should be incentivised to improve their fund rating, which in turn will encourage them to put pressure on companies, which should introduce greater integrity in companies’ climate reporting. 

Some elements of this chain are working well. Investors, for example, have shown themselves enthusiastic for category 8 and category 9 funds, with fund flows for other categories of funds tailing off. However, data from Morningstar2  suggests that there is still a wide range of practices and interpretations. For example, more funds are classified Article 8 or 9 in France, the Nordics and the Netherlands than elsewhere. 

The group’s research also showed that Article 9 funds tend to have clear sustainability criteria and impact. However, article 8 funds will often make the grade if the managers exclude certain sectors, have a lower carbon intensity than the benchmark or have some firmwide ESG practices. This does not, of itself, prevent greenwashing. It showed that Article 8/9 funds involvement in fossil fuels across the board has increased over the past six months. This may be because fund groups are increasingly recognising the merits of engagement rather than disinvestment, but the system appears to have some flaws.  

As a first mover, the EU has inevitably had teething problems. The early incarnation of the SFDR has been significantly watered down. Some of the definitions are not yet clear, such as those over nuclear. Fund managers have been asked to disclose against a taxonomy that isn’t fully fleshed out and against corporate reporting that doesn’t exist yet. These problems should resolve with time and, more importantly, the UK and US should learn from them.  

The UK’s Sustainable Disclosure Requirements have a wider scope than those of the EU, with new ‘double materiality’ rules – where companies need to report the impact of the company’s activities on climate change and the environment alongside financial metrics. This should help combat narrow responses to environmental and sustainable development challenges. 

Equally, the UK is supporting an initiative from the International Sustainability Standards Board (ISSB) to develop proposed global standards for climate and sustainability disclosures.3  These standards build on the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and include industry-based disclosure requirements derived from the standards of the Sustainability Accounting Standards Board. This initiative is important because it would set international standards, making it more difficult for companies to slip through different systems. 

The ISSB’s proposal is clear that “financial reporting shall include a complete, neutral and accurate depiction of its sustainability-related financial information”.

Companies and fund groups that are really determined to avoid action on climate change may still find ways around these disclosure regimes. However, there is more and more scrutiny – from fund managers, from rating agencies and from regulators. While the disclosure regimes may not deliver change on day one, they help companies incrementally to move in the right direction.