The journey of the European authorities to establish trust in the market for sustainable finance products has just begun. Expectations of all European stakeholders involved in the process are extremely ambitious. The call to transition to a green-er economy has been sudden and unveiled new risks for investors and markets alike. Greenwashing being one of the most prominent.    

Instinctively though, we would assume that greenwashing risk impacts only consumers or investors in financial products. That is due to an original understanding, also validated by current regulation at European level, that greenwashing manifests itself exclusively as part of marketing practices. There is indeed another dimension to it. One that transcends the impaired investors’ ability to make sound decisions and affects entities and the broader financial markets.  

This is one of the findings of an initial progress report on greenwashing released by ESMA in May 2023. Requested by the European Commission, the aim of the report is to unveil areas within the sustainable investment value chain susceptible the most to greenwashing risk. The report also wants to provide additional technical input, distinguishing between greenwashing risk for investors and for the broader markets.  

Challenging the Regulatory Assumptions of Greenwashing Risk 

The report from ESMA unfolds from one of the commercial realities of the green transition in Europe. The fundamental mismatch between the sudden surging demand for ESG investment products and the current availability of assets deemed sustainable. The new need for firms and financial market participants to communicate about their sustainability profiles as well as their products creates a fertile ground for misrepresentation. In the run up to increase market share and revenues alike, market participants might end propping up their sustainability profiles.  

In the context of the EU taxonomy regulation, greenwashing is pegged as a marketing practice. Unfair competitive advantage is an essential component thereof, gained by means of presenting a financial product as environmentally friendly, whilst the basic environmental characteristics might have not been met. The report from ESMA attempts to expand this regulatory notion to support a more effective and encompassing prevention of greenwashing.  

Existing references to greenwashing across European regulation become necessarily limited according to the report. That is because they are conditioned by an original mono-dimensional view of greenwashing as a marketing practice. Accordingly, the focus on marketing communications and investment advice, as culprits of greenwashing risk and occurrence, needs necessarily to shift to other areas. Greenwashing risks can and will occur in other places throughout the value chain on sustainable investments and the entire lifecycle of products. Not always because of an action but also an omission. Other dimensions relevant to greenwashing risk can be present also at the issuer level rather than exclusively the products’ themselves.   

The approach adopted in the report is to challenge other basic assumptions with a view to expand the scope of greenwashing. In first instance, the connection with a potential competitive advantage. The materialising of a competitive advance should not be seen as a precondition for an occurrence of greenwashing. There is no systematic link, according to the report, between greenwashing and gaining of any such competitive advantage. The same should be said also for both intentionality of the conduct of greenwashing as well as the actual harm for investors.   

Expanding the notion of greenwashing risk by challenging assumptions so far purported to be core to the concept does not come without downsides. When moving from prevention to enforcement, we can see some of the limits of the approach proposed to divorce greenwashing risk from some of its core regulatory pillars. More namely, for what concerns the actual damage for investors. There are implications of this proposed approach, which could complicate and hinder some of the remedies available in the event of greenwashing risk occurrences. Especially the ones where a remedy could be actionable exclusively where there is a corresponding damage for an investor.  

Core Understanding and Characteristics of Greenwashing  

The report does not challenge the core understanding of greenwashing, which ultimately revolves around a misrepresentation of the sustainability profile of an entity, a financial product or financial services.  

Same as any other misleading practice, greenwashing can take place in different ways. Investors can be misled in their decision-making process because relevant false information is provided. But investors could also be misled when relevant information is omitted. Greenwashing represents the type of misconduct that does not necessarily result in a claim as such but can also materialise in misleading actions.  

For what concerns intentionality, as mentioned, that is not necessarily one of the required features for an occurrence of greenwashing to take place. Misleading sustainability-related claims can and do indeed occur also unintentionally. In the context of enforcement, the element of intentionality, be it direct or indirect – via negligence or lack or appropriate governance – could be considered as an aggravating factor in a greenwashing occurrence. In the eyes of ESMA, greenwashing can also occur at different stages of the lifecycle of a product and not necessarily in the marketing phase. That could as well be at the time of manufacturing and delivering a financial product or else in the monitoring phase.  

Lastly, it is not only a financial market participant as such that has the power to carry out a misleading action or make a misleading claim. Greenwashing can also be triggered by third parties.  

The Four Key Dimensions of Greenwashing 

The report identifies four key dimensions to greenwashing. The i) actors; ii) topics; iii) qualities; and iv) channels.  

The report identifies three main roles that can be played in an occurrence of greenwashing. The initiator or trigger, the spreader and the receiver. There might be different triggers at different levels in the value chain and all can be conveyed using the same channel. A misleading claim on sustainability could come for instance from the administrator or one underlying investee company of a fund.  These could all be conveyed using the same marketing communication. The role of the receiver does not usually change. It is usually either the investor or consumer.  

A misleading sustainability related claim can have several topics. As the sustainable finance market develops, the initial categories of susceptible claims as identified in the report will expand. However, at this stage it can be said that claims related to impact are the highest ones on the list of greenwashing sensitive topics. The same can be said for claims relative to ESG strategy, objectives and characteristics, as well as engagement with underlying investee companies. On the topic of engagement, claims both at entity and product level are both exposed to greenwashing risk. More namely, the report shows that one general engagement related topic that is prone to greenwashing risk is the one related to the general lobbying carried out by market participants. There seems to be inconsistency reported between the lobbying activities and the other sustainability claims promoted at entity and product level.  

The so-called greenwashing misleading qualities are the qualities through which a claim can mislead investors or consumers, organised under the two main brackets of omission and provision of information as follows: 

The premise contained in the report is that the above list of misleading qualities of greenwashing is not exhaustive. Moreover, one sustainability related claim can trigger more than one of the above-mentioned qualities. On average, cherry-picking, omission, ambiguity, empty claims, misleading use of ESG terminology and irrelevance are seen as the most widespread misleading qualities of greenwashing. The so-called cherry-picking or hidden trade-off seems to be the most dangerously common out of the misleading qualities of greenwashing. This practice consists of an approach of selecting disclosure, where a product is purported as sustainable based on a very limited set of attributes without considering the entire spectrum of the characteristics of the product, which may suggest otherwise in terms of its claim of sustainability.  

For greenwashing being considered still as a marketing practice from a regulatory standpoint, there is clearly a tendency to believe that marketing materials are the main channels for misleading claims on sustainability characteristics of investment products. As the concept evolves to encompass the entire value chain of sustainable investments, rather than concentrating on the marketing phase only, also constitutional and other regulatory documents might act as spreaders of greenwashing. The indication from the report is that these should not be overlooked. The introduction of sustainability labels for investment products heightens the risk of greenwashing for instance. Same as what happens with the names of investment products and funds, retail investors tend to rely exclusively on the fact that there is a label rather than trying to understand what the label stands for and whether it matches their appetite and profile for sustainability investment.  

Greenwashing Related Financial Risks   

In the face of a huge market opportunity represented by the green transition, there aren’t yet sufficient deterrents to greenwashing for financial markets participants. But a greenwashing occurrence could have a broader impact also on the stability and orderly functioning of financial markets. 

As mentioned, the report analyses greenwashing by adding a separate dimension to it. That is represented by the financial risks that an occurrence of greenwashing can have on market participants. One of the findings of the report is that market participants started to perceive greenwashing as a separate risk. One which requires mitigation and governance around it, same as any other type of risk.  

Privileged channels for spreading greenwashing risk on financial market participants are of course legal and reputational. In principle, even when greenwashing allegations end up being baseless and unfounded, entities involved in this type of cases expose themselves to reputational risk. The fact of being object of greenwashing allegations negatively affects the credibility of these firms with their investors. They might struggle to retaining market share for their products and other ensuing complications could materialise on their financial standing. There might be less appetite for the equity and debt instruments issued by these entities involved in greenwashing occurrences, with liquidity constraints experienced in relation to these instruments. In a chain of events not always predictable, capital misallocations can have further impact on the stability of the broader financial markets system.  

For the time being though, where we can say that there is a real reputational risk attached to greenwashing occurrences, there seems to be still little evidence of negative impacts on the broader financial standing of firms involved in greenwashing cases. Negative repercussions should not be ruled out altogether. Greenwashing is a new risk altogether for financial markets and it effects remain to be seen.   

Conclusions  

The report looks at greenwashing risk also on a sectorial basis and has interesting takeaways on investment management as an industry segment. Using the four dimensions identified in the report, the channels for greenwashing in the investment management environment are essentially marketing materials, fund names, labels and reports. To a lesser degree for the time being constitutional documents too shall be kept under the radar for greenwashing.   

One of the sustainability topics that seems to be prone to greenwashing is the one of engagement. The acquis from the report here seems to be that asset managers not very advanced on the ESG curve traditionally have used engagement to demonstrate their involvement with sustainability. When looking deeper at these engagement practices, it emerges that there is little information offered on the progress of the engagement and whether it actually results in decisions on portfolio composition of the products based on the specific engagement outcomes.