The global rise of ESG investments in recent years has brought increasing greenwashing behaviors from investment product providers. Greenwashing is known as a cheating practice in which companies exaggerate their environmentally friendly approaches to gain more benefits. The phenomenon becomes more and more common as ESG funds emerge as one of the hottest items on Wall Street. Globally, ESG funds received USD649bn in 2021, marking a 56% increase from the USD285b received in 2019. Incentivized by the allure of ESG funds, investment managers rushed to slap an ESG label on everything, sometimes without due diligence. As a result, greenwashing becomes a legitimate concern.
To curb rampant greenwashing, in early June, the United States Securities and Exchange Commission (SEC) launched an investigation into Goldman Sachs for possibly overstating its ESG criteria for some mutual funds, sending a strong signal to the financial industry that the campaign against greenwashing has begun. This investigation followed closely the SEC’s USD1.5m settlement in May with BNY Mellon Investment Advisers. BNY Mellon was fined for misstatements and omissions regarding its ESG criteria for assessing investments. These events have been seen by observers as a turning point for the asset management industry, as they believe the industry is now under pressure from regulators and law enforcement over greenwashing.
SEC proposed ESG disclosure and naming rules for investment advisers and funds
The SEC proposed two major rule changes to counter greenwashing. Proposal one is the Names Rule (Rule 35d-1) for investment product names, and proposal two is a set of ESG disclosure rules for registered investment companies, funds, and advisers.
Proposal one requires investment products to be labeled truthfully. For example, registered investment companies whose names suggest a focus on a particular type of investment must invest at least 80% of the value of their assets in those investments. Furthermore, fund providers are not permitted to label their products as ESG unless their investment process relies on ESG more than other factors. To illustrate the problem of greenwashing in naming and labeling, a study by corporate social responsibility non-profit As You Sow published earlier this year found that 60 out of 94 funds labeled as ESG products lacked ESG conviction, and many of these funds contained fossil-fuel investments. Fund providers must think about sustainability in a way that involves changing their investment philosophies rather than simply repackaging funds as ESG products.
Proposal two seeks to prevent greenwashing in the strategies employed by investment advisers and investment companies. For fund companies, the SEC outlined layered disclosure requirements for different levels of ESG use. For example, integration funds would face the lowest disclosure requirements while ESG-focused funds would require detailed disclosure and a standardized ESG strategy review table. Meanwhile, impact funds face the highest disclosure requirements, as they would need generally similar disclosures in their brochures with respect to their consideration of ESG factors in the significant investment strategies or methods of analysis they pursue and report certain ESG information in their annual filings to the SEC.
Addressing greenwashing in other jurisdictions
Besides the United States, other jurisdictions also spared no effort to strengthen supervision over greenwashing. Regulators are actively improving and unifying ESG-related standards and putting forward new requirements for asset managers in terms of ESG product definition and classification as well as information disclosure. The EU and Hong Kong are two of the more proactive jurisdictions that are enhancing their financial regulations in light of greenwashing concerns.
The EU is set to become a front runner in setting global sustainability reporting standards. One of the EU’s key regulations to regulate the ESG finance market is the Sustainable Finance Disclosure Regulation (SFDR), which came into force on March 10, 2021. The SFDR raised the bar for investment products, especially those seeking to promote ESG and those with sustainable objectives, by setting strict minimum-disclosure standards. It requires fund managers to provide information about the ESG risks and negative impact of their investments on the planet and society for the first time. Financial market participants and advisers will need to provide both entity-level information and product-level information. Entity-level information should be disclosed publicly on their websites while product-level information needs to be added to pre-contractual documents and periodic publications.
To help investors identify suitable ESG funds and reduce opportunities for greenwashing, in June 2021, the Hong Kong Securities and Futures Commission (SFC) issued a circular to management companies of SFC-authorized unit trusts and mutual funds to enhance disclosure for funds that incorporate ESG factors as a key investment focus. It requires the managers of collective investment schemes (CIS) to consider climate-related risks in their investment and risk management processes and make appropriate disclosures about their methodology for ESG funds. The SFC has laid out specific criteria for ESG-focused funds on disclosures, strategy, and standards. The proposed requirements help ensure that fund managers properly deal with climate-related risks and promote clear, comparable, and high-quality disclosure.
Regulation and Market: the Collaborative Effort to Curb Greenwashing
All in all, these regulations might help alleviate some greenwashing, but the long-term solution will depend on a balanced mix of regulatory forces and market-based measures. Aside from responding to risks from financial regulators, the financial industry should change its perspective and be more intentional about the social and environmental implications of capital. On the other hand, while regulatory efforts to handle greenwashing issues are welcomed, supervision should be proportionate to make sure that investors are not discouraged from creating sustainability-focused products due to burdensome requirements. Ensuring the verity of ESG and sustainability in the financial sector takes a coordinated effort between supervising bodies and fund managers.
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