Good Governance to Guard Against Green Washing

With ESG highlighted as one of the Central Bank's main regulatory priorities for 2023, there is increasing scrutiny of how investment funds, fund management companies and asset managers are complying with their obligations. Eimear Keane (Walkers) discusses how boards of directors are now turning their attention towards potential greenwashing risks facing them and determining how such risks can be mitigated.

With environmental, social and governance ("ESG") highlighted as one of the Central Bank of Ireland's (the "Central Bank") main regulatory priorities for 2023, now more than ever there is increasing scrutiny of how investment funds, fund management companies and asset managers ("Managers") are complying with their disclosure, reporting and governance obligations under the Sustainable Finance Disclosure Regulation ("SFDR") and the Taxonomy Regulation.

Mindful of the focus of the European Supervisory Authorities ("ESAs")1, national competent authorities ("NCAs") and investors alike, boards of directors ("boards") are turning their attention towards potential greenwashing risks facing them and determining how such risks can be mitigated. In the face of increased regulatory, reputational and litigation risks2, boards will be focused on ESG disclosures, due diligence, tracking implementation of ESG integration policies and ensuring the methodologies underpinning the fund/Manager's ESG credentials are sufficiently robust.

In August 2023, the Central Bank commenced its common supervisory action ("CSA") engagement with the issuance of a detailed questionnaire to selected Managers. The Central Bank's work is split into two phases: phase one (due to conclude by 31 January 2024) will specifically address greenwashing risks and phase two (due to finish by 30 September 2024) will focus more generally on sustainability and disclosure risks. The Central Bank along with other NCAs will share knowledge and experience of their supervisory activities with ESMA3. The phase one findings will provide input to ESMA's final report on greenwashing due in May 2024. 

On 1 June 2023, ESMA published its progress report in response to a request for input from the European Commission (the "Commission") on greenwashing in the financial sector. ESMA together with the ESAs put forward their common high-level understanding of greenwashing as follows:

“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 services. This practice may be misleading to consumers, investors, or other market participants”.

ESMA's progress report emphasises high-risk areas 

ESMA's progress report emphasises high-risk areas for investment managers, including, but not limited to:

• Impact claims;

• Statements about engagement with investee companies;

• Fund and benchmark naming issues;

• Claims about governance around ESG;

• Insufficient transparency about the ESG strategy; and

• Lack of binding commitment to sustainable characteristics and objectives.

The Central Bank plans to publish additional clarifications and hold workshops with industry stakeholders to discuss how funds should meet their disclosure obligations. In the interim, the Central Bank has recently identified some disclosure findings, which should be considered. In particular, the Central Bank expects that the minimum proportion of the portfolio allocated to sustainable investments with an E or S objective, must be accurate and not subject to change (unless updated in the prospectus).

Regulatory remediation of greenwashing risk

The sustainability amendments to the AIFMD and UCITS frameworks seek to ensure that sustainability risks are taken into account as part of organisational structure, decision-making procedures and internal control mechanisms of Managers. A key focus of the CSA relates to the demonstration of the integration of sustainability risk including responsibility for managing greenwashing risk, its interpretation and on the application of safeguards to address any potential greenwashing risks.

A number of regulatory measures are underway to seek to remediate greenwashing risk. Such measures include ESMA's proposed guidelines on the use of ESG or sustainability-related terms in funds' names4. Managers and fund boards will need to examine closely the wording of the thresholds once the new naming guidelines are implemented given their potential to trigger a further wave of fund name changes and/or associated compliance obligations. On 2 October 2023, ESMA published a risk analysis report outlining the results of its disclosure study on ESG names and claims in the EU funds industry5. This analysis highlights the use of SFDR designations as proxy ESG labels and the increased usage of ESG terms in marketing materials and KIID/KIDs compared with the prospectus.

ESMA's progress report identified a number of possible regulatory remediation actions including clarifications regarding the concept of contribution to a sustainable objective and addressing the misuse of SFDR as a labelling regime. On 14 September 2023, the Commission published its consultation on the implementation of SFDR including two potential product categorisation systems due to persistent concerns that the current market use of SFDR as a labelling scheme might lead to risks of greenwashing. The two optional frameworks are: (1) converting Article 8 and 9 of SFDR into formal product categories which would involve introducing minimum criteria for each category of product and clarifying existing concepts such as "sustainable investments", do no significant harm ("DNSH") and "E/S characteristics"; or (2) a new product classification system based on the type of investment strategy which would be broken into four new categories potentially aligning with those of the UK's SDR regime.

Regard also needs to be had to any outcome from ESA's consultation on SFDR Level 26, which proposes adding product disclosures concerning decarbonisation targets and proposed changes to the DNSH criteria. The Commission has since published a Taxonomy notice containing FAQs, which confirm that investments in taxonomy-aligned environmentally sustainable economic activities can be automatically qualified as sustainable investments under SFDR. The Commission has also published a proposal with regard to regulating ESG rating providers  and proposals for a Green Claims Directive  and a consumer protection-focused directive to combat unfair commercial practices that mislead consumers away from sustainable consumption choices. At the same time, the European Sustainability Reporting Standards ("ESRS") have been adopted under the Corporate Sustainability Reporting Directive7 commencing from January 2024, including phased-in application for corporates over subsequent financial years. Such standards will increase the quality of the data over time available to Managers including standardised audited reporting on GHG emissions and transition plans.

Good governance to guard against greenwashing risk

The board and senior management's role in guarding against greenwashing should act as a key mitigating factor. In its cross sectoral analysis of greenwashing, ESMA noted that ESG governance "may induce greenwashing by setting targets and asking for outcomes without providing adequate means to reach the objectives"8. Where such objectives/metrics are treated with the same importance as other fiduciary duties linked to a fund's prospectus9, this serves to guard against greenwashing risk.  

Managers need to review policies and procedures and identify clear greenwashing risks facing them. Horizon scanning and training related to best practices and combatting greenwashing risk remain key. ESG integration is set to remain an agenda item with ESG disclosures, fund/Manager ESG credentials and marketing materials being considered for periodic review. At a minimum, Managers and fund boards need to ensure that the Manager's and delegate reporting provides key metrics for sustainability claims, that these match the portfolio composition and minimum binding commitments in relation to sustainable investments are disclosed and are consistently adhered to. Particular attention should be paid to engagement strategies including an assessment of interim targets, divestment triggers and consideration of the use of existing disclosure requirements under SRD II10 in defining such strategies.11

Whilst regulatory and legislative remediation measures are to be welcomed, good governance and clear ownership of sustainability risks and ESG issues by boards will immediately seek to promote a culture that guards against greenwashing risk.

References

1 ESMA, EBA and EIOPA.

2 See Grantham Research Institute on Climate Change and the Environment's Global Trends in climate change litigation: 2022 snapshot. https://www.lse.ac.uk/granthaminstitute/wp-content/uploads/2022/08/Global-trends-in-climate-change-litigation-2022-snapshot.pdf  The UK court decisions in Okpabi v Shell [2021] UKSC 3 and Begum v Maran [2021] EWCA Civ 326 while not yet at final determination stage, emphasise the importance of robust internal policies and procedures throughout the corporate chain which are reviewed and reported on at regular intervals.

3 ESMA launched its CSA with NCAs on sustainability-related disclosures and integration of sustainability risks on 6 July 2023.

4ESMA TRV Risk Analysis ESG names and claims in the EU fund industry ESMA50-524821-2931 2 October 2023. ESMA used natural language processing ("NPL") techniques to analyse the names of more than 36,000 funds with €16 trillion of assets combined with a dataset of over 100,000 fund documents.

5Joint Consultation Paper, Review of SFDR Delegated Regulation regarding PAI and financial product disclosures (JC 2023 09) 12 April 2023

6Corporate Sustainability Reporting Directive (EU) (2022/2464)

7 ESMA's Report on Greenwashing Response to the Commission's request for input on "greenwashing risks and the supervision of sustainable finance policies", para 46 ("ESMA's Progress Report").

8See ESMA's Progress Report, para 102 for related commentary.

9 Shareholders' Rights Directive (EU) 2017/828 amending Directive 2007/36/EC (SRD II Directive) 

10 See ESMA's Progress Report, para 171.