What Europe's greenwashing crackdown means for Australia

New greenwashing regulations

With the increasing interest from investors in sustainable and ethical investment solutions, there has been a corresponding increase in ESG fund launches trying to capture a slice of the lucrative green investment market. Unfortunately, this has sometimes led to "greenwashing" – misrepresenting an investment product as having ESG components ^[1].

While little has come to bear on the market in Australia in terms of greenwashing regulation, in 2011, the first Australian guideline on greenwashing, titled 'Green marketing and the Australian Consumer Law,' was published in the Competition and Consumer Act 2010 ^[1]. In addition, the Australian Securities and Investments Commission (ASIC) has also issued a recent guidance note to define the problem for investors ^[2].

Abroad, the European Commission has created an ambitious legislative scheme to regulate the market for ESG investment products in the form of The Sustainable Finance Disclosure Regulation (SFDR) ^[3]. This may become a template for regulation within Australian markets, considering the issue of greenwashing is on the radar of local legislators. But, for the moment, we are in a unique position to observe the implementation of SFDR and how it shapes the financial services sector in Europe. We can remain informed about what future regulation may come to our shores and what shape it could take.

So what exactly is SFDR legislation?

The SFDR legislation was introduced with two noble goals ^[3]:

1. To improve transparency in the market for sustainable investment products so investors can make informed decisions about their ESG investment strategies.

2. To prevent greenwashing, ensuring that asset managers cannot simply brand a product with an ESG or sustainable label without being transparent about how this is achieved.

The SFDR was developed to tackle the issue of greenwashing in the financial services sector and create a disclosure system to support the ESG credentials of different investment products within Europe. The requirements have been released in stages, with SFDR Level 1 already in effect and requiring financial institutions in the EU to report on sectors they've invested in and their portfolios of companies.

SFDR Level 2 will go into effect on January 1, 2023, and requires investment managers to publish regulatory technical standards (RTS) detailing the asset manager's policy for analysing the negative impacts of its investments on sustainability and product-level disclosures for ESG-focused products.

Asset managers must disclose the different levels of sustainability integration according to the below articles ^{[4] [3]}:

· Article 6 products may include environmental, social, and governance (ESG) risk considerations in the investment decision-making process, or they explain why sustainability risk is not relevant. They do not meet the additional criteria of Article 8 or Article 9 strategies.

· Article 8 products promote social and/or environmental characteristics and may invest in sustainable investments but do not have sustainable investing as a core objective.

· Article 9 products have a sustainable investment objective aligned with the EU Taxonomy. These must only be sustainable investments.

What's the catch?

It sounds simple enough on the face of it, but the legislation in its current form has prompted many questions regarding interpretation and implementation, with the European Fund and Asset Management Association (EFAMA) and Eurosif raising concerns about the lack of clarity in the new regulations ^[5]. Despite this, the law takes effect in less than two weeks and will broadly impact all financial market participants and advisers based in the EU.

The European System of Financial Supervision has recently submitted a document to the European Commission seeking to clarify elements of the SFDR, such as the definition of sustainable investment and if strategies tracking a Paris-aligned or Climate Transition Benchmark can fulfill certain requirements ^[5]. Questions of whether ESG funds should be developed based on hard exclusions of industries or if the "path of transition" is given weight, for instance, can lead to substantial administrative burdens for fund managers to develop in-house data capture that may or may not align with final rulings out of Brussels when they do eventually come.

With much of the ESG data sourced from third parties, based on estimates, strategies, or intentions ^[1], there is often a lack of correlation between ESG ratings supplied by different providers ^[6]. In particular, the lack of consistency in ratings between the big three houses - S&P, MSCI, and Sustainalytics - has raised eyebrows, calling into question the relevance of their actual scoring. To avoid doubt, managers need to supplement these backward-looking measures with forward-looking forecasts generated by manual interaction with investee companies. The elaborate data ingestion and manual engagement with companies have required a significant spend in personnel and system build to capture the data, score it and report on it within firms ^[5], with European fund managers anecdotally quoting 40 odd staff dedicated to their ESG departments.

And there are risks of getting the environmental, social, and governance classifications wrong, including losing the ability to market a fund as ESG or sustainable if the fund is downgraded from Article 8 to Article 6 ^[7]. There has already been a cycle of downgrades from Article 9 to Article 8 as regulatory updates have been released, clashing with strategies developed at the firm level by fund managers trying to interpret and apply the legislation ^[7]. To disclose their funds' ESG credentials correctly, fund managers are not just looking at simple ingestion of the overall ESG rating but detailed data points regarding Scope 1, 2, and 3 CO2 emissions, revenue breakdowns, and other measurements against UN Sustainable Development Goals (SDGs). These are expensive data points and come at a considerable cost to managers.

Ultimately, it begs the question as to whether Brussels has put the cart before the horse in requiring a high level of disclosure and reporting at both the firm and product levels regarding ESG ratings, even though the regulation and the ESG data itself lacks clarity and consistency while rating methodologies lack transparency and comparability.

Conclusion

As the EU prepares to implement Level 2 disclosures in January, it's faced with two significant challenges ^[8]:

1. The undefined and confusing nature of the current legislation

2. The general lack of transparent, consistent, and affordable ESG data

The SFDR regulation was developed to tackle the issue of greenwashing, and it will likely reduce incidences of greenwashing and improve disclosures about ESG credentials. However, the extent and cost to fund managers pursuing an ethical, sustainable, or impact strategy may be a significant deterrent in the future, limiting it to only the most prominent investment houses with the means to deliver it compliantly.

With a similar growth in interest of the ethical investor, it is only a matter of time before increased regulation around ESG funds hits our shores. Whether we see the same degree of legislation is another thing. Improving data and standardising reporting will go a long way to reducing the burden on fund houses and will create a more level playing field for all investment managers rather than those with the financial means to access the information needed to deliver the strategy and continue to allow Australia's investors the breadth of choice in ethical investments.

References

[1] J. Cairns, “The very real risk of greenwashing,” 19 September 2022. [Online]. Available: (VIEW LINK).
[2] ASIC, “How to avoid greenwashing when offering or promoting sustainability-related products,” June 2022. [Online]. Available: (VIEW LINK).
[3] J.P. Morgan Asset Management, “EU SFDR Explained: A guide to the EU Sustainable Finance Disclosure Regulation for investors,” 28 July 2022. [Online]. Available: (VIEW LINK).
[4] Rio, “What are Sustainable Financial Disclosure Regulations?,” 5 October 2022. [Online]. Available: (VIEW LINK).
[5] D. Webb, “SFDR clarifications 'could cause huge burden' for asset managers,” 15 November 2022. [Online]. Available: (VIEW LINK).
[6] OECD, “ESG Investing and Climate Transition: Market Practices, Issues and Policy,” 2021. [Online]. Available: (VIEW LINK).
[7] F. Schwartzkopff, “Fund managers brace for ESG correction with $US4trn at stake,” 12 December 2022. [Online]. Available: (VIEW LINK).
[8] M. Raab, “Why blanket acceptance of current EU ESG regulation has reached a dangerous turning point. We, the financial community, must make ESG investing attractive again—and not a disdained minefield.,” December 2022. [Online]. Available: (VIEW LINK).
[9] S. Pellegrino, “Explainer: What are the SFDR regulations?,” 18 September 2022. [Online]. Available: (VIEW LINK).