Greenwashing in financial services: rising regulatory temperature

A core goal of COP26 is to mobilise finance. It aims to make good on developed countries’ promise to mobilise at least $100bn in climate finance per year by 2020, placing greater pressure on international financial institutions to play their part in this effort.¹

COP26 may therefore usher in an unprecedented public demand for green financial products and a burgeoning supply of such products in the market. Whilst this may have the positive effect of advancing the fight against climate change, a booming market may also heighten existing regulatory risks. One such core risk is “greenwashing”, the practice of exaggerating a company's or product’s green credentials, thereby misleading consumers and hindering meaningful climate action.

This article provides an overview of greenwashing in financial services and the rising regulatory temperature in this area. The article takes a UK financial regulatory perspective, exploring:

1. the conduct that might be considered greenwashing;
2. four key regulatory initiatives being taken to mitigate the greenwashing risk; and
3. practical tips for firms to consider in order to manage legal and reputational risk and safeguard against greenwashing allegations.

I. Identifying greenwashing

Greenwashing is a growing priority for the UK Financial Conduct Authority (“FCA”), and a key component of its broader core strategy tackling environmental, social and governance (“ESG”) issues which it has focused on over the past few years.

The FCA has defined greenwashing as “marketing that portrays an organisation’s products, activities or policies as producing positive environmental outcomes when this is not the case.”² The primary regulatory aim for protecting against greenwashing is to ensure that consumers have access to green financial products and services that meet their needs and preferences.³

Whilst the FCA’s definition and regulatory rationale in relation to greenwashing are straightforward, in practice, it can be incredibly difficult to determine whether something amounts to greenwashing. For example, the term “sustainable” is often applied to green products. However, assessing what amounts to “sustainable” may depend on sectoral or regional differences. Moreover, it can be difficult to determine the net impact of a financial product in supporting sustainability goals.⁴

Helpfully, in July 2021 the FCA provided examples of conduct that might fall within the ambit of greenwashing. These include:⁵

1. A passive fund having an ESG-related name which tracked an index that did not hold itself out to be ESG-focused. The fund in question also had very limited exclusions from the index, based on high-level ESG criteria.
2. An investment strategy to invest in companies contributing to ‘positive environmental impact’ where the intended investments were predominantly in companies that, while reporting low carbon emissions, would not obviously contribute to the net zero transition. The FCA expected to see a measurable non-financial objective alongside the financial objective or strategy with information on how that impact would be measured and monitored.
3. Instances where it was challenging to reconcile a fund’s proposed holdings with statements made setting expectations for consumers. The FCA gives the example of a sustainable investment fund containing two ‘high-carbon emissions’ energy companies in its top-10 holdings, without providing obvious context or rationale behind it (e.g. a stewardship approach that supports companies moving towards an orderly transition to net zero).

It is important to note that each of the above examples is potentially actionable under existing FCA regulatory requirements.

Notably, Principle 7 of the FCA’s Principles for Businesses requires firms to pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading. Additionally, the requirement in the Conduct of Business Sourcebook (COBS) at COBS 4.2.1R requires that firms must ensure their communications and financial promotions are fair, clear and not misleading.⁶

Accordingly, as discussed further below, whilst the regulatory response to greenwashing is evolving, the FCA’s ability to assert regulatory breaches in respect of this conduct is already on the books.

II. Key regulatory initiatives

In response to the rising greenwashing risk, regulators have produced a wealth of material directed at mitigating this issue. Four key regulatory initiatives, which are likely to have a long-standing practical impact on the landscape, are set out below.

1. Central Government’s Green Technical Advisory Group (“GTAG”)⁷

On 9 June 2021, the UK Treasury announced a new independent expert group to oversee the Government’s delivery of a “Green Taxonomy”, a common framework which clearly defines which economic activities count as environmentally sustainable. It is hoped that the common framework will clamp down on greenwashing, assist consumer and investors of all sizes to make more informed investment decisions and support businesses as they plan to transition to net zero. The GTAG will also advise the Government of implications and recommendations for any deviations from existing international frameworks or taxonomies.

The GTAG is made up of financial and business stakeholders, taxonomy and data experts, and subject matter experts drawn from academia, NGOs, the Environment Agency and the Committee on Climate Change. The FCA, Bank of England and HM Treasury are observers to GTAG. The group is expected to run for at least two years. GTAG was scheduled to provide initial recommendations to the Government in September 2021.

2. The Financial Reporting Council (“FRC”) UK Stewardship Code 2020⁸

The FRC’s revised UK Stewardship Code took effect on 1 January 2020 and sets high stewardship standards for asset owners (e.g. pension schemes and insurers) and asset managers (who manage assets on behalf of UK clients or invest in UK assets), and for the service providers (e.g. investment consultants, proxy advisors, and research providers) that support asset owners and asset managers.⁹ Notably, Principle 7 of the revised Stewardship Code requires signatories to “systematically integrate stewardship and investment, including material environmental, social and governance issues, and climate change, to fulfil their responsibilities.”¹⁰ Under this principle, signatories are required to disclose the ESG issues they have prioritised for assessing investments, prior to holding, monitoring through holding and exiting. The revised Stewardship Code has been referred to as a “green-washing code”¹¹, especially for FCA-regulated asset management firms covered by COBS 2.2.3R who are required to disclose the nature of their commitment to the code or, where they do not commit to the code, their alternative investment strategy.¹²

In order to become a signatory to the revised code, organisations must submit a Stewardship Report to the FRC demonstrating how they have applied the code’s Principles in the previous 12 months. In September 2021, the FRC released the first signatory list for the revised code. Of 189 applicants, 125 made the list of signatories representing £20 trillion of assets under management. In relation to successful outcomes, the FRC expressly noted that it was pleased to see better integration of stewardship and ESG factors into investment decision-making, reporting on asset classes other than listed equity and identifying the outcomes of their efforts. With respect to the third of applicants that failed to pass the review process, the FRC noted that these organisations commonly relied too heavily on policy statements, rather than sufficiently evidencing their approach.¹³ This indicates the practical focus of the revised code and its potential to effect real change in the fight against greenwashing.

3. The FCA’s proposed Environmental, Social and Governance (“ESG”) Sourcebook¹⁴

On 10 September 2021, the FCA closed a consultation seeking to introduce a new ESG Sourcebook in the FCA Handbook setting out proposals to introduce climate-related financial disclosure rules and guidance for asset managers, life insurers, and FCA regulated pension providers. The proposals in the ESG Sourcebook are consistent with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (“TCFD”), published in June 2017. The FCA notes that key elements of the proposals are:

• Entity-level disclosures: in-scope firms would be required to publish, annually, an entity-level TCFD report on how they take climate-related risks and opportunities into account in managing or administering investments on behalf of clients and consumers.
• Product or portfolio-level disclosures: in-scope firms would be required to produce, annually, a baseline set of consistent, comparable disclosures in respect of their products and portfolios, including a core set of metrics.

Whilst the FCA anticipates that the ESG Sourcebook will expand over time to include new rules and guidance on other climate related and wider ESG topics, the initial focus on disclosure rules indicates how seriously the regulator is taking the greenwashing risk. The FCA hopes that the proposed rules will help clients and consumers make better informed decisions about their investments, ultimately enhancing competition in the interests of consumers, protect consumers from unsuitable products, and drive investment towards greener projects and activities. The FCA is aiming to publish a policy statement setting out its final ESG Sourcebook rules in 2021.

4. The FCA’s proposal for enhanced climate-related disclosures by standard listed companies¹⁵

On 10 September 2021, the FCA also closed a consultation proposing to extend the application of its climate related disclosure requirements for commercial companies with a UK premium listing to issuers of standard listed equity shares (excluding standard listed investment entities and shell companies). These disclosure requirements reference the recommendations published by the TCFD in 2017.¹⁶

The proposals would amend the FCA’s Listing Rules to require issuers of standard listed equity shares (excluding standard listed investment entities and shell companies) to include a statement in their annual financial report setting out:

• whether they have made disclosures consistent with the TCFD’s recommendations and recommended disclosures in their annual financial report;
• where they have not made disclosures consistent with some or all of the TCFD’s recommendations and/or recommended disclosures, an explanation of why, and a description of any steps they are taking or plan to take to be able to make consistent disclosures in the future and the timeframe within which they expect to be able to make those disclosures;
• where they have included some, or all, of their disclosures against the TCFD’s recommendations and/or recommended disclosures in a document other than their annual financial report, an explanation of why; and
• where in their annual financial report (or other relevant document) the various disclosures can be found.¹⁷ 

The FCA is proposing to issue guidance to help in-scope companies determine whether their disclosures are consistent with the TCFD’s recommendations and recommended disclosures.¹⁸

In terms of the greenwashing risk, the FCA indicates that the proposed change will make it easier for financial services firms to design and structure products involving standard listed equity shares to reliably disclose to consumers how their products are exposed to climate change risks and opportunities. This could lower the risk that consumers buy unsuitable products.¹⁹ The FCA is expected to publish the finalised updated Listing Rules in relation to this proposal by the end of 2021.

The above initiatives show that UK financial services regulators are increasingly serious about tackling greenwashing, particularly through a more rigorous approach to the presentation of climate related product information. Whilst a number of the disclosure related initiatives currently take a ‘comply or explain’ approach, providing a degree of compliance flexibility, some market participants regard this as an interim step towards mandatory disclosure obligations.²⁰ It follows that in-scope firms should take these initiatives seriously and use the current approach to build their capabilities in this area.

III. Practical risk mitigants for firms

Whilst businesses will need to assess their systems and controls to prevent greenwashing on a case by-case basis, to limit regulatory, litigation and reputational risk, it is critical that they should prioritise establishing a clear set of internal procedures to manage climate-related disclosures. Helpful measures in this regard will include:

1. Training employees to ensure they have a greater understanding of what constitutes greenwashing as well as an awareness of the FCA’s growing focus on ESG related disclosures.
2. Implementing an internal assessment process to scrutinise information underlying a product’s represented green credentials and those of any underlying investments to which it is exposed.
3. Ensuring those involved keep a clear documentary record of decisions taken on an individual investment and product-by-product basis covering the ESG issues they have assessed prior to holding, monitored through holding and on exiting.
4. Seeking third party advice on product sustainability assessments where necessary. In many cases the technical expertise required to understand the real sustainability of an underlying green scheme or technological solution will be beyond investment professionals, lawyers, accountants and compliance officers who are engaged in such assessments.
5. Instituting a reporting process by which the green credentials marketed are regularly monitored to ensure they remain up-to-date, accurate and objective.

Importantly, as indicated by the FRC’s approval process for signatories to the revised UK Stewardship Code, firms should be able to provide practical evidence of their approach rather than relying too heavily on policy statements.

Final thoughts

The COP26 conference is likely to increase the supply and demand for green financial products. Whilst supporting the fight against climate change, a growing market in green financial services presents an increased risk of greenwashing. UK financial regulators are therefore rightly increasing their focus on this area. Tackling greenwashing is crucial for market confidence and ensuring a concrete response to tackling climate change, encouraging positive corporate cultural shifts.

Businesses must meet the rising regulatory temperature and prioritise their implementation systems and controls to tackle greenwashing. Up-to-date, accurate and objective climate-related disclosures will be particularly important. Practical evidence demonstrating the integration of ESG factors into the lifecycle of all investment decisions will also be key. Papering pretty policies is not enough. Importantly, FCA regulated firms should be aware that existing regulatory requirements may be used to enforce against greenwashing. Failure to prioritise the growing greenwashing risk now may lead to regulatory, reputational and litigation risks boiling over.