Regulating ESG Investments Becomes More Pressing Amidst Greenwashing Trends

The 27th Conference of the Parties to the United Nations Framework Convention on Climate Change, or COP27, is convening in the Egyptian coastal city of Sharm el-Sheikh between the 6th and 18th of November 2022. The conference seeks to tackle global climate emergency issues: how to reduce greenhouse gas emissions, adapt to the effects of climate change and finance climate action in developing countries. The conference seeks to build on the Paris Agreement in 2015, which set out goals to guide nations on how to reduce global greenhouse gas emissions and limit global temperature increase to two degrees Celsius. The agreement is a legally binding international treaty with 194 signatory Parties. 

The issue of climate change and financing the fight against it are nothing new. Environmental, Social, and Governance (ESG) investing has been rising for the last decade. ESG incorporates a broad set of principles that socially responsible investments should follow and are sometimes commingled with “green” investments, which focus primarily on environmental impact. While there is no clear taxonomy for ESG, it broadly aims to curtail the effects of climate change, carbon emissions, environmental pollution, deforestation and water scarcity. The non-environmental categories of ESG encompass a wider scope, including community impact, human rights, diversity in company boards, bribery, and corruption. A report by the consulting firm Deloitte published earlier this year estimated $39 trillion of assets in 2020 were ESG-focused versus $19 trillion in 2014. This represents 36 percent of total global investments in 2020. The magnitude and proportion of ESG investments are expected to rise dramatically in the coming years, reaching $96 trillion by 2025 and representing 58 percent of worldwide investments. Other measures put the projected amount invested in ESG funds at a few trillion dollars. What is indisputable is that this sector is proliferating.

As interest in the environment and sustainability has increased, so has regulatory focus. In 2021, the European Union introduced its Sustainable Finance Disclosure Regulation, which requires asset managers to provide information regarding their adherence to ESG investment standards. Three categories were introduced in classifying investment funds: article six funds, which do not take sustainability into account; article eight funds, which promote ESG practices; and article nine funds, which is the highest ESG category, with sustainability at the heart of its investment policies. Moreover, since August 2022, the Markets in Financial Instruments Directive II, a regulation seeking to protect investors and standardize practices across the European Union, now requires financial advisors to evaluate not only the client’s risk tolerance but also their preferences for environmentally sustainable investments. 

The regulatory changes by the union are timely and possibly the beginning of a worldwide regulatory convergence in how to classify environmentally responsible investments. The changes have come against a background of mis-selling and misrepresentation by some of the world’s largest asset managers. DWS, Deutsche Bank’s asset management arm, recently saw its CEO step down after evidence emerged that the firm failed to classify investments labelled ESG against the necessary criteria correctly. The term “greenwashing,” which aptly describes DWS’s behavior, is one where a company tries to portray itself as more socially responsible and environmentally friendly than it is. The company may not meet the necessary standards and continue investing in environmentally harmful businesses. A German consumer group recently filed a lawsuit against DWS alleging that its ESG Climate Tech fund was marketed as having zero percent investments in polluting sectors such as coal. Yet, the fund’s investment policy allowed for investments in companies where up to 15 percent of their revenues could be generated from these harmful industries. The problems faced by DWS are not a one-off event, and the prevalence of misrepresentation of what investment funds are doing versus what they are advertising is an issue concerning regulators beyond the European Union, with the U.S. Securities and Exchange Commission and the U.K.’s Financial Conduct Authority reviewing both conduct and current regulation.

Promoting finance to tackle climate change in developing countries is one of the pillars of the Paris Agreement. Yet the investment world, which seemingly has a never-ending stream of scandals and mis-selling driven by greed and a lack of ethics, is yet again undermining an existentially important focus. As the awareness of climate change has begun to alter the behavior of both individual and institutional investors and centered them on environmentally positive goals, the investment world must step up and learn to police itself. Regulators will eventually catch up and create guidelines, but the intermediaries have a significant role as time passes and environmental catastrophe descends on humanity. Let us hope that the outcome of COP27 is a clear message to the investment industry that it needs to address these shortcomings and take substantial steps to finance positive change.