Financial institutions a growing target amid global greenwashing crack down - Financial Services

Financial institutions face increasing exposure to greenwashing allegations, and the interest from regulators and litigants that follows, extending to a range of ESG commitments broader than just those relating to emissions.

The fact that this exposure needs to be carefully managed was demonstrated when Germany's leading asset manager was recently raided by German police. This raid occurred amid allegations that the entity had made false and misleading statements about the extent to which it invested client assets using ESG criteria.

Key global 'greenwashing' developments

In a previous Insight we discussed how the rush by organisations to meet 'net-zero' emissions and other climate-related commitments could leave them exposed to a risk of litigation for engaging in 'greenwashing'.

However, internationally, there have been several key developments that now highlight increasing scrutiny of 'ESG' funds and financial products.

In 2021 the US Securities and Exchange Commission (SEC) and BaFin, the German Federal Financial Supervisory Authority, launched separate investigations into Germany's leading asset manager following allegations by its former head of sustainability that it had overstated how it used sustainable investing criteria to manage client investments.

German prosecutors who instituted the raid are reported to have said that sufficient factual evidence had emerged to show that ESG factors were not taken into account at all in a large number of investments, contrary to representations contained in prospectuses issued by the asset manager.

In May 2022, the SEC fined the investment management arm of a global banking services firm US$1.5 million for alleged misstatements that investments in certain mutual funds had undergone ESG quality review, when in fact that review had not occurred. The investigation which led to that fine had involved the Climate and ESG Task Force within the SEC's Enforcement Division. That Task Force had been formed in March 2021 with a mandate to, among other things, analyse disclosure and compliance issues relating to investment advisers' and funds' ESG strategies.

The SEC has also proposed a pair of new rules to create a disclosure and reporting framework for funds regarding their ESG practices, and to place restrictions on fund names including ESG terms unless ESG factors play a central role in the fund's investment strategy. Just days before the SEC announcement, the European Securities and Markets Authority published a similar supervisory briefing to guide the enforcement of naming conventions of investment funds - particularly around ESG compliance.

What do these international developments mean for Australia?

The Australian financial services market has seen a similar increase in ESG themed financial products and Australian financial institutions are increasingly committing to ESG due diligence or criteria guiding their investment decisions. This has been reflected in the sharp rise in ESG-focused superannuation products, exchange traded funds (ETFs) and other managed investments available in the market.

In 2021, the growth rate of Australian-listed ESG ETFs was greater than that of non-ESG ETFs. There has also been an increase in commitments by financial institutions to specific ESG-related targets as well as promotion of their broader ESG missions.

International experience tells us that the increase in availability of ESG-related financial products is likely to be followed by an increase in supervision, regulation and enforcement of those products. Australian regulators have already signalled their intention to take a closer look at ESG disclosures and compliance.

In March 2022, ASIC announced it was undertaking a review into whether the promotion of managed investment and superannuation funds as ESG-focused or 'green' was actually aligned with the underlying product offering. This is part of a broader engagement by ASIC in climate-related disclosures which ASIC Chair Joe Longo has said is a priority for ASIC, while intimating that the UK and New Zealand are further advanced in this ESG reporting by listed companies. ASIC has since issued some practical guidance on how to avoid greenwashing when offering or promoting sustainability-related products.

At the same time, the ACCC released its annual compliance and enforcement priorities for 2022/2023 which included close scrutiny of "businesses making environmental and sustainability claims, including claims about consumer goods, manufacturing, the energy sector, and carbon neutrality". There was a particular concern about free-riders making claims of environmental and sustainable business practices without incurring the costs to make those claims true.

Rounding out a trio of regulators, in May 2022 the ASX also announced a crackdown on investment funds not being 'true to label'. A spokesperson for the ASX has committed that it will only admit funds for listing that comply with ASIC's naming requirements, and will impose a condition that the issuer complies with those requirements on an ongoing basis.

We expect this consultation and engagement by regulators to turn into enforcement action in coming years. It is important for companies to use this lead-in period to ensure they are not falling foul of greenwashing risks.

Of course it is not just regulators focused on greenwashing. Australia has also seen an increase in activists taking steps to ensure ESG-related commitments are being upheld. In January 2020, Friends of the Earth alleged that by failing to disclose adequately climate change impacts an Australian financial institution prevented its consumers from making informed investment decisions.

In November 2021, the Federal Court granted shareholder activists access to internal documentation from a major Australian bank regarding seven oil and gas projects. The application was made on grounds that investment in those projects may infringe the bank's policies set around commitments to Paris Agreement targets.

As we have previously observed, Australia has, for some years, been a jurisdiction in which climate and ESG-related litigation has flourished. In our Class Actions Predictions Insight, we suggested that climate related class actions will continue to grow in 2022. With the change of government at the federal level, and the likely wind-back of reforms proposed to class actions, funders will explore means in which ESG class actions can be moved from claims for declarations and other strategic relief, to claims for recovery of financial loss.

Keep on top of ESG greenwashing risk

ESG investments form an integral part of the business model for financial institutions as investors seek ethical and sustainable ways to invest. In that environment it is critical for financial institutions to rigorously guard against the risks of greenwashing. The following steps will assist them to do so:

Regular review of the appropriateness of ESG strategy and commitments

Institutional goals, targets and commitments, as well as customer-level marketing of ESG credentials should be reviewed and updated, to ensure that they accurately reflect the actions the organisation is taking, and what it can realistically achieve. Overstatement should be avoided, and corrected where it is identified.

Ensuring that systems and processes are set up to operationalise ESG commitments

When making representations about, for instance, sustainability of investments an organisation should have a clear understanding of the criteria it is going to implement to determine sustainability; how it is going to action those assessments, including who is responsible for doing so; how frequently they will be reviewed; and how they will be reported.

Independent audit and/or review

Given the speed with which understanding of ESG factors and considerations is growing, and the pace at which financial institutions internationally are adopting approaches many institutions may benefit from external assistance with audit and review. An external reviewer can assist in ensuring that sustainability criteria being implemented align with emerging best practice.

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