Friday 11 June 2021 6:00 am

There are trillions of dollars in sustainable finance and ethical investing, how do we tackle greenwashing?

Lee Shankland-Gort is head of social, sustainable and green finance at Addleshaw Goddard

The announcement that the government is setting up a new group to help tackle “greenwashing” is good news for everyone. We know ethical investing is booming. Some models have ESG-linked funds outnumbering conventional ones by 2025, and the combination of climate-consciousness, social awareness, and a desire for purpose as well as profit bodes well for this to continue.

Companies overstating environmental or social credentials – known as greenwashing or rainbow-washing, respectively – is hardly new; it has been common for as long as people have made ethical purchasing decisions. But increased involvement of international finance means the problem has ballooned. There are now trillions at stake globally, in terms of ethical investment and sustainable finance. Hence the demand for comparable metrics, allowing people to make the right investment choices.

It was HL Mencken who said that to every complex problem there is an answer that is clear, simple, and wrong. This is a great example. It is not as easy as demanding metrics – serious questions must first be asked. Who agrees on the metrics? Who establishes them? Who decides if they are ambitious enough?

Within what ambit do the metrics count? Finance is global; it would be nonsense to have one set for the UK, another for the EU, and a third outside. How do they change over time, since investments tend to be longer-term? And how can we make them comparable across different areas of ESG? It is far easier to measure, say, carbon emissions than improvements to quality of life, or some of the social challenges this finance seeks to target. 

Next is who does the measuring? Scrutinising performance of investment products demands reliable information. There are rules around ESG-related data; non-financial reporting requirements have been extended to large listed companies and asset managers are increasingly required to report too. 

This requires a huge reliance on third-party data providers. ESG auditing will morph in the coming years. At present, it is unregulated and employs a range of methodologies and measurements. Those currently reporting on ESG performance are experienced and reputable, but without a regulatory framework – and with so much money at stake – it is easy to see how this could become a race to the bottom as newer players enter the scene.

Similar metrics challenges apply for sustainability-linked lending, where borrowers that hit sustainability metrics benefit from improvements in their margin. We’ve started to see a greater drive by industry bodies (such as Loan Market Association), and across lender policies, for transparency, stretch and measurability of those metrics, both in terms of proof points and demonstrating that borrower companies are making efforts to achieve new and improved outcomes.

But there is added potential reputational risk for sustainability-linked lenders.  If lenders are receiving higher margin – thereby making more money – from borrowers who are performing less well on sustainability, there is a risk some lenders will prefer to fund those businesses that generate an increased margin because they are not as far on their sustainability journey. In addition to this “moral hazard”, we could see a potential long-term risk that badly-performing companies, from a sustainability perspective, become an asset class in themselves, the way subprime loans did 20 years ago.  

None of this is insurmountable. The issues around moral hazard can be solved by requiring lenders and borrowers alike to recirculate their financial rewards into more sustainability projects – rather than taking them as profit. Lenders could be incentivised to fund more sustainable businesses and projects, by beneficial capital treatment for those loans. And the assessor challenge could be solved through regulatory frameworks with much greater involvement of independent third-party verification and audit trails. But all of this needs consideration and regulation.

If the Green Technical Advisory Group is going to be a success – and we need it to be – it will need to carefully consider all of the potential consequences of drawing up a common framework. All the trends and figures show we have an unprecedented chance to use the will and appetite of investors to make society – and the planet – a much better place. But only if we get it right.

City A.M.'s opinion pages are a place for thought-provoking views and debate. These views are not necessarily shared by City A.M.