Why the crackdown on greenwashing must now go further

The Australian financial regulator ASIC recently published a report on its actions against greenwashing misconduct and concluded that its "surveillance indicates there is ample room for improvement".

The report indeed underlines the extent of greenwashing prevalent among investment managers and the potential for consumers to be misled given a lack of existing regulation.

While the report for the 2023-2024 period shows ASIC to be one of the most active watchdogs internationally, the Australian regulatory framework has room for improvement, especially when it comes to the use of ESG scores and protecting consumers who may rely on them.

Environmental, Social and Governance (ESG) ratings are often used as a key input when investment houses build products that claim to be sustainable investments.

They also serve as metrics to inform investors on how these products are constructed and for reporting on their ESG-related performance.

The Australian regulator's interventions have until now centred on verifying that the investments strategies that managers profess to follow really are what they claim to be.

For example, an investment manager paid a $29,820 infringement notice when ASIC found that one its funds invested in companies that had a worse climate-related score than the minimum score threshold which it claimed it would apply to its investments.

This type of greenwashing is the most obvious to detect and prosecute, but is it enough?

ASIC Commissioner Kate O'Rourke says, "Sustainability-related information, like any other, should be accurate, based on reasonable grounds and be easily understood by investors," and the case has been made that ESG scores fail each of these three quality standards.

Hence, going forward the regulator should shift its focus from simply checking whether investment managers use the scores the way they say they do, or whether these scores provide investors with any accurate, reasonably grounded and easily understandable information at all.

There are good reasons to doubt it.

In a 2022 policy recommendation "to improve the transparency and credibility of ESG rating methodologies and promote market integrity", the OECD found that "despite progress, ESG approaches suffer from considerable shortcomings with respect to consistency, comparability and quality of data and transparency of associated methodologies that undermine their broader use and the trust of investors".

Henry Fernandez, CEO of MSCI, the market leader for ESG ratings, concedes as much in a recent interview with the Financial Times, saying that "an ESG rating is an opinion ... we are going to arrive at different opinions, we are going to arrive at a different rating".

Moreover, beyond being inaccurate, investors do not understand what these ratings are intended to convey.

According to a 2021 Bloomberg BusinessWeek article, Fernandez "concedes ordinary investors piling into such funds have no idea that his ratings, and ESG overall, gauge the risk the world poses to a company, not the other way around. 'No, they for sure don't understand that," he said in an interview. 'I would even say many portfolio managers don't totally grasp that'. Understandably, the OECD states that "greater clarity on the high-level purpose of elements in ESG ratings is warranted".

Aiming to address the shortcomings of ESG scores, the EU is moving ahead with its plans to regulate the ESG rating agencies themselves.

The regulatory regime will not be prescriptive, but instead aims to increase the mandatory transparency on what the ratings assess, and how they do it.

The regulation also aims to improve the governance and independence of these providers. The UK is moving in similar direction. Should Australia do the same?

In its report ASIC says it has engaged with ESG ratings providers, but the Australian Government's June 2024 Sustainable Finance Roadmap shows no intentions to prioritise regulating them. And perhaps it is right: ESG ratings may be so flawed that they cannot be cured.

The Government's first two priorities seem more sensible, that is, improve mandatory disclosures and finalise the Australian taxonomy or classification of sustainable activities based on "technical screening criteria".

In the same vein, learning from the failures of the first version of the EU's Sustainable Finance Disclosures Regulation, EU regulators recently issued their recommendations for improvements, which centre on building a sustainable investment product classification system based on "clear objective criteria", favouring the use of the EU Taxonomy Regulation as a "science-based reference point".

Until ESG ratings reasonably accurately measure what their providers intend them to measure, and until investors understand what these intentions are, ESG ratings are a source of investor misinformation.

And instead of trying to fix the irreparable, Australia would be better off discouraging the use of ESG scores for investor information purposes.

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