Stricter ESG regulations may increase greenwashing risks and investor backlash

Erhan Kilincarslan - Senior Lecturer in Accounting and Finance, University of Huddersfield

Jiafan Li - Lecturer in Accounting, University of Huddersfield

Meanwhile, UK retailers Asos, Boohoo and George at Asda have pledged to make only “accurate and clear” environmental claims following a UK Competition and Markets Authority (CMA) investigation into potential greenwashing. This move aligns with the CMA’s crackdown on misleading eco claims across various consumer products, including soaps and toiletries. The retailers committed to transparency about the fabrics they use, ensuring claims about recycled or organic materials are clear, and avoiding misleading imagery. This regulatory action comes as consumer preferences increasingly favour eco-friendly products, prompting scrutiny over green claims in the fashion industry, which is a significant contributor to global carbon emissions. Furthermore, the EU plans to ban unverifiable environmental claims by 2026.

Regional trends reveal varying patterns of greenwashing risk exposure, which refers to the likelihood of companies facing accusations of making false or misleading environmental claims. In Europe and North America, about 54% of greenwashing incidents linked to climate change, greenhouse gases (GHG) emissions, and global pollution. In contrast, only 27% of deceptive eco claims in Latin America and the Caribbean related to climate, with a higher focus on misleading communications about biodiversity, particularly in the mining industry. As regulations and scrutiny around sustainability claims increase, the risk of being exposed to greenwashing accusations and the resulting consequences – such as legal challenges, regulatory penalties, reputational damage and loss of consumer trust – also rises. Subsequently, this growing risk may fuel investor scepticism or oppositions towards ESG investing, leading to what is known as an “investor ESG backlash”.

For instance, Wall Street's largest asset managers, private equity firms, and brokers, including BlackRock, Blackstone, and KKR, are now identifying backlash against sustainable investing (ESG) as a material risk to their financial performance in their annual reports. This concern is driven by campaigns against ESG, labelled as “woke capitalism” by opponents and supported by prominent Republican politicians like Mitch McConnell and Ron DeSantis. Investigations and laws in Republican-led states target asset managers incorporating ESG factors, potentially impacting fundraising and revenues. Indeed, BlackRock faced significant fund withdrawals due to ESG stances, and firms like Carlyle and TPG warned about anti-ESG legislation impeding fundraising.

A recent RepRisk report revealed a 70% increase in greenwashing incidents by banks and financial services globally over the past year, with European institutions responsible for the majority, especially regarding fossil fuel claims. Regulatory bodies are intensifying efforts to eliminate greenwashing to enhance consumer and investor trust, though the lack of a legal definition for greenwashing complicates enforcement. Banks play a critical role in financing corporate efforts to reduce carbon emissions, but unclear definitions of transition finance have led to greenwashing accusations. According to the European Banking Federation, the rise in allegations might result from “increased scrutiny rather than deliberate deception”. However, misleading messaging about environmental and social issues hinders progress toward shared objectives and undermines trust with consumers and investors.

The rapid growth of ESG exchange-traded funds (ETFs) has sparked regulatory concerns over greenwashing, where fund managers make misleading environmental claims to attract investors. The ESG ETFs are investment funds that select and manage a diversified portfolio of companies and/or assets based on certain ESG criteria of which they vary widely in their ESG approaches, from funds aligned with the Paris Agreement to those still invested in fossil fuels. Although traditional ETFs may prioritise financial performance, these ESG ETFs aim to invest in businesses that demonstrate ethical and sustainable values while providing investors with the potential for financial returns. The number of ESG-labelled ETFs doubled to nearly 1,300 by the end of 2022, driven by investor demand for socially responsible investments. Despite their popularity, net inflows to ESG ETFs fell by 54.5% in 2022, partly due to contentious debates over ESG standards and political opposition.

Moreover, incomplete corporate disclosures and shifting regulations challenge fund managers, leading some, like BlackRock and UBS, to downgrade their ESG funds to a less stringent category, such as  moving from the EU's Article 9, which has the highest sustainability requirements, to a lower category. The European Commission's recent guidance allows fund managers more discretion in assessing sustainable investments but requires transparency in methodologies. As regulators in Europe and the UK propose stricter disclosure requirements, the ESG investment market faces ongoing evolution and pressure for greater clarity and accountability.

Despite the US Securities and Exchange Commission (SEC) enacting lighter rules on climate risk disclosures, international companies, especially those operating in Europe, will still face stringent EU regulations. The EU's Corporate Sustainability Reporting Directive (CSRD) mandates comprehensive climate risk disclosures, including carbon footprints from operations, energy usage, and supply chains. This discrepancy creates a risk of regulatory arbitrage, where companies might shift operations to avoid strict EU requirements, potentially impacting the EU's industrial base. While the SEC's new rules omit scope 3 emissions due to compliance costs, the EU's broader requirements push companies to provide detailed climate risk information, reflecting the global push for harmonised standards led by bodies like the International Sustainability Standards Board. Companies must balance the cost of multi-jurisdictional reporting with the need to provide investors with adequate climate risk data.

The divergence in standards poses challenges, with some companies considering delisting from European exchanges, fearing the compliance burden and competitive disadvantages. The SEC's move to require basic disclosures is a step forward but falls short compared to the EU's rigorous demands, raising concerns about the adequacy of climate risk assessments for investors.

As the debate continues, the need for clear, consistent, and enforceable standards becomes ever more pressing to ensure that genuine sustainability efforts are recognised and rewarded, fostering trust and progress toward global environmental goals.