With the new EU Sustainable Finance Disclosure Regulation (SFDR) entering into force on
10 March 2021, much attention has been paid by investment advisors and managers to disclosing Environmental, Social, Governance (ESG) related information about their products and services, such as sustainability risk management practices or the specific environmental and social characteristics promoted by a fund labelled as sustainable.
However, disclosing this information is just one side of the story. Even more important is to ensure that statements made are consistent with the firm’s business practices. Failing to do so bears the risk of being called out as greenwashing your business – a huge reputational risk that should not be underestimated in times where customers expect companies to play their part in creating a sustainable world.
The greenwashing risk is real
That the risk of greenwashing is real has just recently been highlighted by a risk alert issued by the US Securities and Exchange Commission (SEC) on ESG disclosures. Their findings from recent examinations in the financial sector shed light on the most common issues related to statements made about ESG practices and can be broken down into three themes that are strongly interlinked:
As becomes clear from the observations made, poor disclosure quality can be linked to a compliance function that has not been enabled to make informed decisions about ESG-related matters: where compliance has no understanding about the underlying investment decisions and ESG strategies, the establishment of adequate controls and their enforcement remains a challenge. And where effective controls, policies and procedures are missing, the risk that business practices divert from disclosed ESG information increases – resulting in the risk of greenwashing your business.
A question of fiduciary duty
And while the risk of greenwashing is certainly a major driver to install effective controls around ESG investment decisions and business practices, another factor to be considered which is fairly straightforward but often overlooked is that ESG investment approaches are not just a fancy marketing frenzy to attract customers. They aim to improve the risk-return profile of products and services, for example by reducing risks related to potentially stranded assets and raising costs for CO2-heavy industries. Not following through with them may mean not acting in the best interest of the customer and, thus, conflicting with the fiduciary duty.
Implications for investment advisers and managers
The findings of the SEC emphasise the importance of ingraining awareness for sustainable business practices into the whole organisation and installing an effective risk and control framework around ESG matters that is based on solid strategic decisions and that follows a strategic ambition set for the whole organisation.
However, what we often see in the market is that ESG is not approached strategically, which results in various initiatives, unclear requirements and different standards across an organisation. This makes it difficult for employees to navigate the already complex topic, and uncertainty often leads to employees turning away from it altogether.
As a starting point, institutions should focus on the following to increase their resilience related to risks associated with ESG disclosures:
1. Institutions should establish a clear strategic ambition in terms of their ESG positioning accompanied by a clear risk appetite statement based on measurable KRIs.
2. This strategic baseline should be used to set organisation-wide ESG standards in policies and business procedures related to investment decisions and advice.
3. ESG considerations should be embedded in an effective risk and control framework that ensures set standards are being met and followed through.
4. Compliance and risk control functions must be involved in the process of disclosing ESG-related information as well as in decisions impacting the underlying business processes, in order to be able to make informed assessments of disclosed information and mitigate the risk of greenwashing.
Summary
- With recent ESG disclosure regulations entering into force and investors’ increased interest in the topic, disclosed ESG information is moving into the focus of stakeholders of investment advisers and managers.
- Insufficient organisational implementation of ESG-related policies, procedures and controls increases the risk of greenwashing – and may lead to negligence of the fiduciary duty.
- Institutions should focus on setting clear ESG ambitions, risk appetites and standards in order to guide their organisation in navigating the complex topic of sustainability and to ensure that disclosed information is coherent with actual business practices.
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