ESG investing and the threat of corporate greenwashing

Environmental, social and governance (ESG) has become a buzzword in the investment world. Why do you think this is?

Dr. Seng Kiong Kok, interim senior programme manager for innovation and enterprise at RMIT University Vietnam

Business investments are evolving so that the pursuit of returns is accompanied by a desire to engage in some greater good and still gain yield. This amalgam of an individual’s desire for social impact and investment performance is called shared value and is one of the many trends in the investment world. ESG investing is a process of assessing the investment potential of corporations based on their ESG scores. The idea is that investors, the market, and society at large can use ESG scores to assess the greater good that a firm is supposedly providing.

However, using a single measure to capture significantly complex issues means this metric is susceptible to distortion contingent upon the data that goes into its calculation. Greenwashing is a term that we often hear about concerning such distortions.

Can you give us some examples of greenwashing?

Greenwashing is when a firm publishes disinformation that portrays it as environmentally responsible. Examples can range from exaggerating the environmental credentials of a particular product or initiative to outright deceiving the public regarding the firm’s activities.

These acts of greenwashing may include dimensions such as the use of green imagery to portray care for the environment or the concealment of ecologically damaging practices via deceptive claims.

For instance, supermarkets in many countries around the world, including Vietnam, have introduced so-called biodegradable plastic bags to become greener. But several international studies have suggested that some biodegradable bags might not deliver on their promise and may even break down into harmful microplastics.

Why has greenwashing become such a serious problem?

Of concern is the scale and increasing frequency of greenwashing activities among some of the largest firms, but also the extent to which these greenwashing activities impact firms’ perception in light of ESG investing.

It is possible that greenwashed data is sufficiently believable that it gets incorporated into the ESG score, which then distorts the core metric that individuals or markets may use in their investment decision-making. Moreover, such greenwashing distortions can be visualised as ripples in that they can impact areas far removed from their origins, creating inaccurate prices.

Imagine a company that has engaged in sufficiently sophisticated greenwashing activities that the rating agencies have decided to include that disinformation in the ESG rating. Investors now purchase shares in the said company based on its rating, increasing its share price.

Existing holders of said company’s shares will see increases in their own portfolios and net worth.

Now imagine that the investors are not just individuals like you and me but large institutions such as banks and corporations who themselves have issued shares. If their portfolios have increased in value because of their misrepresented ESG investments, then it is likely that this increase in net worth will result in a proportional rise in their own share prices, all borne of the initial environmental disinformation.

What we then have is greenwashing priced into financial assets, pulling prices further away from their true value. Put simply, it is possible that these greenwashing activities make a market more inefficient and that any corrections can have a wider impact. This is concerning because the appetite for ESG or some notion of responsible investing is growing. Statistics from the International Monetary Fund show that ESG-linked borrowing more than tripled last year, with ESG investments now making up almost 18 per cent of foreign financing for emerging markets, excluding China. Moreover, data from financial services firm Morningstar also highlights the considerable growth in ESG funds, with an estimated asset valuation of $2.7 trillion in 2021. Given this increased activity within the ESG arena, there are strong desires to ensure that markets are free from any form of distortion, greenwashing or otherwise.

How can we combat the problem of greenwashing?

While there have been concerted efforts to minimise the effects of greenwashing on markets, the efficacy of such interventions is unclear.

For example, there have been numerous proposals for decentralised blockchain innovations that could help track the environmental credentials of firms. This would help minimise the opportunity to greenwash with greater informational scrutiny. However, such initiatives are young as yet, and there is insufficient data to assess their effectiveness.

Moreover, there are also some concerns about the efficacy of ESG as a metric, given what it is trying to capture. A review of ESG calculation methodologies reveals inherent complexity with numerous categories of data, multiple layers of informational sources, and hundreds of variables that go into formulating a single value. This complex matrix of data and information can lead to a greater number of points of failure in terms of greenwashing assessment.

To add to the trepidation of ESG is the lack of a consistent approach to calculation with different agencies adopting various methodologies, and there is no single universal standard for the reporting of ESG credentials. However, there have been attempts to address this lack of a foundational framework.

For example, recent EU legislation aptly named the Sustainable Finance Disclosure Regulation has provided a standardised framework for ESG reporting. There are also similar policies being developed by the US Securities and Exchange Commission.