Greenwashing is not just another buzzword but a significant risk factor
The word “Greenwashing” is omnipresent. In almost every discussion on sustainable finance and the related ESG risks it is considered as an important issue and its prevention and tackling are prioritised by several financial regulation authorities such as ESMA and SEC.
Everybody knows that it poses a huge risk on the efficiency and integrity of efforts to achieve the sustainability goals. It appears like an external phenomenon floating above all and deep in the background at the same time. The term is, however, so generic and abstract that it is barely included in the definitions of the regulatory guidelines or technical standards. Neither it is included structurally in the classification and methodological concepts of measuring and monitoring the ESG risks.
How are we going to prevent it, if we do not define it?
In simple words, Greenwashing means to present activities as green and sustainable when they are not. Greenwashing can be in this sense intentional and unintentional. Another less widely used terms are also Bluewashing and SDG-Washing, which cover also economic and social aspects.
From regulatory and risk management perspective Greenwashing falls into the same category as misconduct, fraud, corruption, tax evasion and money laundering. However, its distinguishing characteristic lies in its fundamentality for all ESG risks and not only in being part of them. The negative effects of Greenwashing go beyond legal risk and the associated litigation costs, especially when the concept of Double Materiality is applied.
The transmission channels of Greenwashing are multidimensional and affect all risk types. Here are some theoretical but realistic considerations:
Operational Risk
The risk of Greenwashing emerges within the scope of operational risk, when there are no practices to identify it or they are inadequate due to lack of knowledge. When relying on false or bad quality data provided by external counterparties, financial institutions unconsciously run the risk of misleading towards sustainable activities. Also, the lack of internal control mechanism on Greenwashing prevention allows for intentional misconduct and fraud by employees, if for example their remuneration is linked to “green” market activities (which is encouraged by regulators). It is also possible to mislead investors, when the sustainable investments cannot meet the eligibility criteria provided in the pre-contractual disclosures.
Credit Risk
Greenwashing can lead to underestimated ESG risks. A distorted picture of the environmental impact of investments increases the unexpected losses, if the transition and physical risks materialize. Counterparty’s financial situation and even solvability can be significantly harmed, which should be reflected in the estimation of credit risk parameters such as PDs and LGDs. The potential threat of Greenwashing increase market credit spreads and should be considered in the Credit Value Adjustments (CVAs).
Market Risk
Similar to the credit risk channel, assets that have been affected by Greenwashing can lose significantly in market value and even become stranded, so they cannot be sold. This uncertainty should be reflected in the market risk parameters such as Value-at-Risk for example.
Liquidity Risk
If the Greenwashing risk materialises, i.e. the activities claimed as sustainable are not, some investors may withdraw their funds, which in turn will lead to increased funding costs. Stranded assets become less liquid on the market. The respective effect on liquidity buffer and the liquidity ratios should not be underestimated.
Reputational Risk
Closely related to liquidity risk channel the reputation of the financial institution may be harmed by Greenwashing due to loss in trust among stakeholders. The effects are not linear and can be associated with significant costs of re-building the brand and the image on the market.
Legal risks
When Greenwashing is identified financial institutions may be challenged by legal claims through investors and environmental or other activists. The risk is then materialised through increased litigation costs.
Regulatory Risk
Greenwashing is a huge threat for fulfilling regulatory expectations on the management of ESG risks and meeting sustainability goals. The risk of becoming non-compliant is connected with possible regulatory sanctions such as penalising factors or increased capital requirements (e.g. under SREP).
Given the multidimensional nature of Greenwashing, it cannot be left on the sidelines of the internal risk management. Underestimation of its potential impact on the major risk types leads directly to undercapitalisation of such risks.
Moreover, the main responsibility of tackling Greenwashing should not be driven solely by the regulatory authorities. It should be primarily prevented and managed by financial institutions and their customers. To increase awareness and accountability Greenwashing should be integrated as separate risk category and risk factor. It should be included on a stand-alone basis in the risk management and prudential regulation framework. It should be explicitly considered in all three Pillars of the Basel framework as a minimum standard.
