Greenwashing and Credit Risk Sara Cota

Greenwashing is the practice of providing misleading information about a company's environmental efforts or sustainability initiatives, which has become a major concern in the context of credit risk. As stakeholders increasingly focus on environmental, social, and governance (ESG) factors when making investment decisions, the temptation for companies to project a ‘greener’ image has developed. However, this form of deception carries considerable risks that can impact creditworthiness. 

Greenwashing can arise at both individual company level and across investment funds, either intentionally or unintentionally. This can manifest in various ways, such as through advertising that portrays a product as more environmentally friendly than it actually is, selective reporting of sustainability metrics, or the use of vague and unverified claims like ‘eco-friendly’ or ‘sustainable’. While greenwashing can be a marketing tactic to attract environmentally conscious consumers and investors, it undermines the credibility of ESG reporting and creates a distorted view of a company's true environmental impact. Since regulations and disclosure standards differ significantly across regions, with little consistency, greenwashing risks are likely to remain a persistent challenge. 

When companies engage in greenwashing, they introduce several risks that can affect their creditworthiness. 

  • Reputational Risk: If greenwashing is exposed, a company can face significant reputational damage. Negative publicity, loss of consumer trust, and backlash from environmental groups can lead to decreased revenue, harming a company's financial stability. For creditors and investors, this reputational damage can be a warning sign of potential financial instability, affecting a company's credit rating.  
  • Legal and Regulatory Risk: Regulatory bodies and governments are increasingly focusing on ESG compliance. Companies caught greenwashing may face legal penalties, fines, or sanctions. These legal consequences can add to a company's financial burden, leading to higher credit risk. 
  • Distorted Risk Assessments: Greenwashing can create a false sense of security for investors and creditors. If ESG factors are used to assess credit risk, misleading claims can lead to incorrect risk evaluations. Financial institutions might overextend credit to companies with higher environmental risks, potentially leading to a greater chance of default. 

The financial and reputational risks for asset managers due to greenwashing are rising as demand for ESG products continues to grow. A recent academic study examined ESG funds by analysing their portfolio company voting records and ESG ratings and found that 29% of US-based ESG funds are actually engaging in greenwashing. These funds are more likely to underperform, often come from larger and newer fund families, and are less likely to be offered by signatories to the United Nations Principles for Responsible Investment.  

The prevalence of greenwashing can have broader implications for credit markets. Investors and creditors depend on accurate information to guide their decisions. When companies engage in greenwashing, they distort the information flow, which can lead to incorrect risk pricing in the market. This can lead to certain companies being overvalued and their environmental risks underestimated, posing a potential risk to credit market stability. 

To mitigate the impact of greenwashing on credit risk, several measures can be taken. 

Governments and regulatory bodies can introduce stricter guidelines for ESG reporting, with penalties for greenwashing. A recent example of this action is the Financial Conduct Authority (FCA) regulator introducing the anti-greenwashing rule, which comes into effect on 31st May 2024. This rule applies to sustainability-related claims by FCA-authorised firms about their financial products and services being made available to persons in the UK. This can discourage companies from making false claims and encourage greater transparency. 

Independent third-party verification of sustainability claims can add credibility to a company's ESG reporting. This can help investors and creditors trust the information provided by companies. Investors and creditors should conduct thorough due diligence on a company's sustainability practices. This includes examining ESG reports, sustainability audits, and tracking a company's environmental track record. By taking these measures, stakeholders can reduce the risk posed by greenwashing and ensure that credit risk assessments accurately reflect a company's true sustainability and risk profile. 

Arlingclose’s ESG and Responsible Investment Service includes advice on developments, themes and ‘direction of travel’ for ESG investments. Our advice helps public sector officers and members navigate the complexities for treasury investments whilst remaining prudent custodians of public monies. 

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Related Pages

The FCA's Anti-Greenwashing Rule

What is the PRI?

ESG and Responsible Investment Service