Green-Banking or Greenwashing? The FCA’s Anti-Greenwashing Rules and the Implications for Firms

• The Financial Conduct Authority’s (FCA) proposal for revised greenwashing rules is consistent with rising public and industry expectations for how banks and investment firms should be managing their climate impact, i.e., through aligning their financing activities with global climate goals.
• Sustainable Financial Products (SFPs) are the most innovative and in-demand segment of the financial market. Thus far, the industry has relied on an unregulated web of voluntary and principles-based rules to manage SFP risks. Despite the proposed new rules, this will continue to be a complex landscape for firms to navigate.
• Commercial, reputational, and legal risks are growing, and the new rules will have an impact on not only firms’ compliance requirements, but also the demands they can expect from investors and customers.
• While the scope of the rules targets asset managers, the new anti-greenwashing rules CP22/20 currently under discussion apply to all financial service firms. The manufacture and distribution of SFPs are a growing and significant component of bank and investment firm business. However, the risk frameworks and control mechanisms have not evolved sufficiently to effectively identify, assess, and manage the risks associated with greenwashing.

Introduction

Sustainable finance products (SFPs) have been at the forefront of market trends, particularly in the post-pandemic business strategies of financial institutions, and they continue to be the fastest growing segment of the market as of 2023, with annual green bond issuance amounting to $581bn in 2022.

A notable drop in bond markets was apparent in the first quarter of 2022; partly attributed to rising interest rates, global economic uncertainty related to rising inflation and geopolitical conflict. While investments in SFPs also slowed, they have performed relatively well in the bond market.

Other factors that could affect the long-term growth of SFPs include greenwashing, or the practice of making misleading or unsubtantiated sustainability-related claims.

Banks and investment firms with green products will need to consider their greenwashing risks, and how these risks will increase with new regulatory requirements. Moreover, a proactive risk management approach throughout a firm’s business lines will allow it to more easily adapt to a rapidly evolving risk landscape.

FCA’s anti-greenwashing rules: overview

Unlike traditional financial products, SFPs are governed by a set of non-financial and voluntary measures (carbon footprint, environmental impact, energy efficiency etc.) and, while the leeway around these measures has enabled the rapid growth of the SFP market, regulators such have expressed concerns around greenwashing.

As regulators work to advance their goals and actions in line with the government’s plan to deliver a net-zero economy by 2050, they have introduced support to improve confidence and encourage growth in the SFP market.

In October, the FCA published the Sustainability Disclosure Requirements (SDR) and Investment Labels Consulation Paper (CP22/20), containing a set of new rules to tackle greenwashing. This follows other publications in recent years in which the FCA has showed that it will toughen its stance on greenwashing.

Although greenwashing is still considered by some in the banking sector to be an emerging risk, these new regulations in addition to changing investor demands will make greenwashing more of a mature risk area that firms will be required to appropriately address.

The FCA’s proposed anti-greenwashing regulations, CP22/20, are designed to target asset managers, however, if enacted these proposed rules would have a significant impact on the risk management requirements for SFP manufacturers and distributers.

• The anti-greenwashing rule: a general, over-arching rule will be applied across all FCA-regulated firms, and requires, at the bare minimum, that firms do not make unsubstantiated sustainability claims.
• The distributors of products and services rule: this rule ties in with the FCA’s Consumer Duty requirements, ensuring firms are providing retail customers with the information they need to make informed decisions. Distributors of SFPs, such as green lending products (e.g., green mortgages or loans), or those providing retail clients with investment advice will be subject to these new rules.
• Broader impacts: under the FCA’s PROD 3.2. 1, manufacturers of financial instruments need to design them to meet the needs of their target client. As banks play a significant role in arranging the debt financing for low-carbon infrastructure through arranging or underwriting green bonds, they run the risk of passing on greenwashing to the funds their products end up in.

FCA anti-greenwashing rule: risk areas for banks

Previously, greenwashing has been regulated by standard conduct rules, such as Consumer Duty, and other regulations related to false advertising and poor product standards which weaken consumer confidence in the market. Under the new measures in CP22/20, firms will face additional scrutiny into the green credentials of their products and services, making it necessary to increase vigilance in the following areas:

• Controls over the products and services offered: under CP22/20 rule 6.9, the FCA will be taking steps to determine that product details in all external communications match their stated sustainability attributes. Firms could therefore face greenwashing accusations if either the underlying assets or the use of proceeds from its sustainable investment products are found to be environmentally unfriendly or unimpactful.
  
  The risk and control frameworks in place to manage this risk therefore needs to be enhanced to specifically include consideration of greenwashing risk, for example, the new product approval process, new transaction approvals, review of marketing materials.

• Disclosures: regulators have stated their intent to ensure consumers have the necessary information to evaluate the characteristics of sustainable products. Under CP22/20 rule 7, distributors of sustainability-related information to consumers will need to ensure they communicate sustainable investment labels and accompanying disclosures in a clear and substantive manner. For example, a bank passing along information about a green bond will also need to disclose how the bond’s investment strategy and its proceeds will be used to fund environmentally friendly or low-carbon projects.
  
  More generally, banks should be aware of the risks associated with making green claims in any public disclosure, including in their:

1. Green credentials and claims: most high-street banks are setting sustainability-related goals, such as net-zero targets, and commitments to align their business practices with the UN Sustainable Development Goals (SDG). However, in cases where the goals are not aligned with the firm’s overall strategy, there is a risk that weak implementation strategies lead to missed targets and expose firms to accusations of greenwashing.

2. Voluntary sustainability disclosures: given the lack of monitoring and the non-standardised nature of climate disclosures such as the Task Force on Climate-Related Financial Disclosures (TCFD), they are easily susceptible to greenwashing.

Greenwashing: impact on banks

It is clear from the FCA’s recent messaging, including its Dear CEO letters and SDR proposal, that regulators have laid out the grounds on which it will take action to prevent greenwashing. These actions could have major impacts on a firms’ financial and reputational standing, including through:

• Loss of shareholder trust: banks are increasingly facing accusations that the stated green credentials of their products are exaggerated or false. In one case, the Advertising Standards Authority (ASA) did an in-depth investigation into a firm’s business interests and determined that its overall environmental impact was not aligned with its green advertising campaign. Amidst the negative press coverage, the firm faced accusations of irresponsibility and poor management from shareholders. Indeed, under s463 of the Companies Act 2006, individual directors can be held accountable for failure to comply with green commitments.
• Competitive disadvantage: greenwashing accusations could indirectly affect a firm’s clients, particularly large institutional clients which face more pressure, to place a high value on societal issues such as climate change. To retain the confidence of their clients, firms need to manage their own greenwashing risks, as well as potentially passing on greenwashing risks to third parties which support them.
  Firms with best-in-class greenwashing policies demonstrate not only their compliance with existing rules, but also their proactive approach to managing broader risks along the distribution chain.
• Liability claims: as of today, no company has been brought to trial over greenwashing accusations.However, under s90 and Schedule 10A of the Financial Services and Markets Act ( FSMA ) 2000, companies could be liable for compensation if misleading information regarding its green credentials leads to a fall in share price.Recent cases in the media show the heightened level of scrutiny firms are already coming under. As a case in point, a global bank is facing litigation over reports that contrary to its public disclosures, its issued green bonds are being used to finance fossil fuel developments.With the introduction of CP22/20, including the Anti-Greenwashing rule this year, firms can expect further regulatoryaction in this area.

With the heightened scrutiny around green products and services, and the higher risks associated with both financial and reputational loss, firms have a material interest in ensuring greenwashing risks are mitigated in their governance frameworks.

Greenwashing: risk & control considerations

Banks which are arranging deals for issuers for sustainability bonds or loans will need to examine their current risk architecture to ensure they are identifying, assessing, and managing the risk of greenwashing.

Many banks and investment firms have not updated their risk and control architectures to manage the risk of greenwashing. Firms need a cross-cutting approach that is suitably dynamic to respond to regulatory changes and to manage the risks associated with green products:

Adapting firms’ risk architecture

• Identifying new risks: although firms may have existing controls which can address the greenwashing risks highlighted in section 3, it would be prudent to assess whether the design of these controls appropriately consider greenwashing risk and whether there are any risks not considered by traditional controls (such as financial promotion reviews, product governance controls, etc.).
  
  For example, a bank might want to consider whether its approach to product structures and pricing could drive unimpactful environmental behaviours. Greeniums present a challenge if their inclusion in a bond or sustainability linked loan creates targets for green financing which do not provide sufficient incentive based on current behaviours to make a meaningful environmental impact.

• Integrating new risks: there are multiple approaches to integrating new risks into existing risk taxonomies or architectures. For example, some banks have had more detailed product level assessments that then aggregate and map back the conclusions to a smaller number of broader ESG related risks in the risk taxonomy, whereas other firms have incorporated a way to tag the risk type in the risk architecture (e.g., impact types or risk type flags).
• Third parties: several SFPs are often reliant on third-party data providers, for example bond issuers using second-party opinions to rate their alignment to the Green Bond Principles. Firms must consider the risks related to the reliability and accuracy of third-party data, for example, by establishing in-house expertise capable of challenging and verifying the analyses provided by ESG data providers and other third parties.

Considerations for controls

• Enhance the review and approval process for financial promotions: with the new anti-greenwashing rules, firms will be required to review financial promotions with sustainability-related characteristics to ensure there is no risk of greenwashing. Given that financial promotions contain a broad range of communication types (brochures, prospectuses etc.), firms will need a robust review and approval process to ensure all sustainability-related communications are clear and consistent with the sustainability profile of the product or service.
• Improving entity-level data architecture: greenwashing is a broad and complex risk taxonomy and firms should consider the importance of reviewing and enhancing their product and entity-level data architecture to assess data lineage and traceability of sustainability-linked products to ensure that related claims can be substantiated in a clear and accurate method. This includes supporting timely and accurate reporting requirements for data that feeds into Key Performance Indicators.
• Clear lines of responsibility for product management along lifecycle: the definition of responsibilities at a group, business line, and product level is especially important due to the need to monitor distribution of products.
• Training requirements: firms should consider the need for in-house training or capabilities to respond to greenwashing challenges. For example, legal and compliance teams could be trained in non-financial metrics and sustainability analysis so they can appropriately challenge and respond to any complaints.
• Alignment between business line and corporate level reporting: firms should consider the management information (MI) and controls in place around their product, business line, and legal entity levels of ESG reporting that would feed into their disclosures, for example, the MI on the categories of KPIs that are being included in green bonds or sustainability-linked loans.

The practicalities of integrating a new principal risk into a firm’s risk architecture can be considerable task as it impacts risk and control self-assessment, incident management, MI, risk aggregation and reporting, policies and procedures, risk management frameworks, and risk appetite statements. Changes to all these items are likely to have significant internal approval hurdles.

The process of integrating greenwashing risk has similarities to the challenge firms faced when integrating conduct risk into operational risk taxonomies at the outset of the regime.

Having a comprehensive strategy at a firm level can ensure alignment in approach across a firm’s business lines, preventing inconsistent and therefore misleading sustainability claims.

Future considerations

As the source of the funds needed to finance new energy systems, resilient infrastructure, and low-carbon technology, green finance is considered essential in the push towards a net-zero economy. Since 2012, green finance has grown by more than 20 times its market value and as global economies move towards net-zero goals, trends suggest that companies are increasingly reallocating capital away from emissions-intensive businesses to low-emissions businesses.

It is clear from COP27 last year that the next focus for the green transition will not be goal setting, but transparent strategies with clear mechanisms for tracking progress. With COP28 coming up this year, the focus will continue to be on measurable action, including large scale investments into green finance. In this landscape, firms found to be making empty environmental promises or being seen to support such firms financially will face pushback from regulators, consumers, and shareholders.

As governments work to put in place rules to prevent greenwashing, companies have faced greater scrutiny into their green status. For example, the technical realignment under the EU’s Sustainable Finance Disclosure Regulation (SFDR) of Article 9 top rated sustainable funds to the broader Article 8 category resulted in an impact amounting to tens of billions of dollars of client fund value as a result of the downgrade. Similarly, the UK Government will layout its implementation plan for its green taxonomy later this year, which if enacted would create more transparency into funds’ ESG credentials.

Considering the constantly evolving nature of the ESG landscape, firms with a robust green financing risk framework will be able to affect a smooth transition to the new requirements and to take advantage of green financing growth without incurring significant risk of regulatory challenge. Now is the time to review risk management frameworks and take the steps to align with new regulatory requirements and consumer demands.