A New EU Rule Can Expose Greenwashers

In 2023, all companies listed on regulated markets in the European Union will begin applying the Corporate Sustainability Reporting Directive (CSRD), a new rule that will require them to publish, from 2024, detailed information about how they relate to the environment, the treatment of employees, human rights, anti-corruption, bribery, and boardroom diversity. It’s a welcome step toward improving the functioning of a multitrillion-dollar market known as ESG (environment, society, and governance), which has long been troubled by inconsistencies in data quality, reporting standards, and methods used to generate companies’ ESG ratings. 

The new EU rule will try to tame the Wild West of ESG in three ways. First, companies must meet mandatory EU sustainability standards, which should introduce greater quality and consistency to their reporting. Second, companies’ reported information must be audited, which in theory should lead to greater scrutiny (audit firms’ track records suggest vigilance will be needed in this new area too). Third, companies must expand beyond the existing practice of reporting on how ESG factors impact their business to also report on how their business impacts the environment, society, and governance. This dual perspective should make it easier for investors, regulators, and consumers to reward—or punish—companies based on their ESG performance.

The ESG market’s lack of transparency, explainability, and accountability creates risk for investors and companies. In 2022, the US Securities and Exchange Commission (SEC) fined an investment unit of BNY Mellon bank $1.5 million for misstating ESG information and launched an investigation into Goldman Sachs for ESG misselling. Germany’s regulator also opened an investigation into DWS Group, the fund unit of Deutsche Bank AG. 

More regulatory scrutiny is likely in 2023, further straining the credibility of the ESG market itself. Last year Gary Gensler, the head of the SEC, felt it necessary to post a warning on Twitter that companies may be “greenwashing” (falsely claiming to be “green” or “sustainable”) and that there is a lack of consensus over what ESG investing even means. Moreover, Elon Musk tweeted, “ESG is a scam. It has been weaponized by phony social justice warriors” after S&P 500 removed Tesla, his electric-vehicle company, from its ESG index yet rated ExxonMobil, an oil supermajor (and thus a super polluter) among its top performers. S&P 500 defended its decision by pointing to allegations of racial discrimination at Tesla’s factories, which raised philosophical questions, as well as legal ones. For instance, is it more useful to rate companies’ performance on environment, society, and governance separately, rather than in aggregate? Or are the three ESG factors inextricably bound? 

Such questions have been around for years, but they acquired new urgency after Russia invaded Ukraine. ESG ratings agencies asked if they should continue shunning weapons manufacturers (since they make products that are deliberately designed to harm and kill humans) or increase those companies’ ESG ratings to reflect their role in defending democracies. This led some critics to argue that such ethical considerations should not be addressed by the unelected people who work at rating agencies; instead, they should fall to elected representatives. Yet this suggests that only elected representatives should weigh in on business ethics, a view with which many company leaders, employees, investors, and consumers profoundly disagree. In 2023, this debate will become even more intense as companies and ratings agencies think through not only the longer-term implications of Russia’s invasion of Ukraine, but other risks, such as the possibility of China moving against Taiwan.

In 2023, further efforts to regulate ESG will also get underway. Last year the SEC proposed a rule that would make public companies report their climate-related risks, emissions, and net-zero transition plans. Yet even if this does not come to pass, companies will start to feel increasing pressure this year from central banks. The European Central Bank (ECB), the Bank of England, and Sweden’s Riksbank have all announced plans to require higher standards of climate reporting in order to align their portfolios with the 2015 Paris Agreement to limit global warming to well below 2 degrees Celsius. The International Financial Reporting Standards Foundation, which sets global accountancy standards, has also created a new International Sustainability Standards Board that is now working to set global standards for ESG reporting. The Wild West of ESG may not be wild for much longer.