In a recent analysis of ESG risk incidents, data science firm RepRisk found that one in five cases of corporate risk incidents were linked to greenwashing and misleading communications. Greenwashing occurs when an organization provides false or misleading information about their sustainability practices in an effort to appear more environmentally friendly. Higher demand for ESG data is putting a spotlight on sustainability claims, leading to increased scrutiny from regulators, investors, and customers. In the case of private equity, greenwashing risk applies to the investment firm itself and its portfolio companies, as allegations of greenwashing are harmful to both parties.
Transparent ESG reporting is essential to access fundraising capital as a growing number of LPs incorporate ESG considerations into their investment decisions. However, making unsubstantiated claims in ESG reports can decrease stakeholder trust, cause reputational harm, and violate emerging regulatory requirements. Firms that violate these regulations or are otherwise accused of greenwashing face potential legal action. To avoid the risk of accusations, some organizations turn to greenhushing, in which they choose not to publicly share environmental or sustainability efforts due to fear of being called out. According to a 2022 survey from South Pole, one in four businesses do not disclose their science-aligned climate targets.
Greenhushing, or underreporting progress on sustainability initiatives, is not a viable solution in the long term. Failing to communicate about these initiatives is a lost opportunity to demonstrate long-term value creation and risk mitigation. Instead, to increase accountability and accuracy in reporting, investors need to collect high-quality data from portfolio companies that can be used to develop actionable insights and data-informed sustainability reports.
Regulatory Efforts to Combat Greenwashing
ESG data quality, standardization around reporting, and lack of transparency are all challenges to avoiding greenwashing in private markets. In recent years, there has been an increase in sustainability-related regulations, especially in Europe, taking aim at greenwashing by standardizing language and requirements around reporting. For example, the Sustainable Finance Disclosure Regulation (SFDR) is a landmark regulation that has a major impact on sustainability reporting in the EU. SFDR helps reduce greenwashing by increasing transparency in sustainable investment products and requiring funds to disclose certain information on their ESG practices.
In March, the European Commission proposed the EU Green Claims Directive to reduce greenwashing and prevent companies from making unsubstantiated sustainability claims. Under the proposed directive, consumers will have greater clarity and reassurance that a product is actually “green” and the ability to make more informed purchases. Companies would be required to meet certain criteria about their claims, avoid the use of vague sustainability terminology, and receive verification from independent auditors.
Similarly, Europe’s Corporate Sustainability Reporting Directive (CSRD) may also help reduce the risk of greenwashing by providing companies with a standardized reporting framework and detailed requirements on what to report. CSRD also focuses on double materiality, meaning a company would be required to disclose their impact on the environment and how external factors impact financial performance. Beyond the EU, it is estimated that CSRD will impact at least 10,000 companies around the world, mainly in the US (31%).
In the US, the Securities and Exchange Commission (SEC) is expected to release new rules around climate risk disclosure this April. The rules would require companies to disclose GHG emissions and other information about climate-related risks. This move is a clear indication that the SEC considers climate a material financial risk to a company’s performance and investment returns. The new disclosure rules may also help combat greenwashing by standardizing reporting requirements.
Preventing Greenwashing in the Portfolio
For investors looking to prevent greenwashing allegations in their portfolios, here are four measures to help portfolio companies avoid misrepresenting sustainability efforts:
Collect and leverage high-quality data from portfolio companies
One of the most effective ways to avoid greenwashing is by ensuring that you have high-quality ESG data to support sustainability claims. This starts with establishing a clear process and structure around portfolio-level data collection, including what metrics will be collected and guidance to help portfolio companies report accurately. Firms should also communicate why they are interested in specific ESG data, the importance to the portfolio company, and how they intend to use it. Collecting ESG data is more than a “tick-the-box” exercise, and understanding motivations behind requests can help improve data quality. With accurate data, firms and portfolio companies will be able to support sustainability claims, communicate effectively, and measure progress over time.
Set clear, well-defined targets with portfolio companies
One common trap of greenwashing allegations is failing to set targets against which progress can be measured. Having clear, well-defined targets and action plans to achieve them makes it easier to make progress on sustainability goals. General partners (GPs) can work with portfolio companies to set medium-term and long-term targets to measure progress and establish processes to follow up with portfolio companies to help them stay on track. Setting up adequate processes and allocating resources also enables investors and companies to be transparent about targets, action plans, and progress in sustainability reports. Such reporting practices help avoid potential greenwashing allegations by proactively communicating key information on sustainability efforts.
Strengthen internal firm policies on ESG integration
To demonstrate effective ESG integration and mitigate greenwashing risks, a firm should have clear policies and processes on how they integrate ESG into investment decisions and firm operations. It is essential to have alignment across the organization around how they talk about ESG in their messaging around investment practices. Firms should be able to support portfolio sustainability claims with actual data from portfolio companies. For example, if a firm claims that a fund has net-zero emissions, GPs should be prepared with company-level carbon emissions data. From an operational alignment perspective, many firms choose to have a Responsible Investing or ESG policy that explains how the firm incorporates these factors into investment decisions.
Consider portfolio company supply chains
Depending on the industry and company-specific considerations, ESG risks can also be found in the supply chains of portfolio companies. A company’s supply chain can reflect badly on a reporting company and lead to accusations of greenwashing if the company is viewed as trying to conceal or misrepresent ESG performance. To prevent this—and identify additional areas of risk and opportunity—firms should consider how they will manage ESG risks across a portfolio company’s entire value chain. During the ownership period, GPs can work with the portfolio company to help them set supplier-specific targets.
Avoiding Greenwashing Starts with Data
As regulations and stakeholder interest in ESG data rises, GPs will need to work closely with portfolio companies to ensure the information they are reporting is accurate and avoid greenwashing. Doing this starts with collecting high-quality data and extends through the investor’s engagement with portfolio companies and the ability to communicate and track progress over time. No matter where you are in your ESG journey, Novata can help make it easy to collect high-quality, comparable data, analyze for insights, and report on the metrics that matter. To learn more about how Novata can help improve ESG data management, talk to one of our experts.