The recent raid by German prosecutors on Deutsche Bank's asset management arm DWS as they investigate allegations of greenwashing could turn out to be a watershed moment that will make the financial services industry take ESG reporting and data quality more seriously.
The investigation is seen by ESG specialists as one of the first signs of "ESG 2.0" as the market matures and a forgiving approach to claims about sustainability is replaced by greater scrutiny and verification.
“It is just another major step towards making ESG disclosures as regulated and clear for investors as disclosures of profit and loss,” said Joshua Margolin, a partner at US law firm Selendy Gay Elsberg.
DWS chief executive Asoka Woehrmann resigned in the wake of allegations by a whistleblower that the firm misled investors about the green investments in its €994bn assets under management. DWS declined to comment.
The pushback on blanket statements about ESG credentials is seen as long overdue and will make market participants far more careful about information they disclose.
"People will be far more cautious about the claims they're making and their ability to substantiate them. You must be able to justify with detail the claims that you are making,” said Andrew Steel, global head of Sustainable Fitch.
In the US, the SEC has proposed requiring US listed companies to disclose a range of climate-related risks and greenhouse gas emissions in filings such as annual reports. If passed, the new rules would see the SEC police disclosure more tightly.
US regulators launched an investigation into DWS last year alongside a separate probe by Germany's financial regulator BaFin. DWS denied wrongdoing but changed its ESG criteria and said that it had €115bn of ESG assets in its 2021 report published in March 2022, 75% less than the €459bn of "ESG integrated" assets reported a year earlier.
Treading cautiously
While it remains to be seen whether the reputational hit for DWS will result in outflows, the raid and resignation show the magnitude of an issue confronting every asset manager and company with ESG products.
Investors are expected to draw a clearer distinction between marketing materials from fund managers and the legally binding documentation that governs funds.
There will be a direct impact on investment banking, too, with mounting regulatory requirements making it more complex to issue ESG-labelled debt.
Issuing green bonds under current standards, for example, will be easier than issuing under the proposed EU Green Bond Standard, which is expected to be introduced in early 2023 and will require companies to present additional documentation.
The arrangers of sustainability-linked bonds will also face more scrutiny from investors that are keen to ensure that transition deals are appropriately structured and have standardised KPIs that are easier to assess and compare.
Banks are facing heightened internal scrutiny on deals and some are presenting credit committees with information that details the ESG impact on banks' own net-zero targets.
“I’ve been getting so much more from my compliance and risk function to explain what happens if ESG bond proceeds don’t get allocated, for example. There is just more scrutiny and I think people will tread much more cautiously instead of trying to out-innovate each other,” a sustainable finance head said.
Deutsche Bank is a major arranger of ESG-labelled debt and while it owns 79% of DWS, it faces less of a reputational hit due to the Chinese walls that exist between banks and their asset management arms.
Dangerous data
The intensifying focus on disclosure is likely to exacerbate problems about the availability, quality and consistency of ESG data, which is also an issue for ESG ratings firms, and raises the prospect of potential litigation if investors feel that they have been misled.
The widespread use of proxy ESG data is already a problem for asset managers struggling to comply with the EU’s Sustainable Finance Disclosure Regulation. From January 1, asset managers have to show the alignment of their funds to the EU Taxonomy that classifies which investments can be labelled as sustainable.
Asset managers use industry proxies to estimate up to 40% of their portfolios as the companies that they invest in will not start reporting their taxonomy alignment until 2023. The fact that the taxonomy has not yet been finalised is adding to the confusion.
"[The DWS investigation] has big implications for proxy data. I think people will start to be much more upfront about how much data is estimated rather than actual,” Steel said.
The use of proxy data is also an issue for ESG ratings companies that issue questionnaires to companies to gather data and use estimates to fill any gaps. This can give large compound errors when data sets are combined.
While ESG specialists applaud the crackdown on greenwashing, some are concerned that it could prevent the ESG market scaling up to the level required to put a brake on CO2 emissions.
“Scrutiny and questioning is welcome, but time is of the essence and we need to scale up,” the sustainable finance head said.