By Sunil Rana, Founder and CEO of Vyzrd

There is growing unease around the prevalence of greenwashing, which is threatening to put the brakes on the rapid growth of ESG investing – and a growing chorus of voices from figures in business, politics and science around the need to address it.

This lack of confidence in the market has caused some public figures, Elon Musk being one notable example, to go as far as to call ESG a “scam”. The topic was also recently in the spotlight at the World Economic Forum’s summit in Davos, where some criticised businesses for misleading investors and the public about their “green” credentials. According to Bloomberg, the size of the sustainable finance market is now estimated to be over 35 trillion US dollars, which means that problems with greenwashing must be urgently addressed to avoid this bubble bursting and causing significant upheaval to the global economy.

The banking sector has been actively adopting the sustainability push and has underwritten trillions of dollars of loans to various ESG projects. However, banks face significant financial, as well as reputational, risks from greenwashing.

To highlight the magnitude of the issue, Morningstar, an influential investor services firm, recently removed 1,200 funds with a combined value of 1.4 trillion US dollars from its ‘sustainable list’. The sheer size of the combined assets is unnerving in terms of the impact this will have had on the investors in those funds. Similarly, DWS’s 1 trillion US dollar greenwashing probe by the SEC highlights the risks greenwashing poses reputationally and in terms of material investment.

Banks must be careful to perform comprehensive research and due diligence, rather than getting carried away with “box-ticking”, if they want to avoid similar issues with greenwashing. In particular, there are three key factors banks will need to consider in their approach to ESG risk management.

Firstly, there is currently significant superficiality in the integration of ESG principles. Many organisations continue to apply ESG with a check-list centric approach, focussing on whether each investment can be marketed as green, rather than on whether there is actually any true intention to achieve integration and results. Often, ESG credentials are based on self-reported data. Research has shown that up to 80% of algorithm-collected corporate data is based on self-reported data without the necessary data quality assurance.

Without a deeper dive into what the company is actually doing to address ESG issues or holding the management accountable, it is therefore impossible to assess real impact. There is a complete disconnect with today’s approaches to ESG integration and business performance for it to merit any decision-useful insights.

Secondly, we are seeing a lack of coherent ESG capability and tools. A broad lack of ESG expertise has hampered businesses’ ability to meaningfully adopt ESG, and continues to do so today, with research suggesting that 77 percent of financial professionals report  sustainability skills shortage at their organisations. Additionally, whilst ESG reporting frameworks are now commonplace, there is still a clear lack of tools that can help drive meaningful, consequential analysis that assesses fundamental change and real-world impact.

Put simply, the surge in desire for companies to be green has led to a demand for these kinds of services that the current market cannot keep up with. Rather than finding “stop-gap”, superficial solutions, investment in technology and human resources is needed to ensure the long-term legitimacy of the impact investing ecosystem.

Finally, there is misalignment amongst ESG ratings. Confidence in, and the usefulness of, ESG ratings has been hit by the significant divergence between the different ratings produced by ESG rating providers. For example, a recent study by the MIT Sloan School of Management and University of Zurich led by Berg, Koelbel and Rigobon, found that there was very low correlation between the ratings of major ESG rating providers. This should be of great concern from investors’ perspective given the importance and sway that these ratings have started to have on sustainable investment flows. At the same time, it also highlights the increasing might of ESG ratings companies and the need for increased accountability amongst all actors.

While it is easy to criticise ESG ratings providers, the underlying challenge needs to be appreciated. There is a fundamental difference between ESG ratings and the traditional credit ratings business. As opposed to the financials of an organisation, the nebulous nature of a number of ESG aspects and the difficultly in quantifying and monitoring these makes the divergence in such ratings highly probable.

A lot of innovation is coming to the market in this space and needs to be integrated with current methodologies. However, it will be difficult for the existing large players to do so swiftly, as their frameworks have been in use for several years, and there is a wealth of data that has been built on these old frameworks. Any fundamental change could therefore threaten the lucrative benchmarking and data business for these entities. This means that many ratings companies will face an inherent inertia to evolve their frameworks.

Sustainable investing is a significant growth opportunity, and one that our planet and our businesses both need. However, execution needs to be improved significantly for it to deliver on its promise. While the regulators and ESG ratings companies explore ways to address the greenwashing challenge (expect it to be slow and painful), an integral part of risk mitigation for banks is to rapidly develop their competence in this area.

Given the current discordance in ratings, this is necessary in order to address both investment and reputational risks. Adoption of the appropriate technological solutions for analytics, monitoring and reporting will ultimately help mitigate greenwashing. This can be further strengthened through select partnerships with audit and consulting firms where such capabilities exist to augment in-house expertise. It must, however, be noted that this is a nascent area even for these firms and such partnerships will therefore need to be carefully executed.