Insights

A Proposal to Establish an Independent Monitoring Body for ESG-Washing

ㅣ Karl Yang, Founder & Executive Director of KoSIF ㅣ

The era of ESG has arrived. ESG first emerged in 2004 from a perspective of securing the sustainability of finance and corporations. It was designed to help investors achieve more meticulous risk management and capture new opportunities by taking into account non-financial factors—namely Environmental, Social, and Governance (ESG) elements—that influence the financial performance of investee companies. Subsequently, as the United Nations Environment Programme Finance Initiative (UNEP FI) published a report regarding the consideration of ESG as part of a financial institution's fiduciary duty, the concept evolved into a mainstream practice embraced not only by investors but also by all financial institutions, including banks, insurers, and pension funds. Today, moving far beyond finance, many corporations are adopting ESG as a new paradigm for management. ESG is now becoming a powerful strategy to secure a corporate competitive advantage across the entire value chain—encompassing finance, design, raw material procurement, production, marketing, logistics, consumption, and disposal.

Consequently, the growth rate of ESG products is spectacular. According to a study by New York University, the growth of products branded with ESG attributes is 5.6 times faster than those without, and the annual sales volume of ESG products in 2023 is estimated to reach $140.5 billion. As the sales growth of ESG products accelerates and consumer affinity increases, the risk of committing "ESG-washing," whether intentional or not, is growing concurrently. ESG-washing is a term derived from "greenwashing," which refers to cases where products are packaged as eco-friendly but actually exert a negative impact on the environment. Products or services that superficially champion ESG but realistically inflict negative environmental or social impacts can be termed ESG-washing. While the era of greenwashing primarily focused on the environmental impacts of a product, the era of ESG-washing requires us to examine social impacts as well. For instance, even if a product has a low carbon footprint, it constitutes ESG-washing if the raw materials channeled into that product were procured from conflict zones, or if the supplier utilizes child labor or forced labor. If companies engage in such ESG-washing, they might reap short-term benefits once or twice. In the long run, however, public trust in all ESG products will vanish, making it impossible to separate the wheat from the chaff. Consequently, this will lead to a contraction of ESG management as a whole, because the competitive edge pursued through ESG management can no longer be achieved. As such, ESG-washing can be classified as a serious crime that blocks the virtuous cycle of the economy by shattering the social trust that underpins a capitalist market economy.

This type of window-dressing does not exist solely within the manufacturing sector. The detrimental effects of ESG-washing in financial products are, in fact, far more severe. Although financial institutions are the ones selling financial products, the true owners of the money mobilized into these products are not the financial institutions themselves, but the general public. Therefore, ESG-washing in finance inflicts harm upon an unspecified majority and, in severe cases, can disrupt the global financial system. Yet, even in this realm, ESG-washing is widespread. According to a report by InfluenceMap, an independent think tank that analyzes the impact of corporations and finance on climate change, an analysis of 723 equity funds with $330 billion in assets under management (AUM) as of 2021—categorized into ESG funds and climate-related funds—revealed startling results. Among the 593 ESG funds valued at $265 billion, 71% (421 funds) held investment portfolios that fell short of the targets set by the Paris Climate Agreement. Furthermore, among the 130 climate-related funds valued at $67 billion, 55% (72 funds) failed to meet the Paris Agreement targets and held fossil fuel-related stocks totaling $153 million.

Because the damage caused by the window-dressing of financial products directly affects the general public and delays the mobilization of capital for the transition to a low-carbon economy—thereby harming global sustainability—regulations against this practice are tightening in numerous countries. In 2020, the EU legislated its green taxonomy to encourage green finance and present a baseline for determining ESG-washing. Following this, in March 2022, the EU initiated procedures to amend legislation aimed at protecting consumer rights and banning greenwashing—specifically the Consumer Rights Directive and the Unfair Commercial Practices Directive (UCPD). The U.S. Securities and Exchange Commission (SEC) also proposed amendments to the ESG Fund Disclosure Regulations in May 2022, meticulously stipulating disclosure requirements according to ESG fund types. The SEC also instituted the "Names Rule" to ensure fund names do not mislead the public, explicitly stating that a fund must allocate at least 80% of its assets to ESG investments in order to use "ESG" in its name. In 2021, France passed a law mandating that any listed company prosecuted for greenwashing can be fined up to 80% of the expenses incurred for the deceptive campaign.

As regulations against ESG-washing tighten, cases of companies being investigated or prosecuted due to such window-dressing are on the rise. Last year, Deutsche Bank—which manages trillions of dollars in assets—and its asset management subsidiary, DWS, came under investigation by the U.S. SEC and Germany’s Federal Financial Supervisory Authority (BaFin) on charges of "prospectus fraud," alleging they deceived a multitude of investors by distorting the extent of ESG integration within their investment processes. Furthermore, the costs incurred from washing-related disputes are substantial. In 2020 alone, within securities class-action lawsuits related to greenwashing in the United States, 60% of defendants paid settlements exceeding $5 million, and 8% paid settlements exceeding $100 million.

ESG-washing, which inflicts harm on an unspecified majority and impedes the transition toward a sustainable society, is a wrongdoing that must be eradicated. The question lies in who will prevent it, and how. The ongoing legislation centering around the EU and the tightening of regulations by supervisory authorities represent one prescription. However, there are limitations. Particularly within South Korea's political landscape—where even economic issues with clear public benefits are approached from a partisan standpoint—it is no easy task for the ruling and opposition parties to reach a consensus and draft a law to prevent ESG-washing. Moreover, statutory regulations may fail to respond in a timely manner to newly emerging types of ESG-washing, and companies might evade legal punishment if their fraudulent actions go undetected. Corporations may also opt to merely adhere to the bare minimum rules prescribed by law, failing to advance toward genuine ESG implementation.

Therefore, the most desirable way to prevent ESG-washing is for the entire citizenry to step forward. Blocking ESG-washing by financial institutions is, in essence, the path to protecting our own rights as depositors, insurance policyholders, pension subscribers, and investors. The best way to ensure the smooth operation of an economic system is for market order to be established through the market’s own self-purifying mechanisms. For this to happen, collective monitoring by market participants is essential.

In this spirit, I propose the establishment of an independent body to monitor ESG-washing. Since it must monitor corporate window-dressing, budgetary independence is imperative. Furthermore, because it must remain free from political stances, the participation of politically neutral private-sector experts must be fully guaranteed. Given that the new administration has expressed its intent to execute policies for the promotion of ESG, I look forward to discussions regarding the establishment of an ESG-washing monitoring body taking place in the near future.