Greenwashing and Market Failure: The Blind Spot in ESG Regulation

In the classic ‘lemons problem’ in economics, when buyers cannot distinguish genuine sustainability from greenwashing, the entire market suffers. High-quality suppliers are forced to withdraw, and the market gradually becomes flooded with inferior products. Today’s ESG market faces a similar crisis. This is a market failure driven by information asymmetry, capital is misallocated, and systemic risk increases.

The global markets are flooded with companies that project an image of sustainability, publishing glossy ESG reports while their operational reality remains carbon-intensive, thereby creating information asymmetry. Without a consistent, comparable, and verifiable system, the market and consumers struggle to distinguish between companies with genuine sustainability records and those that rely on counterfeiting and misleading advertising. 

This is more than an ethical issue; it is a structural market failure. In a healthy market, capital flows to the most efficient companies. However, in a market full of greenwashing propaganda, capital flows to the best storytellers. Investors and buyers can only rely on unregulated disclosures that are often more marketing than metric. The result: funds meant to finance the energy transition are instead subsidising general businesses, simply because they are wrapped in a green package.

This raises a critical question: if greenwashing is the crime, what is the weapon? The answer lies in opacity. We can adapt TerraChoice’s Seven Sins of Greenwashing to see how capital is misallocated. For example, firms are often guilty of the sin of the hidden trade-off: firms selectively emphasise the metrics that look favourable. Consider a beverage company that announces that its bottle is 100% recyclable. The bottle, however, uses virgin plastic with a significantly high carbon footprint, or the recycling infrastructure is insufficient, meaning the majority of bottles will still end up in landfill, or the Scope 3 emissions from logistics increases that aren't mentioned. Without looking at the whole entity, investors are misled by the “green label”.

The most pervasive mechanism for greenwashing lies in the data itself, specifically Scope 3 Emissions. Scope 3 represents the emissions from the entire value chain. For most sectors, Scope 3 accounts for over 80% of the total carbon footprint, yet it is the least regulated. This combination of high proportion and low scrutiny creates an environment where companies can strategically shape reports around their climate performance.

The critical flaw is that Scope 3 includes upstream and downstream activities, making it extremely complex to measure. Hence, Scope 3 data is modelled, not measured, becoming a structural weakness and an informational blind spot that many firms exploit. Companies often use spend-based methods. They multiply financial spend on a category by a generic industry emission factor. Clearly, the companies can report a reduction in emissions simply by negotiating lower prices with suppliers or switching to a cheaper, dirtier supplier and ironically report a lower carbon footprint because their spending decreases. This is not decarbonisation; it is accounting arbitrage.

Figure 1, Source: https://www.achilles.com/industry-insights/scope-3-emissions-where-do-i-start/

On the other hand, companies are allowed to select relevant categories within the Scope 3 subcategories. This gives firms discretion to exclude high-impact categories. Other methods include double counting, overstating decarbonisation influence, and emission laundering using carbon offsets.

One of the most powerful forces behind greenwashing lies within the financial system. Firstly, there is an incentive mismatch between corporate behaviour and market demands. There is far more demand for green assets than supply. This imbalance creates behaviours that ‘lower the bar’. Asset managers increasingly rely on classifications with flexible or inconsistent definitions; this allows them to assign a sustainability label to assets that would not meet stricter criteria.

Secondly, while external pressure on ESG performance has never been higher, the core power within public companies remains tethered to short-term financial metrics. This forces company strategy to choose the path of least resistance rather than a costly and difficult operational transition.

The theoretical risk of greenwashing has translated into tangible legal and financial crises. A 2025 industry report revealed that nearly a quarter of “Article 8” ESG-labelled funds remain at risk of greenwashing.

Greenwashing is not a series of isolated ethical lapses, shaped by information asymmetries, weak regulatory boundaries, and the expanding commercial demand for “sustainable” credentials. The path forward requires mandatory, third-party assurance and standardisation of ESG metrics, closing the regulatory loopholes that facilitate accounting arbitrage are essential to restore trust and ensure capital flows toward genuine sustainability.