Sustainable Finance: The Rise, Regulation, and Reporting

 

Nicholas Leaver.jpg

Author

Nicholas Leaver

FinTrU Associate

Published
Tuesday 1 December 2020

Introduction

Driven by soft law, regulation, and investor demands, Sustainable Finance and ESG (Environmental, Social and Governance) investing has gained importance on the global financial stage.  ESG investing covers the range of investment activities which considers a company’s environmental impact, how it demonstrates its obligations in its relationships with the communities and societies where it operates, and how leadership deals with issues including pay, audits, risk controls and shareholder rights.[i]

Strategy on Sustainable Finance

The European Commission has assessed the impact of Sustainable Finance as part of its commitment to achieve Sustainable Development Goals and comply with various international agreements. The aim is to promote an investment process that takes account of ESG considerations when making investment decisions in the financial sector, leading to increased longer-term investments in sustainable economic activities and projects.[ii]

In response, The European Securities and Markets Authority (ESMA) has set out its ‘Strategy on Sustainable Finance’. The strategy places sustainability as its primary focus by embedding ESG factors in order to facilitate a regulatory framework which supports and promotes sustainable investment in the EU. It seeks to create a harmonised approach to transparency obligations, risk analysis on green products and ESG investing, benchmarks, taxonomy, and supervision.

Core Elements of the Strategy

The core elements of the strategy are:

Sustainable Finance Disclosure Regulation (SFDR), which comes into effect in March 2021, will impose transparency obligations to improve the disclosures from financial market participants to investors regarding sustainable finance products. This will subsequently strengthen protection for investors and promote greater market integrity. 

Taxonomy Regulation will establish criteria for determining how environmentally sustainable an economic activity is and whether it should include additional product-level reporting requirements for products that promote environmental characteristics. EU Taxonomy will outline taxonomies associated with sustainable investment in ways that will help clarify aspects of ESG. It is expected to facilitate a ‘pan-European ecolabel’ for financial products to give more transparency, consistency, and resilience.[iii]

Low Carbon Benchmarks will introduce a new framework for climate related benchmarks, covering a wide range of financial instruments, with the purpose of achieving EU sustainability goals.[iv]

Regulatory Amendments, for example: changes to AIFMD and the UCITS Directive[v] will require the integration of sustainability risk into management processes. For firms subject to MiFID, it will also be required that sustainability factors are taken into account in product governance and suitability processes.[vi]

Overall, through the core elements described above, regulators seek to mitigate two main issues. Firstly, regulators are concerned about mis-selling or 'greenwashing': a process where managers claim to integrate ESG policies into their investment strategy; however, considerations are not substantively integrated into the investment process. Therefore, a consistent classification is required in order to understand the quality of manager sustainability and to identify those that are merely ‘window dressing’. Secondly, regulators are concerned with misreporting and seek to introduce standardisation of reporting across the industry. Lack of standardisation makes it difficult for investors to measure the ESG performance of one asset or fund manager against another. It is noteworthy that the FCA is yet to introduce formal guidance on ESG; however, given the growing regulatory scrutiny surrounding ‘greenwashing’, it is reasonable to expect that updates to the FCA handbook on ESG matters are imminent.[vii]

Disclosures

The EU has identified the asset management sector as a key driver of investment strategy, which can play a major role in the inception of its ESG agenda.[v] SFDR seeks to harmonise sustainability related disclosures at the entity (manager) level and the product (fund) level, irrespective of whether sustainability risks or principal adverse impacts are integrated into investment decision-making processes by March 2021.

The definition of ‘sustainability risk’ will be key for asset managers: drafts of SFDR indicate that it should be defined as events that could cause a material negative impact on the value of the investment arising from an adverse sustainability event.[v] Meanwhile, ‘principal adverse impacts’ are described as the impacts of investment decisions and advice that result in negative effects on sustainability factors.[viii] These definitions should refocus corporate engagement on long-term, sustainable decision making that will embed ESG considerations into governance standards, for which the senior management of a firm will be held collectively responsible.

At the entity level, firms will be required to disclose information on their policies regarding the integration of sustainability risks within decision-making processes. They will also be required to provide a summary of how remuneration policies are consistent with the integration of sustainability risks, and where they consider principal adverse impact within investment decisions on sustainability factors. This will include evidencing that due diligence processes have been completed on the outlined impacts or, conversely, if they do not consider adverse impacts, clear rationale must be provided.

At the product level, firms must include the following in their precontractual documentation: a description of how sustainability risk is integrated into investment decisions; the assessment of likely impact on the returns of the product or; if sustainability risk is not considered, then an explanation as to why these are not deemed relevant. The regulation broadly follows the mantra of ‘comply or explain’.

Where financial products promote ESG characteristics, or have sustainable investment as their principal objective, asset managers must disclose prescribed information on how these characteristics are met and any index designated as a reference benchmark. This disclosure will also be required at the product level to display into which ‘basket’ products fall. The Article 8 basket promotes environmental and/or social characteristics by incorporating ESG factors, while the Article 9 basket has sustainable investment as its primary objective. Therefore, Article 9 products will be required to include additional disclosure of how products meet this standard through the investment and selection processes. A statement of disclosure regarding lack of ESG characteristics will also be required for those products that do not fall into either the Article 8 or the Article 9 baskets.

The concerns for managers in scope will be the potential to misrepresent the ESG profile of fund shares, and the impact of sustainability risks on the returns of financial products caught by the regime.[v] Additionally, conflicts of interest may arise as fund managers will be required to consider into which basket their products fall, or into which they wish them to fall. These considerations will include the “tension between reputational impacts and the feasibility of complying with the relevant standards”.[viii]

Furthermore, regulatory questions posed to fund managers in the past have focused on investor suitability and risk tolerances: ESG preferences and the suitability of potential investors are likely to be added. The practical outcome of this is a heightened need for active engagement concerning what is true ESG profiling and how best to understand and comply with product governance and investor suitability.

Brexit

When the regulation comes into effect, UK managers will be caught in scope of the SDFR and required to comply with the disclosure obligations when marketing funds to the EU. There is still uncertainty in respect of the UK’s post-Brexit position: the UK may adopt a different set of product level disclosure requirements which overlap with, but are different to, those of the EU. It is possible that funds marketed in both the UK and the EU may simply adopt the more demanding of the two standards to manage this process.[ix] This will mean extremely onerous ESG disclosures in order to comply.

A need for further classification

The ongoing consultations by European Supervisory Authorities (ESAs) have considered not only the SFDR but also Taxonomy Regulation, due to the overlap between the two. Taxonomy Regulation will be key to ensuring that financial participants have a common means of making disclosures and performing due diligence on ESG products. The unanimous belief amongst ESAs is that clear and consistent ESG data will be critical in performing effective due diligence to realign the financial markets towards sustainable development and help achieve the Sustainable Development Goals.[x]

Despite this, Taxonomy Regulation has different timings and terminology to SFDR: both include their own, diverging concepts of what constitutes a ‘sustainable investment’. SFDR encompasses products with environmental and/or social objectives, while Taxonomy Regulation is only concerned with environmental objectives. Therefore, the environmental pillar of ESG ratings suffers from high levels of ambiguity. Should this persist, it could impact market integrity and investor trust by facilitating the very processes of ‘greenwashing’ it seeks to prevent.

Thus, the primary concern for ESAs is: “where there should be a seamless overlap between the two regulations, there is not”.[xi] While ESAs continue to align the two regulations, there is no doubt that, in their current form, each of the regulations produce quite different results. This is in stark contrast to the clarification it is intended to bring. The European Commission might, therefore, need to reconsider some of these primary issues if this regime is to succeed.[xi] Meanwhile, firms in scope may potentially need to adopt a tiresome approach to comply with SFDR.

Looking Ahead

Fund managers are coming under increasing pressure from investors and regulators regarding the quality of their ESG credentials and policies. ESG is an issue that is not going to disappear: the need to prioritise sustainability in financial markets remains vital in planning and implementing a path to a more positive environmental, social and governance-based global financial system. This process can only be moved forward effectively through understanding the priorities and perspectives of a wider range of market participants and will require clear definitions to ensure a common understanding.  If the Sustainable Finance Strategy is to be successful, data quality will play an essential role in creating clear definitions and, therefore, enhance the overall effectiveness of the strategy’s impact.

Regulatory and industry emphasis has shifted from a solely environmental focus to looking beyond climate change with a more holistic focus on ESG. While some environmental focus will remain, increased focus on governance is essential to enforce the effective oversight of companies that shareholders expect. Of late, there has also been a developing focus on global social issues which has been accelerated and highlighted as a result of the Covid-19 pandemic.

The landscape as we know it is rapidly changing: “Millennials care more about sustainability than any other generation before them”.[iii] If fund managers wish to remain a desired source of generating capital in the future, adapting to these investor demands is necessary: failure to do so may leave managers at risk of falling behind. The incorporation of ESG principles is, therefore, becoming the default. Fund managers must consider more than just the asset balance sheet and focus on an additional set of sustainability risks when acquiring and managing assets within their portfolios. “Sustainability is no longer a question of whether or when, but of how”[x].

 

References

[i] https://www.linklaters.com/en/insights/publications/2020/march/the-esg-landscape-and-opportunities-on-both-sides-of-the-atlantic

[ii]Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD Paris, www.oecd.org/finance/ESG-Investing-Practices-Progress-and-Challenges.pdf

[iii] www.ashurst.com/en/news-and-insights/insights/esg---something-private-funds-simply-cannot-ignore/

[iv] www.bovill.com/new-esg-disclosures-for-asset-managers/

[v]www.bakermckenzie.com/-/media/images/insight/publications/2019/07/esg-regulatory-reforms/esg-reforms--implications-for-asset-managers.pdf?la=en

[vi] https://www.dechert.com/knowledge/onpoint/2020/5/overview-of-the-esg-driven-amendments-to-mifid.html

[vii] www.ashurst.com/en/news-and-insights/insights/esg---something-private-funds-simply-cannot-ignore/

[viii] www.linklaters.com/-/media/files/document-store/pdfns/2020/june/8933_lin_esg_disclosure_regulation_final_2

[ix] https://www.sidley.com/en/insights/newsupdates/2020/06/esg-disclosures-for-asset-managersy

[x]  www.omfif.org/wp-content/uploads/2020/09/The-role-of-data-in-sustainable-investment-policy-and-regulation

[xi] www.ashurst.com/en/news-and-insights/legal-updates/consultation-on-requirements-for-esg-sustainability-disclosures/

About FinTrU

Founded in December 2013, FinTrU is a multi-award winning RegTech company that is committed to giving local talent the opportunity to work on a global stage with the largest international investment banks. FinTrU provides its clients with high quality, cost-effective, near-shore resourcing solutions. FinTrU’s products are: Legal, Risk, Compliance, KYC, Operations and Consultancy. Its clients are all Tier 1 Investment Banks based in London, New York, Tokyo, Frankfurt and Paris. FinTrU employs over 700 people across offices in Belfast, Derry/Londonderry, London and New York.