The ESG challenges for funds in a more sustainable economy
The European Union is implementing a major regulatory reform to ensure the investment management industry supports the transition to a more sustainable economy, and that sustainability risks are adequately integrated into investment decisions. Arendt’s Nadia Bonnet and Antonie Peter take stock.
While some of the reporting requirements around an investment industry that supports a more sustainable economy are still being finalised at European Union level, investors around the world are already drawing on the emerging framework to shape their approach to sustainable investing, and to compare the impacts of different funds across regions.
Under Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (the “SFDR” or “Level 1 requirements”), financial market participants must disclose the extent to which their financial products promote environmental or social characteristics or make sustainable investments (as defined in the SFDR). Under Regulation (EU) 2020/852 on the establishment of a framework to facilitate sustainable investment (the “Taxonomy Regulation”), financial products must disclose how and to what extent they are aligned with the delegated act on climate and the forthcoming complementary delegated act on the environment.
Finally, the Regulatory Technical Standards (“RTS” or “Level 2 requirements”) that are currently being developed to enhance the SFDR and the Taxonomy Regulation, and that will come into force in January 2023, will further specify the format and content of the taxonomy alignment disclosures required of financial products, and will also introduce more detailed transparency requirements for disclosures under the SFDR.
The regulatory puzzle
Since its sustainable finance action plan a few years ago, the European Commission has been working on an ambitious agenda to lead the way in sustainable finance. As described above, the plan comprises numerous regulations that are progressively being implemented.
The SFDR, the Taxonomy Regulation, the NFRD or the CSRD are some of such regulations, with the intended combined effect of integrating environmental, social and governance issues into collective investment management in a consistent and harmonised manner.
“Since its sustainable finance action plan a few years ago, the European Commission has been working on an ambitious agenda to lead the way in sustainable finance…the plan comprises numerous regulations that are progressively being implemented.”
Challenges
Beyond the feat of deciphering the dense regulatory package, numerous practical challenges with respect to ESG await fund managers - and the financial sector as a whole - in the coming years.
Long-standing problems as yet unresolved – such as the lack of data, timeline inconsistencies or the state of overall literacy on the topic (among fund managers and investors alike) – are now combined with new hurdles, such as the emergence of disparate national rules.
This sequencing issue leaves fund managers and the whole industry faced with significant operational challenges when attempting to calculate taxonomy alignment. It also impedes their ability to adequately integrate sustainability risks in investment decisions, and to assess the potential adverse impacts of their investments on sustainability factors.
Unfortunately, there are also other pieces in the regulatory puzzle whose timing could place the financial sector in a difficult position. For example, the proposed reform of the MiFID rules on suitability assessments is planned to come into force in August 2022.
These revised rules include the need to take into consideration end clients’ sustainability preferences when distributing financial products. Such sustainability preferences are to be assessed on the basis of three strict criteria, and in order to be suitable, such assessments will require much more detailed information and disclosures at financial product level than are currently being produced. That level of detail will not be achieved until January 2023, when Level 2 enters into force.
Extremely detailed information is required under many of the emerging legislative provisions (for example, those on principal adverse impact indicators), and while there is often insufficient granularity of non-financial reporting to meet such a requirement within the EU, the situation is even worse outside of it.
This renders some fund managers, such as impact managers, unable to demonstrate compliance with the framework of their investments in other parts of the world (especially in developing countries), despite having conducted successful impact investing actions in those regions for many years prior.
A fragmented EU market
Finally, asset managers currently must deal with an increasingly fragmented market in terms of ESG rules. This is true in the EU where the AMF, BaFin and other authorities have introduced gold-plating or local rules for sustainable/ESG financial products.
Although these apply only to national products distributed to domestic retail investors and often focus mainly on marketing material, fund managers looking to distribute their products in these countries must still take them into account and must find ways to accommodate them at the risk of being shut out of the market for misalignment with local rules or client expectations.
Such rules can introduce minimum sectoral exclusions, materiality thresholds for proposed ESG approaches, or minimum sustainable investment percentages, all of which can add onto the EU-level rules (which themselves ought to be seen as a transparency mechanism above all else).
In December 2021, the UK FCA even published its own sustainability-related disclosure framework (SRD) that is similar to the SFDR, but with key differences, creating further headache for fund managers with global operations.
Meanwhile, in the US (supported by, and in support of, the Biden administration), the SEC, the Commodity Futures Trading Commission, the Labor Department and the Federal Reserve have all announced ESG regulation projects, the creation of new ESG-related positions and task forces, or both.
Conclusion
Many of the challenges presented in the second part of our article have already been identified by EU policymakers, who are working hard to propose regulatory solutions. The latest example of this is the work on ESG ratings initiated by ESMA.
Where regulatory solutions fail or are too slowly implemented, market initiatives and solutions flourish. Specialised actors looking to tackle specific topics and industry working groups, alliances or collaboration platforms are here to take some control and provide market participants with practical solutions to these – hopefully short-lived – issues.