Demand for ESG investment products has rapidly outstripped the development of regulation. For every story highlighting record inflows and market-beating returns, there have been calls from fund groups and investors for greater clarity around ESG ratings, data and disclosures.
With ESG investing now firmly at the top of the agenda, regulators in Europe have been working for some time to standardize its rules. Where once fund groups relied on the discretion of the companies they invested in to accurately report the ‘environmental’, ‘social’ and ‘governance’ impacts of their products and services, from March 10 when the Sustainable Financial Disclosure Regulation (SFDR) comes into effect, there will be a fundamental shift in how groups disclose, report and position their funds in future.
The SFDR introduces transparency and reporting requirements for mutual funds (among other financial instruments), which can be used by investors to assess the sustainability of their investments. Fund groups must disclose which of their products have sustainable investment as their objective (known as article 9 products), which promote an environmental or social characteristic but do not have it as their objective (known as article 8 products) and those products which do not factor in any kind of ESG objective whatsoever (article 6 products). Disclosures will have to be made publicly in the prospectus, on the firm’s website, in annual reports and in pre-contractual disclosures.
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The course of regulation never did run smoothly. With only a few weeks until its implementation, the European Supervisory Authorities (ESAs) is seeking clarity from the European Commission on a number of fundamental points around SFDR, including what exactly constitutes an article 8 or article 9 product.
While the regulators continue to work on the level two regulatory technical standard (RTS), the date of March 10 is set in stone and the SFDR will come into effect. The RTS will then be published at a later date to provide the details.
Perhaps without any firm agreement at policy level, the French regulator, the AMF, has now set its own criteria. France already goes further than other EU countries in having its investor information doctrine that impose standards on sustainability reporting for funds there.
Depending on your interpretation, this could be seen as either France trying to set the bar high for sustainable reporting across Europe or introducing a touch of protectionism, making any fund that wants to market as an ESG fund in France improve its standards.
There is also of course the matter of Brexit. Within the trade agreement that was struck on Christmas Eve 2020 between the EU and the UK, financial services were conspicuously absent. What this means in practical terms is that the SFDR does not apply to funds domiciled and marketed in the UK.
Instead, the UK has vowed to ‘match the ambition’ of the SFDR through aligning with the Task Force on Climate-related Financial Disclosures (TCFD) to improve and increase reporting of climate-related financial information. To complicate matters, UK fund groups that also have an EU presence will still have to comply with SFDR at the entity level.
Whatever is eventually decided upon, the UK is keen to set itself up as a responsible investment hub and in November last year committed to publishing a sustainable finance taxonomy based on the EU’s own taxonomy text. We can expect further developments on this over the coming year.
While a lot remains ‘up in the air’, the direction of travel is clear. Reporting and disclosure requirements are not going to go away, which will present their own challenges. In the early years of mandatory reporting, it will be difficult for funds to get (and rely on) accurate and comprehensive reporting by underlying companies, as they are only starting to report themselves.
Additionally, further regulations could be on the horizon. The European funds regulator, ESMA, has called for the regulation of ESG ratings agencies, so investors can understand what an ESG rating means.
Over time, reputational risk and peer/media pressure will make all funds ESG to a greater or lesser degree, but they won’t all be the same, so investors and advisers need to know the differences between rating agencies’ approaches.
ESG rating is not, nor should it be, like credit rating, where all rating agencies are trying to assess the same thing (the likelihood of a company going bust); ESG rating agencies will undoubtedly put different emphasis on the ‘E’, the ‘S’ and the ‘G’. Ultimately, values-based investing is about meeting an investor’s subjective values.
ESG is also a challenge for passive funds. Are all investors wishing to avoid tobacco stocks (although not necessarily a sustainability question) aware that both Philip Morris and BAT are constituents of at least one Dow Jones Sustainability index? Should BP be avoided or applauded for its roadmap to becoming a renewable energy company? These are difficult questions which have no easy answer.
Mikkel Bates is regulations manager for data provider FE fundinfo.