Regulators, and in particular the EU, have increased the level of disclosure as regards sustainable investing through the SFDR/Taxonomy/NFDR/CSRD etc. Their intention is that in time this will have clear benefits for investors and more importantly the planet. However, be in no doubt many financial actors will try to game the system.

Image: ESGToday

Therefore, the stick of regulation must still be waived as the carrot of climate resilience and carbon neutrality take too long for impatient investors whose performance is monitored not just quarterly but daily. Indeed, one aim of regulators is to remove this short-term thinking by fund managers and get them to invest sustainably with an eye on the long-term. In reality career risk generally clashes with objective long-term goals.

Thus the effectiveness of sustainable finance policies also depends on an adequate level of enforcement across the EU. Supervisors have a key role in monitoring compliance with sustainable finance regulation and making full use of their supervisory and enforcement powers to ensure that investors and consumers are protected against unsubstantiated sustainability claims.

Let us have a very quick recap of what the EU is trying to achieve with SFDR. In short, the EU is requiring increased disclosure from asset managers that claim to be investing sustainably. Managers need to be able to evidence this through proscribed transparency obligations. Firstly, they must categorise their products (article 6/8/9[1]). Allied to this is a “Taxonomy” in essence a classification system for those activities considered, in simple terms, “good for the planet” – largely taken to mean “Paris aligned”. However, this only covers the ‘E’ bit of ESG. There is, as yet, no Taxonomy for the S[2] or the G. Thus, in theory an Article 9 fund could have a social objective (perhaps a focus on companies that meet certain board criteria in terms of diversity) but is not “Taxonomy aligned”.

Financial market participants and financial advisers are also required to consider “adverse sustainability impacts”. A fundamental aim, if not the primary aim, of the regulation is to reduce “information asymmetries” in terms of information flows and transparency so end investors can compare products that claim to invest sustainably.

Transparency is key to SFDR for a couple of reasons. Firstly transparent disclosure makes it harder for investment managers to “greenwash” their products and fool investors that they are following altruistic goals. Secondly transparency allows investors to compare products enabling them to make informed decisions and ultimately having better outcomes[3].  

Fiduciary duties

Fiduciary duties apply equally to boards of funds (who must ensure the Fund Manager is doing what he or she claims in the prospectus and marketing documents which must not conflict) and to fund managers themselves. If a manager claims to be investing sustainably then it is clear they must be able to evidence doing so. However this gets muddied for example where a fund manager invests in companies that are “transitioning”. How far does a company need to be along its transition path to score well in ESG ratings?

Data challenges

The difficulty in collecting data for a relatively immature industry[4] is well known at this stage. The EU via (NFDR[5] and CSRD[6]) is forcing companies to report on their ESG. Whilst the NFRD, which came first, covered approximately 11,700 large companies, the CSRD will increase this to approximately 47,000 entities. There are some aspects to the CSRD that will it is hoped will minimize greenwashing  – it requires the audit (assurance) of reported information and introduces more detailed reporting requirements, and a requirement to report according to mandatory EU sustainability reporting standards. The data must also be machine-readable (“digitally tagged”).

Whilst this is a large improvement many small companies are exempt. In addition, global ESG standards currently differ and many emerging markets have no requirements for companies to report on ESG. This makes it exceeding difficult for managers of emerging market funds to collate and report on sustainability risks.

Finally, post Brexit the EU and the UK are beginning to diverge as the UK follows its own (TCFD led) path in conjunction with new Sustainability Disclosure Requirements (SDR). Even within Europe some countries are imposing additional measures with the AMF first out of the blocks. So harmonization of international standards would seem like a distant dream. It doesn’t bode well and surely adds to the potential for greenwashing.  That said we all can “learn by doing” – the data will undoubtedly improve over time and things will look very different in five or ten years. Its certainly possible to demonstrate that you at least tried to meet the standards. 

Footnotes:

[1]  Art 6 – generally taken to mean ESG is not considered

   Art 8  – products that “promote” ESG

   Art 9 – having sustainability as an objective of the product

[2] There is likely to be a Social Taxonomy in the future

[3] Indee investors may decide reduced investment returns is an acceptable price to pay for investments that do not harm the planet

[4] albeit socially responsible investing and/or exclusion based investing has been around for 20+ years

[5] Non-Financial Reporting Directive

[6] Corporate Sustainability Reporting Directive

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