By Lee Clements, Head of Sustainable Investment Solutions
It’s boom time for sustainable investing. But as assets flood into ESG-oriented products and strategies, a simultaneous boom is underway in regulation. Predictably, the drafting of that regulation is triggering differences of opinion and vigorous lobbying by the various stakeholders, creating uncertainty for the investment managers to whom the new rules will apply.
The uncertainty and complexity involved can make it appealing for investment firms to disengage and adopt a wait-and-see stance. But we would argue that, while the endpoint may not be in sharp focus, the intention is clear—and there is work that can usefully be done now to prepare.
Currently, the European Union is ground-zero for the tussle over sustainable finance regulation. The European Commission’s Action Plan for Financing Sustainable Growth has triggered a number of regulatory initiatives, most notably the EU Taxonomy and the Sustainable Finance Disclosure Regulation (SFDR).
The former is a list of those economic activities which contribute to the EU’s environmental goals, namely climate change mitigation, climate change adaptation, sustainable use of water, the transition to a circular economy, pollution prevention and control, and biodiversity protection.
The EU will require companies to disclose, from 2023, the extent to which they earn revenues from these activities, and financial services providers will have to disclose, from the start of next year, whether and how they use the Taxonomy to assess the sustainability of underlying investments. The intent is that it should help drive capital towards these environmental goals.
So far, the EU has only produced a draft taxonomy for its climate objectives, but even this has proved contentious. Ten member states have objected, primarily to the exclusion of natural gas from the taxonomy’s ‘transition’ category. And more than 46,000 submissions to a consultation process were received by end the of last year. The Commission has delayed publication of the taxonomy and has yet not indicated when it will emerge.
Similarly, the Commission is facing headwinds with its SFDR rules. Introduced in 2019, the SFDR requires investors to show how the integrate sustainability into investment decision making, and the extent to which their activities have adverse impacts on people and planet.
Last October, it was forced to delay the introduction of the underpinning technical standards from March 2021 to late this year or early 2022. Since then, it has been reported that it plans to reduce the number of ESG indicators that financial services groups covered by the regulation will have to report against. Industry groups had criticized the earlier proposals as unworkable, although campaign groups disagreed.
In many regards, including regulation, the EU is ahead of the US, where regulators appointed by the Trump Administration showed little interest in sustainable finance. This is likely to change as President Joe Biden replaces the leadership of key agencies such as the Securities and Exchange Commission. Expect similarly vigorous lobbying from industry groups and campaigning organizations.
Investment managers might be forgiven for throwing up their hands at the drawn-out and complex process of drafting sustainable finance regulation. This would be a mistake. While there is ongoing dispute about the exact destination, the direction of travel is clear.
Opinions, and regulations, will change about exactly what is and is not sustainable. The timeframe for some new rules may be unclear. But the industry faces significantly enhanced disclosure. Investors will be expected to report ESG indicators. Underlying this disclosure is the expectation that investment managers will have to better understand the sustainability implications of the investments they are making.
Depending on the size of an investment firm and the extent of its commitment to sustainable finance, there may well be a case for diving into the lobbying effort in one direction or another. But regardless, it is important for investment managers to begin preparing for a regulatory environment where sustainability is high up the agenda.
It's vital to recognize the importance of a taxonomy, or a classification system, that can identify companies engaged in the transition to a green economy. Since 2009, we have been working on Green Revenues data to identify companies with green economic activities. The associated FTSE Russell Green Revenues Classification System (GRCS) provides definitions on green products/services in 10 sectors, 64 subsectors and 133 microsectors, which has a significant alignment with the EU Taxonomy.
The starting point should always be a clearly articulated sustainable investment philosophy and set of investment policies, which most institutions have already have in place. In the spirit of ‘if you can measure it, you can manage it’, they should ensure they have systems, data and analytics needed to collect, disseminate and disclose sustainability information, which is at the heart of most disclosure-based regulations. Smart investors can then understand the ESG and climate characteristics of their portfolios, allowing them to quickly react to upcoming regulations as well as more effectively address stakeholder concerns and build robust, sustainability focused investments.
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