Tuesday, January 31, 2023

EU rules promise to reshape the dark world of sustainable investing

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Anders Bertramsen likes to know what he eats so when he does his weekly shopping he checks food labels for nutrients and provenance before choosing products. But in his professional role of selecting sustainable investment funds for high net worth investors, he finds it much more difficult to make such judgments.

“It’s a labyrinth,” says Nordic bank’s head of external fund selection and Nordea asset manager. “Knowing which funds are truly sustainable takes a lot of time and experience.”

For Bertramsen, the EU’s introduction in March of historic rules demanding greater transparency for environmental, social and governance funds cannot come soon enough. “We’ll have a lot more data, which will help weed out managers who talk to each other about ESG but don’t do anything.”

Sustainable finance disclosure regulations require fund groups to provide information on the ESG risks of their portfolios for the first time. A central element of the EU green agreement, they aim to push more capital towards sustainable activities by injecting discipline into the ESG market.

The rules aren’t just good news for professional investors like Mr. Bertramsen; they will also help retail savers, from millennials to sustainability-minded seniors, who want tools to ESG noise.

ESG investment has exploded in recent years as increasing investor awareness of issues such as climate change prompts them to invest in funds that benefit society in addition to generating returns.

ESG funds in Europe attracted net inflows of € 151 billion between January and October last year, an increase of almost 78% from the same period in 2019, according to Morningstar. Yet the boom has been overshadowed by fears that some vendors have exaggerated their sustainability credentials to gain business, a trend known as greenwashing.

However, the new EU rules will shake up ESG investing by exposing laggards and forcing the investment industry as a whole to improve its offering.

“It’s hard to overestimate the impact that regulation will have,” says Thomas Tayler, senior director of the Center of Excellence in Sustainable Finance at Aviva Investors. “It will change the way people run their businesses by putting sustainability at the heart of the investment process.”

The ambition of the new regime is clear from its scope: it does not only target sustainable funds. Under the rules, all asset managers will have to consider sustainability risks alongside other financial risks, before disclosing to investors how they are managed or why they are not relevant.

Just a few years ago, this approach – known as ESG integration – was the preserve of a handful of ESG specialists, says Tayler. But he adds that the compliance or explanatory nature of the new rules will push more asset managers to act, turning ESG integration into a core requirement for all funds.

At the same time, the increased reporting requirements imposed will also raise the bar among asset managers focused on sustainability. Under the new rules, funds that claim to go further on ESG – such as impact funds, which put environmental or social goals on a par with financial profit – will need to back up their virtuous claims with clear evidence of their sustainability efforts.

Valentin Allard, senior consultant at the Indefi research group, says that the fact that ESG managers will have to disclose the same data will make it easier to sort the wheat from the chaff.

“A lot of masks will fall,” he predicts. “Once everyone reports on the same metrics, some people may find that they are past how green they really are.

At the same time, the European framework shining the spotlight on ESG is likely to lead to a surge in sustainable fund launches, as asset managers rush to adapt their products to the new world.

“The market will be changed by regulations,” says Olivier Carré, partner at PwC Luxembourg. “Asset managers must decide how they want to position themselves in this new environment.”

PwC believes that ESG funds could increase their share of total European assets from 15% to 57% by 2025 thanks to EU rules, with most of the growth coming from the conversions of non-ESG funds into funds that comply with the new regulations.

The burden on managers to improve their game is made more urgent by the fact that their clients – pension funds, insurance companies and financial advisers – will also be forced to consider sustainability as part of the rules, which will result in even greater demand for ESG funds.

However, start-up issues with regulations and questions about how they relate to other EU legislation will likely hamper the growth of the ESG industry.

Brussels recently delayed date whereby asset managers will have to submit the bulk of disclosures following industry resistance.

But even with the delay, compliance will be difficult due to the sheer volume of data to be collected. “If I look at how many people in my company are working on [the ESG regulations], it’s almost as big as Mifid II was, ”says Gilbert Van Hassel, managing director of 158 billion euros, Dutch asset manager Robeco, referring to the radical European market rules that came into effect in 2018.

A major hurdle for asset managers is obtaining sustainability data from the companies in which they invest. global standards for corporate ESG disclosures, the availability and quality of information vary greatly.

Sustainable finance trade body Eurosif estimates that of the 32 ESG data points that asset managers are required to report under current proposals, only eight are available today.

The EU aims to tackle this problem by imposing new obligations on companies as part of its review of the Non-Financial Reporting Directive, which governs sustainability reporting. But that might not be finalized in time for the first detailed ESG reporting deadline for asset managers in 2022.

Another challenge is the lack of alignment between reporting requirements and EU taxonomic regulation, the flagship rating system on what qualifies as a green investment, which actually requires fund groups to make two separate sets of ESG disclosures.

Tayler says asset managers will learn by doing and evolve over time to meet the high expectations of decision makers.

However, a more important long-term question is whether disclosure regulations will be truly effective in eliminating greenwashing and channeling money into sustainable economic activities.

Victor van Hoorn, executive director of Eurosif, says a lot will depend on whether or not the information is read by investors and the extent to which regulators scrutinize it. Financial regulators at the two largest European fund hubs, Luxembourg and Ireland, have indicated they will allow asset managers to self-certify that they are following the rules.

Since European regulations do not impose minimum standards for ESG funds, “this could actually make it more difficult to detect good ESG asset managers,” he warns.

This is a view shared by the French financial regulator, the AMF, which recently started demanding local funds that they minimum thresholds in order to market itself as an ESG.

The watchdog wants similar rules to be introduced at EU level to protect investors and protect the credibility of ESG investing. It also calls for EU-wide monitoring of ESG data and rating providers, who have been criticized for their inconsistent methodologies. “We believe that this problem, directly linked to greenwashing, has not yet been addressed by the [forthcoming] European regulations ”, declares Robert Ophèle, president of the AMF.

Nathan Fabian, Director of Responsible Investment at Principles for Responsible Investment, says that with the new ESG rules, investors can judge for themselves the sustainability of a fund and act accordingly. However, he adds that “if the money does not start to be redirected, governments will have no other choice” than to introduce minimum standards.

Given the net zero emission targets that many countries have set themselves, they are likely to impose more stringent rules in the future to ensure that financial products are aligned with sustainability goals, he said.

The EU’s ESG roadmap

March 10, 2021

Entry into force of the regulation on sustainable financing disclosures

Asset managers should define ESG policies at entity level and publish ESG information in pre-contractual documents

Q1 2021

European Commission to launch review of Non-Financial Reporting Directive governing ESG corporate disclosures

January 1, 2022

First deadline for asset managers to submit annual ESG statements at product level in accordance with SFDR

Asset managers should report on climate change mitigation and adaptation in accordance with EU taxonomy

Q1 / Q2 2022

Expected application of rules requiring financial advisors to consider clients’ sustainability preferences

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