24 Nov 2020

6 min read

portrait of Susan Hudson

Susan Hudson

Head of Regulatory Management

portrait of Michael Baldinger

Michael Baldinger

Head of Sustainable & Impact Investing

Will regulation shape the sustainable investing agenda? - Susan Hudson's insights

Sustainability risks are increasingly viewed by asset managers, investors and regulators as a potential source of financial risk. This is why we have seen some asset managers integrate environmental, social and governance (ESG) considerations into their investment processes, not least to meet the requirements of clients who also recognize the financial and other benefits of sustainable investing (SI).

As a large-scale asset manager, we believe that the capital markets will ultimately help address these challenges. We expect capital allocated towards those companies best placed to transition to a long-term sustainable future, and away from those less able to do so, will most likely deliver improved returns.

The regulatory landscape

To respond to the threats posed by sustainability risks, governments and national regulators are focused on establishing frameworks and disclosure standards for the financial sector to take sustainability into account in investment decisions.

The United Nations has taken the lead with the United Nations Paris Agreement adopted on 16 November 2016, and agreed by 125 countries, including the UN 2030 agenda for sustainable development. Adopted by 193 countries, this is a wider agenda than climate change and is also focused on economic, social and environmental development.

Other initiatives include the Financial Stability Board’s task-force on climate related financial risks, the UN Principles for Responsible Investment, and steps taken by the UK and France on stewardship and ‘comply or explain’ principles which encourage companies to increase disclosure. It is clear that governments are becoming increasingly serious about tackling this issue and Hong Kong, Singapore, Germany, Switzerland, Spain, Canada and the US are all examining this topic more closely.

Sustainable investment in the EU 

But it is the European Union that is the first jurisdiction to make a major start in setting out new guidelines. In 2018, under the Action Plan on Financing Sustainable Growth, the EU launched a 10-point program to re-orient capital flows, impose requirements on financial institutions to take sustainability risks into account and encourage companies to disclose more information on sustainability on the basis of effective metrics and a long term view.

The EU wants to encourage investment in sustainable activities and the new disclosure regime is intended to increase transparency and give investors the ability to compare products and sustainability outcomes.

Today all firms in the EU are free to define sustainable investments as they see fit. But from March 10, 2021, investment firms will be required to classify their offerings according to whether and how they incorporate sustainability based on new standards published last November in the Sustainable Finance Disclosure Regulation (SFDR).

For certain products, classified under Article 8 and 9 of the SFDR, investment firms must explain how environmental or social characteristics are promoted or investment in sustainable activities is achieved.

The EU wants to encourage investment in sustainable activities and the new disclosure regime is intended to increase transparency and give investors the ability to compare products and sustainability outcomes.

Initially, this disclosure will be high-level and principles based but will be further enhanced once the SFDR Regulatory Technical Standards are in force and new rules requiring corporations to disclose more non-financial information on sustainable activities are introduced. Currently, we expect these developments from 2022.

Key points

  • Investment firms marketing ESG products in the EU will need to report on sustainable investment using EU categorizations and definitions.
  • Investment firms will engage with companies to request better information on sustainable activities.
  • Data companies will strive to bridge the gap by mapping their existing data points to the EU requirements.
  • As more data becomes available from corporations, the disclosure of sustainable characteristics and activities is intended to become a comparable metric for certain products.
  • It remains to be seen how other jurisdictions will use the work done in the EU to inform their thinking.

According to a survey conducted by the Board of the International Organization of Securities Commissions (IOSCO, April 2020), there are more than 12 initiatives currently underway across the globe on reporting principles and frameworks.

Fragmentation remains a risk in the near term with more clarity and alignment needed. In April 2020, IOSCO decided to establish a Sustainability Task Force with a mandate to promote transparency and investor protection, including “decision useful” disclosures.

This will be welcomed by issuers, investors and regulators and will help drive a level playing field over time.

From ESG to SDGs : shifting to outcomes - Michael Baldinger gives his views

What does the European Union’s commitment to a carbon neutral economy by 2050 mean for the way we invest? Are we standing on the cusp of a transformation in the capital markets?

For investors, the change in mindset demanded by the EU’s new regulatory standards for sustainable finance, is, in our view, little short of transformational. Not only does it carry the clear potential to accelerate the shift towards sustainable investing, it also signals a fundamental change in investment approach.

We have written previously about ESG shifting from a ‘nice to have’ to a ‘must have’. What the new regulatory frameworks are signaling is the need for investors to go further still. The integration of ESG factors has become a given; now we see a move towards investing for measurable impacts and outcomes aligned with the Sustainable Development Goals (SDGs).

EU Taxonomy objectives

To illustrate this point we can look at the objectives of the EU Taxonomy, described as “ a tool to help investors, companies, issuers and project promoters navigate the transition to a low-carbon, resilient and resource-efficient economy”.1 As well as seeking to define a “unified classification system” for sustainable economic activities, it also aims to drive sustainable outcomes across the ESG spectrum.

To be included within the EU taxonomy, an investment first has to meet the regulation’s definition of “sustainable”.2

Broadly speaking, this means it is:

  • An investment in an economic activity that contributes to an environmental objective, in a measurable fashion. For example, by quantifiably impacting more efficient use of land and water in a positive fashion
  • An investment in an economic activity that contributes to a social objective. For example, by tackling inequalities or investing in economically or socially disadvantaged communities.
  • An investee company which is characterized by “sound management structures, employee relations, staff remuneration and tax compliance”

But the obligations implied by the Taxonomy don’t end there. Taxonomy eligible activities also need to:

  • Make a substantial contribution to at least one of six pre-defined environmental objectives, these being:
    • Climate Change Mitigation
    • Climate Change Adaptation
    • Sustainable use and protection of water and marine resources
    • Transition to a circular economy, waste prevention and recycling
    • Pollution prevention and control
    • Protection of healthy ecosystems
  • Do no significant harm (DNSH) to the remaining objectives
  • Meet minimum social safeguards, for example, the UN Guiding Principles on Business & Human Rights

The latest UNPRI guidelines for responsible investment amplify this approach, by urging investors to aim for outcomes rather than minimize risks in the portfolio. Most UNPRI signatories committed to the principles over a decade ago. Implicit in the latest guidelines is an assumption that they’re already up to speed on integration and now need to move on from here.3

Regulation implications

This reshaping of the regulatory and policy landscape has fundamental implications for the growth of ESG and the allocation of capital. As PWC summarized in their recent report, The Growth Opportunity of a Century, 2020

“… rising legislative and regulatory pressure has bolstered the increased attention ESG is receiving and is likely to have the biggest impact on accelerating the shift to a sustainable model of investing. As the regulatory landscape develops, unsustainable corporates will lose out on capital and non-compliant sectors will be penalized as a result.”

A shift in flows

Already we see this shift reflected in flows – according to our research in July earlier this year, SI Focused Funds had raised USD 124bn Net New Money (NNM), out of an overall industry NNM figure of USD 196bn. The next step will be the realization of positive impact generated by that capital. That will represent one of the greatest transformational opportunities for economies, societies and the environment.

The latest UNPRI guidelines for responsible investment amplify this approach, by urging investors to aim for outcomes rather than minimize risks in the portfolio.

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