For years the claims and disclosures made by companies and providers of financial products relating to environmental, social and governance (ESG) issues have lacked a consistent framework. This will change shortly as a flurry of new regulations force market operators to take a critical look at their activities.
During the last decade, the value of financial assets classified as ESG investments has increased almost exponentially. According to some estimates, they could exceed US$ 53 trillion by 2025. At the same time, the range of ESG-related financial products has increased. Further, in the aftermath of the recent COP26 climate summit, “green finance” has been singled out as an important tool for combatting climate change.
However, how “green” some of these products are may be questionable. For instance, some products that essentially track a general stock market index with a very limited ESG allocation component have been marketed as green. Similarly, it may be difficult for interested outside observers, including sophisticated external asset managers (EAMs), to decide whether the ESG efforts of potential investments – whether listed or private companies – amount to a genuine plan of action or whether they should be dismissed as “greenwashing”.
In fact, due to the lack of clear ESG standards in many market sectors, numerous companies may find it challenging to determine whether their actions actually have the desired impact. Thus, if a company lacks a clear plan and philosophy on ESG goals and how to implement the stated principles in practice, its well-intended efforts may be reduced to mere “box ticking”, which can drain a company’s resources.
New regulations coming
Regulators in many jurisdictions have taken heed and have released, or are in the process of rolling out, substantive rules intended to clarify the application of ESG metrics, as well as to reign in some of the excesses in disclosures and representations. The most significant developments in the near future are expected from the EU and the United States.
We already see substantial movement in the EU, with even more expected in the near future. In order to meet the EU’s climate and energy targets for 2030, and reach the objectives of the European Green Deal (a set of proposals affecting EU climate, energy, transport and taxation policies with a goal to reduce net greenhouse gas emissions by at least 55% by 2030, compared to 1990 levels), the EU Commission has concluded that a common language and a clear definition of what is ‟sustainable” is needed. Thus, as a part of its action plan for financing sustainable growth, the Commission enacted Taxonomy Regulations that entered into force on 12 July 2020. These regulations serve as a classification system, listing economic activities considered environmentally sustainable. A first delegated act of sustainable activities was formally adopted on 4 June 2021 for scrutiny by the co-legislators, and a second delegated act for the remaining objectives will be published in 2022.
In the United States, the regulatory picture is also quickly becoming clearer. According to the Securities and Exchange Commission (SEC) Chairman, Gary Gensler, the agency wants mandatory disclosure on climate risks, and it may move with urgency on new rules. Such rules would require issuers to provide their investors (and investment professionals) with consistent, comparable and decision-useful ESG-related disclosures. The proposed rules should be released by the end of 2021.
These proposed rules and regulations, and similar ones in other jurisdictions, if implemented in a well-balanced manner, should help EAMs to scrutinize and compare the ESG characteristics of financial products and companies, and select appropriate investments that meet their clients’ preferences.
However, any regulations aiming to address such complex issues will naturally be imperfect. So, instead of relying blindly on mandatory ESG disclosures, EAMs are responsible for evaluating the ESG characteristics of any investment, and related risks, independently or through reliable third-party analysis and metrics. While relying on trusted outside advisors is advisable, developing relevant in-house knowledge, such as familiarity with applicable regulations, will become ever more important as ESG considerations become deeply incorporated into the investment management process.
EAMs must also be sure to understand their clients’ ESG goals when implementing investment decisions. This task will require client management skills that emphasize clear and open communication in order to avoid any misunderstanding of clients’ wishes, as well as the ability to explain why certain decisions were taken.
- The number of ESG-related financial products and company disclosures has increased rapidly, yet due to lack of clear standards a critical scrutiny of green claims may be difficult.
- Regulators, especially in the EU and the US, are expected to take action in the near future in order to address this issue.
- EAMs should develop in-house capabilities, including knowledge of regulations, as part of their investment process.