Environmental, social and governance (ESG) issues are so firmly entrenched in today’s investment discourse, that most companies, a large proportion of the financial services industry and many investors consider integrating these factors in their daily and longer-term operations a top priority.
Such evolution is critical to ensuring the world not only moves towards its net zero carbon emissions targets by 2050, but meets the 17 UN Sustainable Development Goals (SDGs) which are designed to achieve peace and prosperity for all mankind.
However, in the scramble for transparency and accountability, there is a risk we will fail to achieve these goals.
‘…unless disclosure is accompanied by real teeth that drive positive change, we may find there is more reporting for reporting’s sake.’
What gets measured gets managed
Regulation, especially for the disclosure of ESG-related factors, has accelerated. Measuring and reporting carbon emissions is mandatory for FCA-regulated companies with more than £50 billion in assets under management, listed and large private companies in the UK and in line with the Task Force on Climate-related Disclosures (TCFD).
This means investors have clearer sight into companies’ exposure to climate risk and their plans to reduce carbon emissions. At the same time, regulated fund managers and pension providers must also understand the carbon emissions in their portfolios, and take steps to reduce them.
But under TCFD companies are expected to report at an entity level which means that asset managers must disclose Scope 1,2 and 3 emissions for SICAVs and other open-ended funds. The question is whether reporting at such a granular level, which is both time-consuming and expensive, offers value to investors, or risks distraction from responsible asset allocation.
Classified information
Similar concerns have been raised about the EU’s Sustainable Finance Disclosure Regulation (SFDR), which was designed to make it easier for investors and their advisers to scrutinise asset managers’ ESG claims.
Based on standardised disclosures about how ESG factors are integrated at an entity and product level, funds receive a classification, with Articles 8 and 9 considered the most ‘responsible’.
In practice, SFDR’s classification criteria have been subject to considerable differences in interpretation, which has muddied the waters for investors. While Article 9 funds are required to deliver both financial returns and a sustainability objective, the rules do not prescribe a single methodology to account for the latter.
This has led to inconsistency and confusion for investors, with several Article 9 funds including allocations to thermal coal, a major contributor to harmful greenhouse gas emissions.
As regulators signalled intentions to tighten up criteria, some asset managers downgraded their funds from Article 8 or 9 in favour of Article 6 classification. Research from Morningstar reveals that in the fourth quarter of 2023, investors withdrew €26.7 billion from Article 8 funds while Article 9 funds lost €4.7 billion. Meanwhile Article 6 funds attracted €15.7 billion of net new money.
However, there is little evidence to suggest fund managers saw a significant divestment following the downgrades, which raises questions as to the validity of the classifications or the seriousness with which they were interrogated by investors.
SFDR is under review presenting a good opportunity for regulators to think about how they can provide investors with a labelling system that will better help them to select authentic sustainable funds.
Unintended consequences
While much of the regulatory focus has been on the E of ESG, S and G are getting their fair share of attention.
The EU’s Corporate Sustainability Reporting Directive (CSRD) requires large and listed companies to share more than 1,000 ESG data points covering qualitative and quantitative measures across short, medium and long-term considerations, spanning the entire value chain.
Organisations must report on how their business is impacted by sustainability risks and opportunities, as well as how their own activities impact society and the environment.
Again, these are important disclosures that help investors understand more about the ESG risk in their portfolio, opening the door for more engagement with companies.
But unless disclosure is accompanied by real teeth that drive positive change, we may find there is more reporting for reporting’s sake.
And exemptions that apply to CSDR - and TCFD - may disincentivise smaller private companies from going public, leaving large swathes of the corporate world operating under the ESG regulatory radar.
Taming the data Wild West
As sustainable disclosure requirements have grown, so too has the ESG data industry which aims to support organisations in meeting their reporting obligations.
However, the ESG data and ratings market has been something of a Wild West with recipients, including investors, often unable to test the validity of the information provided nor understanding how conclusions were reached.
While the transition from voluntary to mandatory disclosures picks up pace, companies have been at risk from accusations of manipulating reports or have struggled to justify how and why they received a particular score or result.
This picture could be about to improve, following the recent launch of a voluntary code of conduct for ESG ratings and data products providers from the International Capital Market Association (ICMA) and the International Regulatory Strategy Group (IRSG).
But as we wait for the code to bed in – alongside moves toward formal regulatory oversight of the sector - it is important that reporting is seen as a best endeavours exercise, or companies may be reduced to cursory box-ticking.
Time for action
The evolution of sustainable investment has seen companies and their investors driving positive change, thanks partly to an ongoing uptick in policy and regulatory initiatives, itself a reflection of pressure from stakeholders across society.
Investors are playing their part, but it’s clear that ESG or sustainable investing has not yet fully matured. There is more education needed, for example, especially in helping investors understand that while sustainable investment strategies can by more volatile in the short term, they keep pace with more traditional portfolios over the longer term.
Similarly, investors need to be clear about where they sit along the spectrum, when it comes to balancing financial returns and real-world impact. With the World Meteorological Organization recently confirming 2023 as the hottest year on record “by a clear margin”, and funding gaps for the UN SDGs still widening, there is more for all of us to do.
To keep our eyes on the main prize, the key to future success lies in ensuring rules, standards and action must remain material, relevant and focused on achieving a sustainable future.
A version of this article originally appeared in ESG Investor on 4 April 2024.