ESG Regulation is Coming...

What does that mean for the industry?

Interest in environmental, social and governance (ESG)-orientated investing has seen a meteoric rise and investors of all types now demand not just positive financial returns but positive impacts on society. However, to date there has been no comprehensive regulatory framework.

The understandings, measurements and metrics underpinning ESG concepts are often amorphous making it difficult for investors to understand the merits of particular products – or to hold asset managers accountable in delivering on ESG objectives.

THE EU’S ESG FRAMEWORK – A JOURNEY TOWARDS COMMON UNDERSTANDING OF ESG CONCEPTS

At a European level, efforts are now being made to develop such a framework. Detailed measures start applying to asset managers from as early as next year. Under the EU Disclosure Regulation, they will have transparency obligations, including whether their investment processes feature sustainability considerations.

There will be obligations around precontractual disclosure and reporting. These differ in scope and complexity depending on the investment objectives, and the most comprehensive apply to products offered as pursuing environmental objectives. A comprehensive set of supplementing draft disclosure and reporting rules were published in April but remain to be finalised.

We are likely just at the beginning of significant ESG regulatory development. Firstly, for all its focus on improved disclosure and information flow, the EU’s rules do not currently extend to creating a pan-European “ESG” label for investment products. The EU’s Taxonomy Regulation, likely to pass soon after long negotiation, makes some tentative steps towards this. It will create a common, binding framework for establishing what activities can be classified “sustainable”, but it will be for national regulators to establish marketing frameworks for investment products supporting these objectives. The EU Disclosure Regulation and the EU Taxonomy Regulation, whilst representing progress towards a pan-European framework, are not fully integrated. For example, the definition of “sustainable investment” in the Disclosure Regulation does not refer to – and therefore does not use – the classification system in the Taxonomy Regulation. This is sure to create confusion over the scope of application of some disclosure requirements.

Further, the Taxonomy Regulation (unlike the Disclosure Regulation) only covers the “E” part of ESG.

INCREASED SCRUTINY OF ESG DATA INEVITABLE

The ability of asset managers and investors to properly scrutinise the performance of investment products against ESG criteria will depend on having reliable data. Some aspects of the new rules aim to improve the availability of such data, for example by extending non-financial reporting requirements to large investee companies listed on an EU exchange but large gaps will remain, especially in relation to unlisted companies. Asset managers are themselves faced with new rules requiring them to provide ESG-related data for any investment product offered. Much reliance will be placed on third party ESG data providers – which are often unregulated and may employ divergent methodologies and metrics. There is scope for accidental and deliberate data misuse and misrepresentation. Regulators will be looking at this closely. Moves by policymakers aimed at making ESG investing more accessible to the retail market will only accelerate this.

ESG data provision’s likely to become more regulated going forward and we may see parallels emerging with the focus on rating agencies after the last financial crisis.

WILL COVID-19 ACT AS BRAKE ON, OR ACCELERATOR OF, REGULATORY DEVELOPMENT?

Some might say that given the pandemic-related losses to portfolios, the near-term focus for investors and asset managers will be on driving up returns, not ESG. Policymakers’ attention might also on keeping the wider economy going, meaning a slowing in ESG regulatory activity. On the other hand, performance data shows investment funds and products with ESG strategies appearing to weather Covid-19 better than others, positioning the sector for increased in-flows and continued scrutiny. There has been much focus during the pandemic on how companies treat their staff, and asset managers and institutional investors are weighing in. We may see a developing taxonomy for the ‘S’ of ESG similar to what we have seen on the ‘E’ side.

BREXIT – AN ADDED CHALLENGE OR AN OPPORTUNITY?

The Brexit transition period is set to end on 31 December. Many of the EU’s new rules apply from early next year. UK asset managers will be asking what steps need taking. Much of the EU framework will apply directly or indirectly to asset managers raising funds in the EU, requiring compliance by those firms wishing to continue raising money in Europe. Furthermore, the bulk of the EU's ESG framework will be turned into UK domestic law when the transition ends. Nevertheless, the UK government will soon have greater freedom in pursuing its own ESG regulatory agenda. This could mean going beyond current EU proposals or falling behind. With the expectation that the UK will remain a key global centre for investment management, the developing UK ESG agenda and potential divergence from the EU‘s will be closely scrutinised by asset managers and investors. Whatever happens next, ESG investing is likely to keep our collective attention for the foreseeable future.

A previous version of this article has also been published in a recent edition of The Drawdown >

Key contacts

We are currently advising a number of our financial institution clients on how they navigate the emerging regulatory framework in relation to ESG. For more information please contact: Jan Gruter and Lorna Finlayson.