A green game changer
New EU green finance requirements will increase demand for better and more comparable ESG data
Currently, buy-side firms tend to view ESG strategies as a competitive differentiator, more than a business requirement or regulatory imperative. That is set to change in Europe.
Before legislative work came to a halt for the recent EU elections, the European Parliament voted through regulations introducing stronger sustainable finance requirements for buy-side firms. When they take effect, most likely between 2020 and 2022, European asset managers will have to disclose how they integrate sustainability risks into their decision-making process.
While certain requirements around climate change already exist across member states, this EU-wide harmonisation marks a step change. The new European Commission and Parliament are widely expected to reboot the EU Action Plan on Sustainable Finance, marking a new cycle of EU rule-making in the area1.
European asset managers are starting to realise they will have to change their procedures and introduce ESG data to ensure they take into account sustainability risks and opportunities. Ultimately, this will drive further demand for ESG data and software solutions as firms prepare for compliance.
The two new regulations form part of wider a push to integrate ESG considerations into financial law. Concretely, the new rules require asset managers to disclose2:
● procedures they have in place to integrate environmental and social risks into their investment and advisory process;
● the extent to which those risks might impact on the profitability of the investment;
● where institutional investors claim to be pursuing a ‘green’ strategy, information on how this is implemented and the sustainability or climate impact of their products and portfolios.
Earlier this year, Verena Ross, executive director at the European Securities and Markets Authority (ESMA), outlined how the authority has been given the power to draft rules to flesh out the obligations, and ensure convergence and harmonisation of the required disclosures3. She noted that the timeline is quite tight, as most of the requirements must be drafted within 12 months of the formal entry into force of the new disclosure regulation, which is expected just after the summer.
In parallel, the existing EU Benchmark Regulation has also been amended to introduce two new types of benchmarks4:
● climate-transition benchmarks, which will offer a low-carbon alternative to the commonly used benchmarks; and
● EU Paris-aligned benchmarks, which bring investment portfolios in line with the Paris Agreement goal to limit the global temperature increase to 1.5oC above pre-industrial levels.
Benchmark providers will be required to explain how ESG factors are reflected and disclose how data is used in their selection criteria, in the hope that clarity on methodologies will encourage investor confidence and inform their decisions.
How to prepare
A lack of standardised data is the most prominent challenges that asset managers are facing, as they seek to integrate sustainability.
Although ESMA still needs to work out the implementation rules, one conclusion that asset managers need to draw is that the EU’s regulatory push will compound regulatory demand for better and comparable ESG data on top of existing market demand. This should incentivise corporates to disclose more data on the one hand, and on the other hand, focus asset managers on the task of ensuring they have access to high quality ESG data, analytics and tools to manage their investments.
An increasing number of buy-side firms are starting to engage with data providers, as they realise that structured and reliable data is essential to manage the enormity of the task, and provide a more consistent and auditable approach to mobilising capital into sustainable returns.
In parallel, corporates are starting to apply the recommendations of various recent initiatives, including the FSB Task Force on Climate-related Financial Disclosures (TCFD), and the Sustainability Accounting Standards Board. This June, the TCFD recommendations were also integrated into the European Commission’s guidelines on reporting climate related information5.
Another groundbreaking EU initiative was a group of 35 technical experts tasked to come up with an EU classification system – or taxonomy – to determine whether an economic activity is environmentally sustainable. This initiative will underpin the raft of new ESG related rules and address the often-identified weakness of work-around ESG initiatives, in terms of defining what exactly is sustainable and how to measure it. This is considered key in tackling so-called greenwashing.
While EU rules do not place direct obligations on non-EU investment managers or companies, they can be expected to set new global standards, as demonstrated in the case of MiFID II.
Spillover effects can already be seen in the US, as European investors are starting to ask their investment managers, regardless of location, to include ESG factors in their investment process, and incorporate sustainability considerations in risk management, in order to retain investment mandates.
Similarly, non-EU benchmark providers may have to incorporate explanations of how ESG factors are reflected, and disclose how data is used in selection criteria to retain global appeal. Moreover, globally operating firms are likely to be further incentivised to implement global disclosure and operating standards to realise efficiencies and minimise risk of compliance gaps.
Similar to the experience with MIFID II, non-EU jurisdictions may decide to pick and choose principles and approaches from EU legislation which they think make sense for their own markets. And international standard setting bodies will likely take inspiration from the new EU framework when deciding what approach to take to global standards. Financial firms should prepare for the EU to continue to drive strategy and global standards in terms of ESG in the next five years.
Joe McHale is regulatory affairs specialist and Nadia Humphreys is business strategist for sustainable business and finance, both at Bloomberg