EU rules promise to reshape opaque world of sustainable investment

Anders Bertramsen likes to know what he is eating so when he does his weekly shop he checks food labels for nutrients and provenance before choosing products. But in his professional role selecting sustainable investment funds for wealthy investors, he finds it much harder to make such judgment calls.

“It is a maze out there,” says the head of external fund selection at Nordic bank and wealth manager Nordea. “Getting to the bottom of which funds are truly sustainable requires a lot of time and experience.”

For Mr Bertramsen, the EU’s introduction in March of landmark rules mandating greater transparency for environmental, social and governance funds cannot come soon enough. “We will have a lot more data, which will help weed out the managers who talk themselves up on ESG but don’t do anything.”

The sustainable finance disclosure regulations require fund groups to provide information about the ESG risks in their portfolios for the first time. A central plank of the EU’s green deal, they aim to push more capital towards sustainable activities by injecting discipline into the ESG market.

The rules are not just good news for professional investors such as Mr Bertramsen; they will also help retail savers, from millennials to sustainability-focused older people, who want the tools to cut through the ESG noise.

ESG investing has exploded in recent years as investors’ growing awareness of issues such as climate change pushes them to invest in funds that benefit society in addition to generating returns.

ESG funds in Europe attracted net inflows of €151bn between January and October last year, an almost 78 per cent increase from the same period in 2019, according to Morningstar. Yet the boom has been overshadowed by concerns that some providers have been overstating their sustainability credentials to win business, a trend known as greenwashing.

However, the new EU rules will shake up ESG investing by exposing laggards and forcing the investment industry as a whole to improve its offer.

“It is hard to overstate the impact that the regulations will have,” says Thomas Tayler, senior manager at Aviva Investors’ Sustainable Finance Centre for Excellence. “It is going to change the way people run their businesses by putting sustainability right at the heart of the investment process.”

The ambition of the new regime is evident from its scope: it is not solely targeting sustainable funds. Under the rules, all asset managers will have to consider sustainability risks alongside other financial risks, before disclosing to investors how these are managed or why they are not relevant.

Only a few years ago, this approach — known as ESG integration — was the preserve of a handful of ESG specialists, says Mr Tayler. But he adds that the comply or explain nature of the new rules will jolt more asset managers into action, transforming ESG integration into a baseline requirement for all funds.

Meanwhile, the increased reporting requirements imposed will also raise the bar among sustainability-focused asset managers. Under the new rules, funds that claim they go further on ESG — such as impact funds, which place environmental or social goals on a par with financial profit — will have to back up their virtuous statements with clear evidence of their sustainability efforts.

Valentin Allard, senior consultant at research group Indefi, says the fact that ESG managers will have to disclose the same data will make it easier to sort the wheat from the chaff.

“A lot of masks will fall,” he predicts. “Once everyone is reporting against the same indicators, some people might realise they overstretched how green they really are.”

At the same time, the spotlight that the EU framework will shine on ESG is likely to lead to a surge in sustainable fund launches, as asset managers rush to adapt their products to the new world.

“The market will be changed by the regulations,” says Olivier Carré, a partner at PwC Luxembourg. “Asset managers have to decide how they want to be positioned in this new environment.”

PwC believes ESG funds could increase their share of total European assets from 15 per cent to 57 per cent by 2025 on the back of the EU rules, with the bulk of the growth coming from conversions of non-ESG funds into funds compliant with the new regulations.

The onus on managers to up their game is made more urgent by the fact that their clients — pension funds, insurance companies and financial advisers — will also be obliged to consider sustainability under the rules, leading to even greater demand for ESG funds.

ESG funds are powering into the mainstream

However, teething problems with the regulations and questions over how they link up with other EU legislation will probably hinder growth in the ESG industry.

Brussels recently delayed the date by which asset managers will have to submit the bulk of the disclosures following resistance from the industry.

But even with the delay, compliance will be a struggle due to the sheer volume of data that must be gathered. “If I look at how many people in my company are working on [the ESG regulations], it is almost as big as Mifid II was,” says Gilbert Van Hassel, chief executive of €158bn Dutch asset manager Robeco, referring to the sweeping EU markets rules that came into force in 2018.

A major stumbling block for asset managers is sourcing sustainability data from the companies they invest in. The lack of global standards for corporate ESG disclosures means that the availability and quality of information varies wildly.

Sustainable finance trade body Eurosif estimates that of the 32 ESG data points asset managers are required to report under current proposals, just eight are available today.

The EU is aiming to solve this problem by imposing new obligations on companies as part of its review of the Non-Financial Reporting Directive, which governs sustainability disclosures. But this may not be finalised in time for asset managers’ first detailed ESG reporting deadline in 2022.

Another challenge is the lack of alignment between the reporting requirements and the EU’s taxonomy regulation, the flagship classification system on what counts as green investment, which effectively obliges fund groups to make two separate sets of ESG disclosures.

Mr Tayler says asset managers will learn by doing and will evolve over time to meet policymakers’ high expectations.

However, a bigger long-term question is whether the disclosure regulation will truly be effective in stamping out greenwashing and channelling money to sustainable economic activities.

Victor van Hoorn, Eurosif executive director, says much will depend on whether investors read the disclosures and the extent to which regulators vet them. The financial regulators in Europe’s two largest fund hubs, Luxembourg and Ireland, have indicated they will allow asset managers to self-certify they comply with the rules.

Given that the EU regulation does not impose minimum standards for ESG funds, “it could actually make it more difficult to spot the asset managers that are good at ESG”, he warns.

This is a view shared by the French financial regulator, the AMF, which recently started to require local funds to comply with minimum thresholds in order to market themselves as ESG.

The watchdog wants to see similar rules introduced at EU level to safeguard investors and protect the credibility of ESG investing. It is also calling for EU-wide oversight for ESG data and rating providers, which have come under fire over their inconsistent methodologies. “We feel that this issue, which is directly linked to greenwashing, is not yet addressed by the [forthcoming] EU regulations,” says Robert Ophèle, chairman of the AMF.

Nathan Fabian, chief responsible investment officer at Principles for Responsible Investment, says that with the new ESG rules, investors can judge for themselves how sustainable a fund is and act accordingly. However, he adds that “if money doesn’t start to be redirected, governments won’t have much choice” but to introduce minimum standards.

Given the net zero emission targets that many countries have set themselves, they are likely to impose more binding rules in future to ensure financial products are aligned with sustainability goals, he says.

The EU’s ESG road map

March 10 2021

Entry into force of Sustainable Finance Disclosures Regulation

Asset managers required to define entity-level ESG policies and make ESG disclosures in pre-contractual documents

Q1 2021

European Commission expected to kick off review of the Non-Financial Reporting Directive governing corporate ESG disclosures

January 1 2022

First deadline for asset managers to submit annual product-level ESG disclosures in line with SFDR

Asset managers required to report on climate change mitigation and adaptation in line with the EU taxonomy

Q1/Q2 2022

Expected application of rules obliging financial advisers to take into account clients’ sustainability preferences

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