The Growing Importance of ESG | Regulatory Focus – June 2020

Environmental Social and Governance (“ESG”) investing is not a new concept, and we know that it has been part of many firms’ business and investment strategies for some time. Environmental issues, climate change, sustainability, social issues, good governance and accountability have all become more prominent in the media in recent years. ESG’s significance for asset managers is growing, as it becomes more important to investors. In the aftermath of COVID-19, ESG is likely to become even more significant as both the industry and investors have time and cause to reflect on the importance of environmental, social and governance issues.

So What is ESG? 

It is a set of criteria which are used to assess a company by evaluating their performance in certain categories. The following examples are not exhaustive:

  • Environmental
    Climate change, use of renewable energy, greenhouse gas emissions, pollution, waste generation, deforestation and the treatment of animals. 
  • Social
    Working conditions, effect on local communities, health and safety, discrimination and human rights. 
  • Governance
    Accountability, board level oversight, diversity, equal opportunities, shareholders’ rights, bribery and corruption and remuneration.

One of the main issues currently is the lack of regulation around ESG, and therefore a lack of consistency in the measurement of ESG factors. “Greenwashing” has been an issue, where firms claim to have green credentials, but in fact present a misleading impression, or misleading information, about how their products are environmentally sound. 

Current Standards

There are a number of standards in place currently, for example, the most widely used is the UN Principles of Responsible Investment (“PRI”), which are a voluntary set of principles that asset managers and investors can become signatories of. 

The Shareholder Rights Directive II has been implemented by EU member states and applies in the UK. It aims to encourage long term shareholder engagement and transparency. The UK also has the UK Stewardship Code, which aims to enhance the quality of engagement between investors and companies.

Regulatory Developments

ESG is now a high priority for regulators, particularly in Europe. In 2018 the European Commission (EC) published an action plan for financing sustainable growth, which supports a number of regulatory changes being implemented in the EU. One of the main principles of the action plan is a belief that financial services firms can play a key role in the transition to a low carbon and more sustainable economy.

The proposed Framework (or Taxonomy) Regulation would provide a unified EU classification system for sustainable investments and activities. This will provide a new taxonomy to be used in determining the degree to which an economic activity can be described as environmentally sustainable. This will mainly be relevant for asset managers which offer financial products that either have an objective of environmentally sustainable investment or promote environmental characteristics. This draft regulation proposes a phased implementation, with certain rules applicable from December 31, 2021 and the rest applicable from December 31, 2022.

The Disclosure Regulation on sustainability related disclosures is intended to provide better information on how asset managers integrate ESG factors in their investment process and will come into effect on March 31, 2021.  This should make it easier for investors to make informed choices. This regulation will require firms to make decisions about their business and policies in relation to how sustainability impacts their investment processes as well as the disclosures they will have to publish. This will be relevant to all in-scope asset managers.  In April 2020 the European Supervisory Authorities (ESAs) jointly published a consultation paper on draft Level 2 measures in the form of regulatory technical standards (RTS).  This covers in more granular detail the requirements on content, methodology and presentation of certain disclosures.

In addition, the EC has drafted amendments to MiFID II, which would require investment firms to take account of any ESG considerations when providing investment advice and portfolio management to clients. ESMA has also published technical advice on integrating sustainability risks and factors into AIFMD and UCITS Directive.

ESG has been high on the FCA’s agenda as well. In 2018 the Regulator published a discussion paper on climate change and green finance. Its Asset Management Market Study considered non-financial objectives including ESG matters.

Conclusion

One of the key questions is how this impacts UK based FCA regulated firms with Brexit in mind. The UK left the EU on January 31, 2020 under a Withdrawal Agreement that provides for a transitional period until December 31, 2020. So the new EU regulations and rules will not come in until after the transitional period has ended. Whilst the application in the UK is still to be clarified, it is highly likely that the Government will introduce domestic measures that will closely align with the EU requirements and Level 2 provisions.

We are keeping abreast of the situation and are currently working on ESG matters within Duff & Phelps. We will continue to communicate to our readers on this increasingly important subject.

 
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