ESG Regulation in 2023: Riding the wave rather than waiting for the end
The 2018 Sustainable Finance Action Plan has been translated into ambitious regulations. As their implementation period starts, efforts made by the industry are considerable. But will this bear fruit in the long term? Asset managers stand between enthusiasm, scepticism and fear of greenwashing. Laetitia Hamon, Head of Sustainable Finance, Luxembourg Stock Exchange, shares her views.
Ambitious regulations have been a game changer
For years, I witnessed first-hand the concept of ESG and sustainable investing being brushed off as wishful thinking. However, regulations have now driven the majority of financial players to take notice and act. That, in itself, is a major achievement.
The 2018 Sustainable Finance Action Plan has many merits. Its broad net covering definitions, data at entity and product levels, product marketing and distribution was quite a bold move. The fact that it would target the fund, banking, insurance, pension and capital markets industries all at once is even more revolutionary.
Now that these bold ideas have, generally speaking, been translated into regulations, the implementation period starts. The efforts are considerable. They require strategic coordination, imply financial and human resources and certainly a vision too. Let’s be honest, these can be pain points for some actors that face what seem to be a daunting task. The question is: Will this bear fruit in the long term?
To answer this question, let’s start with the cornerstone of the European Union (EU) Sustainable Finance Package – the EU Taxonomy.
The EU Taxonomy as a tool rather than the solution
Until now, the absence of an agreed classification framework has allowed room for different interpretations of “green activities” and with that unfortunately some level of greenwashing. Thanks to the EU Taxonomy, we will not just move towards mandatory reporting, we also have the perfect foundation to move towards a more understandable, science-based assessment of a company’s share of green activities, the level of green assets in its balance sheet and the sustainability characteristics and impacts of our investments.
However, the EU Taxonomy is not yet complete. Major sectors are missing within the current form of the document including agriculture. Intense debates were also ignited due to the inclusion of nuclear and gas, and the multiplicity of regional and local taxonomies do not ease the work of international investors. With these limitations and the stark reality that our current economic model is definitely not aligned with climate objectives, the percentage of taxonomy alignment is generally very low.
With this in mind, the EU Taxonomy should be looked at as a tool rather than the solution to reorient capital. In addition, many of the investments necessary to meet net zero by 2050 are too small, not yet profitable enough, or take place in emerging economies that are considered riskier.
A recent study from the Luxembourg Green Exchange (LGX)1, demonstrates the voluntary use of the EU Taxonomy by issuers as a tool to report alignment of their bonds. Indeed, while the Taxonomy is still a work in progress and issuers of sustainable bonds are under no obligation to report on alignment, a number of issuers have started to adapt their disclosures to reflect this key part of the Sustainable Finance Package. The study’s analysis of 5,451 sustainable bonds indicates that elements of the green classification system are already included in the disclosures for 27% of the green, sustainability and sustainability-linked bonds listed by EU-based issuers.
It is then fair to say that the EU Taxonomy is, even if still showing room for improvement, a powerful tool to propel positive change.
Sustainability preferences alongside education campaigns
Looking at the amendments to MiFID II2 and IDD3, it is fair to wonder whether asking for investors’ sustainability preferences will eventually boost demand for sustainable products.
It is probably too early to say. Whilst the proposed approach of bringing the concept of sustainability preferences closer to the investor is absolutely key, the “how” to do it meaningfully remains a burning question. As the European Banking Authority outlines, “the definition of the three categories of financial instruments between which investors must choose is very technical and contains references to regulatory sources that cannot be illustrated to the client in a simple and understandable way.” So, not really something that can be covered during a 30-minute meeting with your financial advisor.
Sustainability preferences will put this topic of discussion on the table and make people realise that their investments have an impact on the real economy. Something that was so abstract in the past, and so far-reaching that it was completely overlooked.
What is certain is that these efforts must be accompanied by massive public campaigns and education programmes to raise awareness of the end investors, who sit on the fence between enthusiasm and scepticism of sustainable products.
Disclosures making financial players more conscious of their sustainability claims
Lastly, will SFDR4 succeed in reducing information asymmetries when it comes to sustainability risks, impacts and characteristics of financial products?
I recall a time when asset managers would say that they were doing “ESG integration” and deem their full range of funds to be sustainable. SFDR made asset managers look at every single product and become more conscious when it came to their claims. This is a big step indeed.
But the fear of greenwashing should not be discouraging
However, regulation, the fear of being accused of greenwashing, the complexity of complying with the smallest details, may also deter asset managers from crossing over to the “green” side.
The recent investigations and fines by several regulators like the US SEC5 or the UK’s FCA6 related to misleading sustainability claims, as well as the Call for Evidence for greenwashing from the European Supervisory Authorities, are very welcomed developments. Whilst these initiatives rightfully pinpoint what is misfunctioning, one should not forget that the industry is also making considerable, genuine efforts to disclose accurate and reliable information.
Regulation should create enthusiasm rather than fear
It is important that regulation continues to encourage rather than discourage. Create enthusiasm for sustainable products rather than fear.
Is a systemic shift on its way? Only time will tell. In any case, these regulations are here to stay, and most asset managers will figure out the nuts and bolts over time.
Regulation can certainly not change how we, as individuals, ultimately save, invest or borrow by itself, nor will asset managers and other financial players. For our mindsets and habits to change, massive amounts must be invested in financial and sustainable finance education, even if these two areas should not be considered separate, isolated concepts.
Laetitia Hamon, Head of Sustainable Finance, Luxembourg Stock Exchange
2Markets in Financial Instruments Directive
3 Insurance Distribution Directive
4 Sustainable Finance Disclosure Regulation.
5 United States Securitie and Exchange Commission.
6 United Kingdom’s Financial Conduct Authority