EU Sustainable Finance Regulation in Context
Sustainable investing has entered the mainstream, with more than US$35 trillion being allocated towards environmental, social and governance (ESG) approaches, according to the Global Sustainable Investment Alliance (GSIA)’s "Global Sustainable Investment Review" (2020)*. The trend is clear: the adoption of ESG funds continues to grow unabated.
The Sustainable Investment Market in Context
Bloomberg Intelligence (2021)2 estimates that the sustainable investment market may even reach up to US$53 trillion by 2025.
The increased emphasis on ESG considerations in investments is not limited to the amount of assets that ESG-themed funds managed to attract but also extends to forward-looking considerations of such investments in the context of long-term value creation.
Active ownership, where investors use their rights and position of ownership to influence the behaviour of investee companies3, underpins this approach and supports investors in engaging for positive change trajectories. Indeed, active ownership is closely aligned with the aims set up in corporate governance and stewardship codes, and it is what shareholder groups are using to pressure companies to further tighten their ESG objectives.
Overall, the Global Sustainable Investment Alliance (GSIA) highlights seven main ESG approaches for sustainable investing into which most sustainable investment funds fit. They include ESG integration, negative screening, norms-based screening, positive and best-in-class screening, corporate engagement and shareholder action, sustainable-themed investing and impact and community investing.
Regulatory Drivers and the Implementation of the EU’s Sustainable Finance Action Plan
Alongside the growing interest in ESG investing, there have been a range of ESG regulatory efforts initiated by regulators around the world, with the Principles for Responsible Investing (2021)4 reporting that there are now more than 750 policy tools and guidance frameworks globally, including 159 new or revised ESG policy instruments.
In Europe, the EU Commission launched the Green Deal (2020), a set of policy initiatives with the overarching aim of making the European Union (EU) climate neutral in 2050. The aim is:
to review each existing European law on its climate merits,
to introduce new legislation on the circular economy, building renovation, biodiversity, farming and innovation, and
to make the EU's climate, energy, transport, and taxation policies fit for reducing net greenhouse gas emissions by at least 55% (= “Fit for 55”) by 2030, compared to 1990 levels.
EU sustainable finance regulations have been following suit: The EU’s Sustainable Finance Action Plan, first introduced in 2018, introduced a range of major ambitions for financial markets in alignment with the 2015 Paris Agreement and Agenda 2030 for Sustainable Development: to “reorient capital towards sustainable investment”, to “manage financial risks stemming from ESG risks”, and to “foster transparency and long-termism in financial and economic activity”.
A core piece of this regulation is the EU Sustainable Finance Disclosure Regulation (EU SFDR, 2019/2088/EU), a set of rules that aim to disclose the sustainability profile of investment products. The regulation introduces 3 key definitions:
1. “sustainable investment”, 2. “sustainability risk” and 3. “sustainability factors”, which are defined as follows:
Sustainable investment is an investment in an economic activity that (i) contributes to either an environmental or a social objective; (ii) does not significantly harm any environmental or social objectives and (iii) where the investee company follows good governance practices.
Sustainability risk is an environmental, social or governance event or condition that, if it occurs, could cause a material negative impact on the value of an investment.
Principal Adverse Impacts (PAIs) on sustainability factors are the investment’s impact when considering environmental, social and employee, human rights, anti-corruption and anti-bribery matters.
EU SFDR uses a “three-pillar” classification system as laid out by (1) Article 6 (“no”), (2) Article 8 (“light green”) and (3) Article 9 (“dark green”). The disclosure of “sustainability risks” and “Principle Adverse Impacts” in line with EU SFDR will be achieved through a list of pre-defined metrics for assessing the environmental, social and governance (ESG) outcomes of an investment process.
EU SFDR goes closely hand in hand with the EU’s Sustainable Finance Action Plan, as well as with existing sustainable/finance regulations, such as MiFID II (clients’ sustainability preferences) and the EU’s Green (and in future Social) Taxonomy, when and where sustainability risk and principle adverse impact assessments and overarching principles such as “do no significant harm” are concerned. The ambition is centred around creating more harmonisation, standardisation, and better corporate and investor disclosure standards when and where ESG frameworks, metrics and classifications are concerned. However, multiple challenges remain, especially when and where differences in EU versus local disclosure regulation, implementation timelines for all the regulatory components and reporting commitments in alignment with the EU Taxonomy on the corporate versus the investor side are concerned. And there is still an “Aggregate Confusion”5 when comparing the different ESG research and rating methodologies, which all follow separate approaches in relation to their “scope”, “measurements”, and “weightings”.
Looking at the recent report by the International Organisation of Securities Commissions (IOSCO) report on “ESG Ratings and Data Products Providers” (2021)6 and the announcement by the European Securities and Markets Authority’s (ESMA) aiming to address greenwashing and promoting transparency in ESG ratings7, there is hope that all these efforts combined will finally lead to more clarity, comparability, and consistency around ESG convictions, narratives and definitions across the investment value chain.
Martina Macpherson, Global Head ESG Product Management, Six Group
* Global Sustainable Investment Alliance, Global Sustainable Investment Review, 2020.
2Bloomberg Intelligence, ESG Assets May Hit $53 Trillion by 2025, a Third of Global AUM, 23 Feb. 2021.
3A Practical Guide to Active Ownership in Listed Equities, UN Principles for Responsible Investments, 2018.
4PRI, Regulation Database, Link: www.unpri.org /policy/regulation-database.
5MIT Sloan Business School, The Aggregate Confusion, May 2019.
6International Organisation of Securities Commissions, Environmental, Social and Governance (ESG) Ratings and Data Products Providers, Final Report, Nov. 2021.
7European Securities and Markets Authority, Sustainable Finance Roadmap 2022-24, 10 Feb. 2022.