The UK has a chance to draw first blood in the post-Brexit war over sustainable investment reporting. After leaving the European Union, the UK quickly identified this area as a regulatory battleground, announcing its refusal to align with upcoming EU legislation and intention to become a global green finance leader.
But it is a risky move. Many UK fund managers warn that diverging from EU rules could force them to negotiate clashing regulations. This could create uncertainty and weaken their position in the lucrative field of sustainable investing. Divergence could also make the complex field of sustainable investing even harder for consumers to understand.
The stakes are high. European assets invested in environmental, social and governance (ESG) strategies are forecast to overtake those in conventional funds and reach a colossal €7.6 trillion by 2025, according to PwC.
The EU’s Sustainable Finance Disclosure Regulation (SFDR), coming into force this March, could grow this even further as it effectively forces managers to disclose ESG issues.
In November, UK ministers made their first powerplay by refusing to align with the SFDR because technical aspects of the rules have been postponed and not yet published. However, they clearly see this delay as a chance to gain competitive advantage.
Instead, the UK announced plans for its own regime, in which it would become the first country in the world fully to mandate climate disclosures for companies and financial institutions. Many believe this stricter approach will spark a race to the top on ESG reporting regulation.
The ESG race to the top
Sustainable investing has long been plagued by patchy or confusing measurement and reporting. Some asset managers’ claims have been overly positive, known as greenwashing, leaving investors disillusioned. But as ESG becomes more mainstream, investors will demand more and better information, and asset managers will have to respond.
Sustainability disclosures from companies and fund managers have improved in recent years through voluntary reporting frameworks such as the G20’s Task Force on Climate-Related Financial Disclosures and Global Reporting Initiative.
We want the UK government to enhance sustainability disclosures, with strong taxonomies that drive us in the direction of net zero
SFDR is set to strengthen these international frameworks in the EU. But it does not force disclosure. Instead, players can choose not to comply and explain why. Given the huge and growing popularity of ESG investments, they will have little choice in practice. But the UK believes it has an opportunity to boost its green credentials in comparison by forcing all companies to disclose such information, with no comply-or-explain option.
The EU’s postponement of the SFDR’s technical regulations, possibly until the end of this year, is necessary to ensure rigour in the consultation process, but the delay is causing uncertainty and might have handed the UK government another chance to grab the upper hand.
Improving sustainability disclosures
James Alexander, chief executive of the UK Sustainable Investment and Finance Association (UKSIF), which represents UK fund managers, says most of his members have some EU operations. As such, they already align with SFDR as much as possible or plan to.
“Some of our members have reported sustainability well, some less so,” he says. “SFDR allows for a wide interpretation; you can comply by doing a lot or slightly less. It is also not enough to get us to net-zero carbon emissions.
“We want the UK government to enhance sustainability disclosures, with strong taxonomies that drive us in the direction of net zero and that ensure leaders in ESG reporting can differentiate easily from those who are doing less. That will make us the world leader.”
Another criticism of SFDR is it focuses on disclosing information about fund managers’ intent on ESG issues, rather than outcomes, which are harder to measure but ultimately more important.
Louisiana Salge, senior sustainability specialist at UK advisory firm EQ Investors, says EQ is already meeting SFDR disclosure standards and will continue to do so regardless of Brexit.
“We aim to lift fund managers to apply best practice on ESG integration, processes and reporting,” she says. “These new standards are a significant step towards achieving that goal.
“Most investment managers have been lagging on transparent reporting of sustainability outcomes, leaving investors to doubt they are delivering on their intentions. For example, we still see asset managers calculating carbon emissions in ways that paint a wrong picture of climate change contribution and risk.”
Salge says the EU taxonomy – a set of definitions that will help managers report ESG issues more consistently within SFDR – will streamline disclosure on funds’ intent.
“But that is just the intent,” she says. “Reporting on tangible impacts and outcomes is still missing, though it would be highly beneficial.”
Will Brexit impede green cohesion?
Brexit manoeuvres must be seen in the context of global sustainable investment reporting initiatives. Regional rules must harmonise with international standards if the industry is to reduce complexity and inefficiency.
Several initiatives are working to increase global cohesion and clarity. These include the United Nations-backed Principles for Responsible Investment, International Platform of Sustainable Finance and proposed new Sustainability Standards Board.
Furthermore, the Big Four accounting firms have launched international ESG metrics that aim to align existing standards. And finally, five standard setters, which together guide most sustainable investing globally, have agreed to align their frameworks.
In this context, the UK government has pledged to match the level of SFDR and align with global standards, a move welcomed by UKSIF.
Andy Mason, senior ESG analyst at Aberdeen Standard Investments, believes Brexit will not affect these global collaborations. “There’s an alphabet soup of initiatives and standards,” he says. “Though we are UK listed, we have investments globally, so we need a single global standard. Multiple regional standards lead to reporting fatigue and stifle innovation.”
There will be a race to the top in practice and disclosure. But the market is moving fast.
But Julia Dreblow, director at consultancy SRI Services, says Brexit is impeding better international rules. “The EU rules are helpful but complicated, highly prescriptive and useful parts of a puzzle, rather than a magic wand for delivering net-zero carbon,” she says.
“To deliver net zero, we will also need higher-level principles that avoid misleading clients and ensure fairness and internationally agreed standards to steer us towards that target. Both are being worked on. But Brexit has slowed this activity substantially and been a headache for many investors.
“For example, we were expecting to welcome other EU rules that obliged financial advisers to discuss sustainable investment with their clients. But they seem to be on hold. The EU has been a positive force in this area. Thankfully, the UK government has signalled a desire to match their aims and indeed lead in this area. So we hope these impediments will be short-term glitches, rather than anything more substantial.”
Sarah Gordon, chief executive at the Impact Investing Institute, says that while SFDR is welcome, the UK can go much further. “The EU taxonomy addresses environmental exposures comprehensively, but only touches on the vast spectrum of social issues superficially, with little more than a do-no-harm requirement,” she says.
“There is much more to do. The UK has an opportunity to lead development of European and global thinking on a social or ‘just transition’ taxonomy, which provides a framework for connecting climate action with an inclusive economy. The UK can build out the societal implications of the green taxonomy well beyond ‘do-no-harm’.”
Longer term, Gordon expects Brexit to spark a race between the UK, EU and other countries to boost green finance market credentials by providing the most effective regulation.
“It is inefficient to operate two standards, so there will be a race to the top in practice and disclosure,” she says. “But the market is moving fast. This moment represents an opportunity to take advantage of the momentum around sustainable investing and show global leadership.”
Reshaping the asset management industry
Experts expect the SFDR to trigger an investing revolution by forcing all financial market players to disclose information on ESG issues.
Unless providers give good reasons for opting out, the SFDR will oblige them to disclose the sustainability risks and adverse impacts in their investments and their overall approach to ESG.
For products defined as ESG or sustainable, SFDR will also require asset managers to report investment goals before a sale and regularly thereafter. These requirements will force many managers to radically change their approach to sustainable investing.
Though the main regulations will come into force in March, the European Commission has delayed publishing technical details. This is because it needs extra time to consider the huge number of responses to its consultation on SFDR, underlining the significance of the changes to the industry and wider society.
This delay is causing uncertainty for managers around how they will apply the new rules in March. But it is unlikely to dilute the commission’s determination that SFDR should align the finance industry with the EU’s Green Deal targets, especially as 98 per cent of consultation responses urged the commission to uphold this ambition.
Rodolfo Fracassi, co-founder and managing director of consultancy MainStreet Partners, says SFDR will be a “game-changer” for asset managers because it obliges them to communicate on how they integrate sustainability risks, calculate adverse sustainability impacts, and explain how they consider and promote environmental or social characteristics in their investment processes.
For products defined as ESG or sustainable, additional requirements will include reporting on specific and verifiable metrics.
Any managers marketing their funds in the EU will have to comply, says Fracassi. “The alternative is to ignore ESG risks and communicate that decision, with potentially severe business consequences, given the increasing demand for ESG products.”
The regulations could also sift out weaker ESG players, due to the heavy investment necessary for compliance.
“Margins are already under pressure from passive rivals, other regulatory burdens and technological developments,” says Fracassi. “Committing to this investment will test the mettle of many active investment firms, especially small boutiques that lack the scale for large ESG investments.
“There are rewards; global assets in ESG-driven investments are now over $40 trillion. But investors’ requirements of firms that claim to satisfy their ESG needs are significant and will only increase in future.”
Boosting global cohesion
New international metrics from the World Economic Forum (WEF) for sustainable value creation have boosted the momentum behind global cohesion in ESG standards. However, some warn that success of the metrics will depend on how companies and investors use them.
WEF teamed up with the Big Four accounting firms to develop the metrics, which aim to help companies and investors align reporting on ESG factors. Since their launch last year, more than 60 companies, including Bank of America, Mastercard and Dell, have committed to using the metrics.
Crucially, the standards are based on existing standards and disclosures, and align with the United Nations Sustainable Development Goals’ four pillars of governance, planet, people and prosperity. This is helping accelerate convergence between standard setters around the world.
Dreblow says: “The 2008 financial crisis and COVID-19 pandemic have highlighted the need for investors to remove their blinkers and look at the sustainability of company operations. By working with the Big Four, alongside other excellent initiatives, the WEF recognised auditors’ role in long-term value creation and holding companies answerable for their impacts.
“But if companies focus on softer issues, such as volunteering and ‘engagement’ with stakeholders, the metrics will struggle to prove their worth. If they focus on carbon emissions, and difficult issues like diversity and fixing failures in the international tax regime, they will be worth their weight in gold.”
James Alexander, at the UK Sustainable Investment and Finance Association, says the association and its members strongly support the WEF’s promising initiative.
“The focus on the UN’s four pillars is vital in helping forward-thinking investors recognise the interrelation of economic, environmental and social factors in long-term value creation,” he says. “We want increased consistency in reporting to help meet the overwhelming demand from investors for sustainability-related disclosures.”
Sarah Gordon, at the Impact Investing Institute, says all efforts to improve ESG reporting, transparency and accountability are welcome, and the commitment by major companies demonstrates the progress mainstream businesses and investors are making in this area.
“Ultimately, all businesses and investors will have to disclose their positive and negative impacts, so consistent global standards are the goal,” she adds.
