Regulation and ESG: the investment agenda

As demand for investments with an ethical or social profile has soared over the past few years, fears have grown that some asset managers may be cashing in by making exaggerated claims about the credentials of their products. 

It’s led to mounting scrutiny of how ESG (environmental, social, and governance) standards are defined and applied, and an increasingly assertive approach by regulators. 

There have been probes and fines into so-called greenwashing and asset managers are under pressure to show they remain compliant. But this is no easy task, given the costs and resources involved, the shortage of good ESG performance data shared by companies, and a complex regulatory landscape. 

So how do asset managers keep pace with changing rules and requirements, and ensure that their investments truly meet their clients’ expectations?

Lack of clear data

Perhaps the biggest challenge for the industry is the lack of common, quantitative definitions of greenwashing and clear guidelines on how to measure ESG performance. That has made it easier for misleading claims to slip under the radar. 

Currently, UK firms are only required to disclose some ESG-related information under legislation such as the 2006 Companies Act, the 2010 Equality Act and the 2015 Modern Slavery Act. But most data is still supplied on a voluntary basis and interpreted by independent ratings agencies with very differing approaches and methodologies, making it hard to get a truly accurate picture.

This data gap makes it hard to obtain the truly transparent ESG reporting needed to “build trust with clients”, says Daniel Bowie-MacDonald, a senior investment specialist at asset manager abrdn. And in the absence of commonly accepted standards, he says fund managers must go the extra mile and maintain “robust frameworks, effective risk management processes and promote a positive culture to mitigate against compliance failures”. 

“It’s important to attract talented subject matter experts and stay up-to-date with ESG-related regulations, research, ratings and data providers as they all play an important part in ensuring we meet the expectations of our clients,” he says. 

“Active ownership and engagement also play a key role in helping us understand the companies we invest in.”

Changes ahead

Governments around the world are aware of the problem and reviewing the regulatory environment. New sustainability disclosure requirements (SDRs) set to be introduced in the UK soon will specifically target environmental greenwashing at investment firms. 

Under the plans, product marketing rules will be strengthened to crack down on bogus ESG claims, and firms will have to make more detailed sustainability disclosures aimed at a wider variety of stakeholders.

Graham Hook, head of UK government relations and public policy at Invesco, says “Combined with new corporate sustainability disclosures in the EU, [SDRs] could represent a significant step forward in the ability of portfolio managers to assess the sustainability-related risks and opportunities of investee companies.”

Over time the SDRs’ framework will expand, Hook adds, pushing companies to make further improvements. The UK is also consulting on making ESG ratings providers subject to regulation and developing an industry-approved code of conduct for them to follow – all of which should improve transparency.

But UK rules are likely to continue diverging with those in the European Union and other jurisdictions, potentially creating headaches for globally focused asset managers. For example, the EU’s recently introduced sustainable finance disclosure regulation requires asset managers to adhere to the bloc’s do no significant harm (DNSH) principle, unlike the UK’s equivalent SDRs. 

The UK will also use a different classification system to label bona fide ESG assets to the EU, which could cause confusion.

This post-Brexit trend could be “a real challenge for global asset managers” who face an increasingly complex set of rules when operating across borders, says Bowie-MacDonald. 

Efforts are afoot to develop common global standards for ESG, but Hook says the gaps in interpretation between countries currently are so wide that agreeing on rules will take time.

Assertive approach

Whatever the barriers, officials are taking an increasingly assertive approach to tackle alleged mis-selling of ESG assets, and asset managers must prepare themselves. 

Over the past few years there have been financial penalties levied and investigations launched over greenwashing claims at major investment companies. The EU meanwhile has outlined plans to fine firms up to 4% of their global revenue for greenwashing under its green claims directive. 

Steve Round, co-founder at banking technology firm SaaScada, says asset managers must “lay the foundations to achieve a comprehensive view into the environmental and social impact” of their own business operations, and those of the investee companies they hold shares in. 

The data gap will remain a challenge in the short term, he says, but regulation should improve matters over time.

“New regulation will create greater reporting overheads for asset managers, but it will also enable them to state clear targets and remove ambiguity on how they can communicate on environmental and social impact. This will push the industry to make the financial services sector a force for good.”

Claims of greenwashing at major asset management firms have sparked headlines, police raids and even fines over the past few years. Regulators are also taking an increasingly tough approach to those who break the rules. 

Yet the mis-selling of ESG assets is rarely intentional: “Many investors genuinely want to implement environmentally, socially and governance practices in their investments, but there is often a gap between intentions stated in a policy and actual implementation,” says Eleanor Fraser-Smith, head of sustainability at Victory Hill Capital Partners.

Daniel Bowie-MacDonald, a senior investment specialist at abrdn, agrees.

“In my experience, the overwhelming majority of ESG practitioners are committed to doing what they believe is the right thing for their clients.”

Industry professionals say unclear ESG standards and regulations, patchy data on company performance, and a lack of in-house expertise can result in the misrepresentation of an investment’s ESG profile. This in turn leaves asset managers at risk of litigation and reputational damage. 

So how do asset managers overcome these blind spots and reduce the risks?

‘What good looks like’

It is hard to say exactly how common unintentional greenwashing is, but experts believe it to be widespread. A big part of the problem is the lack of standardisation in both ESG measurement and definitions, which means the financial services industry still struggles to agree on what “good” ESG performance looks like.

“Many ESG issues are highly subjective,” says Bowie-MacDonald. “People can base their decisions on different data sets and even when using the same data sets, users may have different interpretations of it.” 

Typically investors rely on ratings agencies to score listed firms in terms of their ESG risk. But despite their best efforts, such agencies have to base their judgements on limited disclosures from companies, multiple (and in some cases contradictory) metrics, and complex scoring methodologies. 

This means ESG ratings can be highly subjective depending on what is being measured, says Conor Hartnett, ESG client strategies manager at Invesco. 

“There is also plenty of research that has shown a weak correlation between different ESG ratings agencies’ ratings with each other. This greatly reduces their overall reliability and market-wide usefulness.” 

Given the circumstances, it is fairly easy to make a slip-up. So Invesco believes fund managers should always fully understand the methodologies and sources of ESG ratings or data providers themselves, so they can use the scores with confidence.

There have also been calls for data providers to be more transparent about their methodologies and offer more detail. Lee Clements is head of applied sustainable investment research at FTSE Russell, part of the London Stock Exchange Group, which provides customers with detailed breakdowns of companies’ exposure to green revenues. 

“What is needed is greater disclosure, more transparency on the methodologies and better granularity on what is underlying the sustainable investment metrics,” he says.  

“For example, with our green revenues data we break down the percentage of revenues exposed to green products and services by three tiers of ‘greenness’, 133 different micro-sectors of activity, whether the data is reported or estimated and how the number was compiled on a company-by-company basis.”

Incompetence greenwashing

Moves to regulate ratings agencies and mandate company disclosures on ESG should provide asset management firms with a clearer set of data to work with. But some professionals argue that firms could be doing more to help themselves. 

Fraser-Smith points out that ESG covers a breadth of subject matter that no one fund manager can be expert in, from climate change and carbon accounting to health and safety and human rights.

Firms need to develop their own in-house expertise to gain a deeper view of the companies they back, building multidisciplinary teams. Too often, though, ESG is left to a small team or lone function in the business with little background or experience.

“ESG courses a few weeks long are not enough to build the expertise required. ‘Incompetence greenwashing’ is a term growing in use,” Fraser-Smith says. 

Another cause of unintentional greenwashing is poorly thought-out marketing, often resulting from a disconnect between investment and marketing teams within a business. 

For this reason, training investment teams and marketing departments in tandem by ESG experts is essential, says Oliver Collin, co-head of the European Equities team and a fund manager at Invesco. 

“This ensures alignment between what is being done and how it’s being communicated.”

Overall, asset managers should take an active approach to investments and due thorough diligence, Fraser-Smith says. 

“This goes beyond checking whether the investee company or asset manager has a policy but understanding how it is implemented, including the management systems, practices and key performance indicators.” 

Transparent, honest communication from asset managers to investors on goals, progress and challenges can also reduce the risks associated with unintentional greenwashing. 

 “Asset managers should not overstate or overpromise what their approach aims to achieve. If a particular goal is not feasible, it is crucial to explain why,” says Collin. “Most clients appreciate the challenges and realities of ESG investing.”

For many years it has been difficult for investors to ascertain precisely how green, ethical or well-governed a fund portfolio truly is, or to see the evidence behind those credentials. Limitations over transparency, inconsistency of data, and unreliable access to core metrics, have all raised uncertainties.

Both regulators and funds are aiming to change this. Regulators have introduced significant mandates on transparency and classification descriptions, with further discussions taking place around the labelling of funds. In Europe, transparent disclosure of data points has been the focus, while in the UK and US discussions are tending towards a form of standardised investment labelling. Funds, meanwhile, are seeking the data they need to comply with existing regulations and to accelerate along the direction of travel.

The changes introduced so far are having a strong impact. Measured by assets under management (AUM), sustainable funds are growing more quickly than non-sustainable alternatives.

“The real catalyst is a big change in the narrative as a result of suitability requirements. Instead of waiting for the asset owner to request sustainable products, the manager has to ask what the owner's sustainability preferences are and find a product fit for purpose,” explains Nadia Humphreys, head of climate finance and sustainable regulation solutions at Bloomberg, the market data provider.

While previously investors needed to state their goals, then an asset manager would attempt to provide a relevant investment product, the regulations have resulted in managers opening that conversation on preferences. “This is exposing the demand around sustainability, because asset owners, when asked, do have sustainability preference,” Humphreys says. “There’s a huge, visible flow of capital to sustainably marketed financial products as a result.” 

Beyond this, funds in the most stringent ESG classifications are generally more effective at attracting and retaining capital. Bloomberg data shows that in the first quarter of 2023, article 9 exchange traded funds – whose products must demonstrate ESG improvement objectives – had far better capital flows than less demanding article 8 funds. Some 70% of article 9 ETFs attracted capital inflows in the period, as opposed to 53% of those in article 8. Meanwhile, only 19% of article 9 ETFs had outflows, as opposed to 32% in the lower category.

Any upcoming regulatory changes around accurate labelling could further cement these advantages. “It’s critical that investors can easily see and understand what they are putting their money into,” Humphreys says. “With investment labelling, for example, all funds should disclose the impact their product has on sustainable outcomes – just like with food labelling, where you can see nutrition KPIs on all products not just those marketed as 'healthy'.”

Nonetheless, significant challenges remain around the limited disclosure of data by the companies being considered for investment. The funds able to harness far deeper data to guide and evidence their choices are able to build advantage. “We can see investment funds increasingly going above and beyond on how they measure and benchmark the deeper ESG credentials of their portfolio,” explains Humphreys. “They are accessing transparent and reliable insights, to more quickly make better-informed decisions on investments, prove these in practice, effect targeted changes, and confidently market themselves in the advanced classifications.”

The fund managers achieving these improvements are reliant upon sources of extensive, rigorously collected and evidenced insights. This data allows for proper measurement of portfolio companies’ performance in all ESG areas, so managers can decide where to put their money to meet their stated objectives. It can also track performance, testing regularly against their own ESG targets and in context with their competitors, and reporting as needed to regulators and investors.

Funds globally are turning to Bloomberg for this in-depth ESG data. Bloomberg’s extensive team of researchers and intelligent technology provide powerful analytics across all areas of ESG, with those calculations entirely evidenced for managers to assess. Critically, the data is unique in fully transparent to source and configurable, enabling internal decisions and performance measurement settings, and helping firms comply with rigorous regulatory obligations.

“Funds currently use our data to demonstrate results against their full range of stated ESG objectives, such as carbon footprints, gender pay gaps, water usage, waste management and beyond,” says Humphreys. Data is available to meet and exceed all local regulatory mandates – and for non-EU markets where only estimates of taxonomy alignment are required, companies’ representations are tested with unparalleled robustness.

Looking ahead, Humphreys expects the demand for reliable ESG data to increase, as regulatory mandates become stronger and investor interest grows. “As tougher reporting regimes lead to more good data being provided by companies, and that information becomes more widely available, the appetite of asset owners will rise,” she says. “When companies are obliged to properly measure and communicate these factors, it also empowers investors to become highly influential with their capital allocation. This will deliver real progress around sustainability, ethics and governance, as money flows consistently into demonstrably compliant companies.”