New Horizons in ESG Integration
New Horizons in ESG Integration
March 2020
By Lawrence Langenhan
Interest in sustainable investments amongst market participants has risen sharply in recent years. In turn, the inclusion of Environmental, Social and Governance (ESG) considerations into investment analysis and decision-making has gained considerable momentum. Policymakers and regulators are playing a significant role in shaping sustainable investment practices across the European Union, seen as a global leader in ESG.
Although each jurisdiction has its own nuances, ESG integration in European markets is growing.
The mobilisation of the European Commission around the UN’s 2030 agenda for sustainable development and the 17 Sustainable Development Goals (SDGs) has played a key role in driving increased interest and adoption of ESG analysis in the investment process. In 2018, the European Commission demonstrated its commitment to a low carbon future, releasing its Action Plan on Sustainable Finance as part of a strategy to integrate environmental, social and governance considerations into its financial policy framework and mobilise finance for sustainable growth. Subsequently, to execute its Action Plan, the European Commission released a number of legislative proposals to increase transparency and comparability of ESG data, critical for further uptake of ESG integration.
The EU Taxonomy - A Potential Global Standard
In December 2019, the European Commission (EC) welcomed political agreement between the European Parliament and the European Council on the creation of an EU classification system for sustainable economic activities – known as the EU Taxonomy Regulation. This regulatory framework establishes common standards and definitions for investors attempting to identify and select sustainable investment opportunities by specifying the criteria of which an economic activity would need to meet in order to be classified as ‘environmentally sustainable’.
Many investors in non-EU member countries are following this Taxonomy closely, as their countries seek ways to achieve goals set out on climate change and shift toward more sustainable economic growth and activity. Notably, Japan’s largest pension fund, GPIF, publicly stated that it would refer to the EC’s sustainability classification1. If the classification system becomes more widely adopted, it has the potential to encourage a hike in cross-border sustainable capital flows.
More generally, a common framework for definitions and analysis is critical to advancing the rigor and adoption of ESG investment practices. The EU Taxonomy has the potential to significantly reduce the barriers to sustainable investing as investors continue to face challenges with handling and interpreting non-financial information.
New Disclosure Requirements for Institutional Investors and Advisors
A new regulation on sustainability-related disclosures for the financial services sector (‘ESG Disclosure Regulation’) has now been finalised by the EC, European Parliament, and Council, and published in the EU Official Journal. Under this new regulation, financial market participants – including institutional asset owners, investment managers and advisors – are required to disclose on their procedures for the integration of ESG considerations and risks into their investment and advisory processes, as well as the extent to which risks might affect profitability. These disclosure requirements, due to come into effect in 2021, also require institutions that claim they are pursuing environmentally friendly or sustainable investment strategies to disclose details on the methodologies they apply, with specific reference to the EU Taxonomy, or alternatively, disclaim that it has not been used.
The Disclosure Regulation comes at a time when there is increased pressure on investors to be aware of the impact of their business on the environment. In early 2019, a directive, IORP II, prompted occupational pension schemes to consider their ESG practices more closely through its own disclosure requirements.
Importantly, both the EU classification system and these disclosure requirements seek to tackle ‘greenwashing’ – the mislabelling of investment products as environmentally friendly, which is a predominant industry concern. The ESG Disclosure Regulation intends to harmonise sustainability disclosures for investment products, increasing the accessibility for investors to comparable information.
Social, Governance and Environmental Considerations
It is an ongoing, iterative process to find the right framework for ESG analysis and integration, and challenges still remain. One of the greatest challenges in implementing the Taxonomy will be how market participants are able to provide or gain access to standardised data and disclosures relevant to Taxonomy related activities from companies they choose to invest in. The EU Commission has initiated its review phase of the Non-Financial Reporting Directive (NFRD), which currently requires non-financial disclosures, including on environmental, social and human rights activities and matters, for companies with over 500 employees. Much of this information from securities issuers remains difficult for investors to access today.
In addition, there is the consideration of the broader spectrum of E, S and G. To create a wholly sustainable financial system, frameworks that foster a clearer understanding of the sustainability of an investment beyond what is defined to be ‘green’ or environmentally friendly - the current focus of regulatory developments will be required. Corporate governance factors currently account for a large portion of ESG analysis for European practitioners and investors. And according to a recent study conducted by the CFA Institute, the majority of Europe-based market participants believe over the next 3-5 years that social factors will become systemically important in the investment process2.
Paving the Way for a Sustainable Future
The European Commission’s Action Plan is a potential blueprint for a global standard for sustainable finance, laying the foundation for accelerating private capital flows toward sustainable economic activities. As the regulatory environment for sustainable finance and economic development evolves, market participants and regulators will, together, need to balance the need for clear guidance and regulation with the need to ensure regulatory compliance does not become so onerous that it inhibits growth and innovation.
The views expressed herein are those of the author only and may not reflect the views of BNY Mellon.
1https://www.youtube.com/watch?v=w10p7IjsLUM&feature=youtu.be
2ESG Integration in Europe, The Middle East, and Africa: Markets, Practices, and Data (https://www.unpri.org/investor-tools/esg-integration-in-europe-the-middle-east-and-africa-markets-practices-and-data-/4190.article)
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