By Sophie Evans
Over the past year environmental, social and governance (ESG) factors have advanced to the forefront of considerations made by investors. ESG factors are standards which encompass a company’s mindfulness for the environment, social management in terms of employees, suppliers and communities and governance regarding leadership, internal controls and shareholder rights. These criteria are then used by investors in their decision making during the investment process. Though once a niche, it is clear that sustainable investing is here to stay. A 2019 survey from Morgan Stanley found that 85% of investors are interested in sustainable investing – an increase from 71% in 2015. Coinciding with this growing sentiment of sustainable investing is the nascent belief that investors should seek to understand companies not only through their financial performance but through their sustainability strategies. Look no further than the U.K., where investors placed £124 million a week into ESG funds in the first ten months of 2019, according to data from Morningstar. Certainly, an ethically focused approach to internal and external stakeholders has become an increasingly visible indication of a company’s long term investment capabilities. With the growth of interest in sustainable investment, the need for a robust regulatory framework to manage companies labelling themselves as ‘sustainable’ has grown in tandem.
The E.U.’s new Sustainable Finance Disclosure Regulation (SFDR) is one way in which companies’ implementation of ESG factors is being managed. In a controversial move, but one that fits tellingly with Boris Johnson’s ‘take back control’ narrative, the U.K. government decided to opt out of aligning with the regulation and has declared its intention to deliver its own innovative proposals to mandate climate disclosures by large companies and implement a new ‘green taxonomy’. U.K. ministers decided against converging with the SFDR on the grounds that technical aspects of the regulations had yet to be published until 2022. Sustainable investing is a fast-paced and quickly evolving market and as such the E.U.’s delays could allow for other countries to attempt to take a leading role in regulating this new surge of sustainable investing. Indeed, policymakers seem increasingly concerned with reaching impressive climate goals – with Joe Biden promising to invest trillions into decarbonising the American economy and Xi Jinping claiming that China will be carbon neutral by 2060. As such, this could certainly present the U.K. with an opportunity to strike while the iron is hot and stake their claim on ESG reporting and regulation. Chancellor Rishi Sunak stated boldly in a speech to parliament in November 2020 that the U.K. plans to go “further than recommended by the Taskforce on Climate-related Financial Disclosures. And [be] the first G20 country to do so”. Is this a chance for the U.K. to take the lead on green finance post-Brexit?
Indeed, the U.K.’s decision to deviate from E.U. law could be seen as a purely tactical power move. The announcement of this regulatory divergence comes in the months leading up to the U.K.’s presidency of the G7 alongside its hosting of the auspicious UN Climate Change Conference (COP26). As such, Brexit has provided a platform for the U.K. to develop its own framework for regulating sustainable finance that has the potential to be superior to the E.U. model.
To understand what U.K. policy makers are up against, one must explore what the SFDR actually is. In the most basic sense, the SFDR is a directive that aims to introduce sustainability standards across the European asset management sector. It requires funds to disclose sustainability risks within the investment process – however, it does not force disclosure and is rather on a “comply or explain” basis, where companies can choose to communicate their decision to ignore ESG criteria. Asset managers will also have to decide whether a fund they offer fits into one of three areas: article 6 which encompasses regular funds, article 8 which deals with ‘light green’ funds or those that display sustainable characteristics and article 9 – ‘dark green’ funds that have explicit sustainability objectives. This labelling system is designed to aid investors in distinguishing between the various ESG strategies present on the European market. As of right now the regulatory technical standards of the SFDR will be delayed to a ‘later stage’. This poses challenges for firms when attempting to disclose light green and dark green products without knowledge of the technical criteria of what constitutes as a particular sustainability standard. Global head of regulatory intelligence for investor services at Brown Brothers Harriman, Adrian Whelan, has commented that the “lack of uniform standards” for what constitutes as an Article 9 fund will lead to greenwashing – or the attaching of specific words or phrases to the name and advertisement of a product/fund in order to create the appearance of being ESG compliant. Whelan argues “the fund classification system was designed to allow for a spectrum of ESG commitment across the E.U., underpinned by data in order to remove greenwashing” but that the “inexact method of measurement [means] there may be confusion about what is and what is not the more sustainably focused fund”. With pitfalls such as these, many financial experts including Sarah Gordon, chief executive at the Impact Investing Institute believe that the “U.K. can go much further” with regulation.
The regulatory environment is a challenging one for firms to navigate generally, let alone in an area as new and undefined as sustainable finance. So how can the U.K. provide a more efficient and comprehensive regulatory process in order to facilitate a more sustainable economy? The U.K. government has already asserted that it will take a stricter approach by requiring firms to deliver climate disclosures. However, there are other ways the U.K. can go further with regulation. The wide interpretation allowed in the SFDR means that firms “can comply by doing a lot of slightly less”, as stated by James Alexander, chief executive of the UK sustainable Investment and Finance Association. Therefore, the U.K. government should instead be aiming to enhance sustainability disclosures to allow consumers to differentiate between those who are doing more and those who are achieving less for sustainability initiatives. Additionally, on the converse of the ambiguity surrounding the SFDR’s labelling system, a degree of flexibility could be given in the U.K. policy on what constitutes having a ‘sustainable’ company strategy. Mitigating climate change will require broad investment into companies that are not yet considered green in order to facilitate their transition to become more ESG compliant and such labelling may work to divert capital away from activities that are perceived as unsustainable because they do not fall explicitly under article 8 or 9. This could impact market competition and lead to a sudden inflow of funding into activities categorised as ‘sustainable’. Such an influx could create a ‘green asset bubble’ – a newfound phenomenon of investors pumping cash into “anything that looks ‘green’” and sending the valuation of ‘green’ companies sky high despite dubious returns. As such a balance must be struck between incentivising firms to invest in green initiatives and also ensuring overvaluations of ‘green’ companies are mitigated. The way to do this could be perhaps through independent reports on companies’ sustainability alongside government regulatory requirements – however ensuring firms are honest in their statements could pose a further challenge. Evidently, sustainable investing is a tricky area – and a plethora of risks accompany it, many of which are only just becoming identifiable.
The U.K. should also be addressing issues that have yet to be dealt with efficiently by the E.U., including the need for better definitions across regulations. For example, there are fears that the SFDR’s definitions do not recognise that sustainability can take many forms and the 32 sustainability indicators that have been proposed by the E.U. to be implemented in 2022 could result in a ‘tick box exercise’ rather than generating useful sustainability information for investors to consider. Rishi Sunak has already stated that the U.K. government will be “robustly classifying what we mean by ‘green’ to help firms and investors better understand the impact of their investments on the environment”. Driving these discussions is one such way that the U.K. can lead in the arena of green finance.
Leadership aside, one last major issue presents itself. Sustainability in the long run will require global cohesion. Though Brexit may provide an opportunity to take the lead, political policy must not dominate social responsibility. Deviating from the E.U.’s rule could lead to further time-consuming negotiations to deal with increasing divergence in regulations and such processes could weaken the U.K.’s position in a field that is growing increasingly lucrative. It could also further complicate a regulatory environment which is already difficult for consumers to understand. The most appropriate method for the U.K. is to find a medium in order to mitigate the risks of international fragmentation. Many U.K. companies will still be subject to the SFDR if they operate within the E.U. and as such the U.K. must aim to improve areas of the E.U. regulatory framework that are unclear whilst also remaining aligned with its major principles to avoid cross-border compliance challenges.
Yet, regulation of a sustainable economy is not limited to the U.K. and E.U. but is an international affair as global assets in ESG-driven investments are now totalling over $40 trillion. The bottom line is this: sustainability is a global initiative and tackling climate change will take a worldwide effort. Therefore, any lack of international coordination on ESG standards could result in multiple different and potentially conflicting frameworks across different markets. The U.K. should certainly aim to have a leading place in shaping a global agenda for regulation. However, diverging for a political purpose could risk missing the opportunity to create a global market for sustainable investment – and saving the environment at the same time.
The views expressed in this article are the author’s own and may not reflect the opinions of The St Andrews Economist.