Regulation, consumer sentiment drive ESG vision worldwide

This article was first published on Thomson Reuters Regulatory Intelligence on September 26, 2022

In the financial services market, this means driving capital toward ESG, informing the market about sustainability, discouraging investment in sectors and activities that cause harm to the environment, and imposing financial penalties on those that do. The financial system — and regulatory frameworks — are being leveraged to expedite the necessary change, and to coordinate how money flows into and out of industries, activities and sectors that may have a damaging impact on the environment.

Regulation round-up

The ESG vision is being implemented through both the "push" of regulation and the "pull" of consumer sentiment. In the EU, the Sustainable Finance Disclosure Regulation ("SFDR") and Taxonomy were implemented in March 2021, to provide a framework for disclosing investment activity aligned with protecting the environment, or not.

The EU requirements also encompass governance structures at financial institutions and the remuneration incentives they offer — to ensure such incentives encourage appropriate behaviour rather than perpetuating conduct that has an adverse impact on the environment.

Following Brexit, the UK is developing its own version of the SFDR in the form of the Sustainable Disclosure Requirements and the UK Taxonomy, which also focus on disclosure in respect of capital flows into ESG investments and how such organisations are governed.

Many Asian jurisdictions, meanwhile, have implemented the recommendations of the Task Force on Climate-Related Financial Disclosures ("TCFD").

All these regulations aim to drive capital into ESG investments which protect the environment, and to transition economies away from activities, products and sectors that may have an adverse impact. More transparent disclosure about how investments are being made, as well as how financial institutions are governed, is pushing capital toward more sustainable investments and leading to greater accountability.

Customer sentiment

Mandatory regulation has not been the only driver, however. The UK has experienced a strong trend toward impact investing of late, with 70% of the public wanting their money to make a positive difference to people or to the planet, and to contribute to the shift toward a net-zero economy.

According to the Investment Association, 49% of the £9.4 trillion assets managed in the UK were integrating ESG data into their investment processes in 2020, up from 37% in 2019. Even if institutions are not domiciled in a jurisdiction that has defined ESG regulations, they may still voluntarily opt to respond to wider investor and client sentiment. 

ESG data and impact on integrity

Reliable data and metrics are critical if assets are to demonstrate alignment with a particular ESG strategy — a clear investment methodology that evidences how a portfolio or manager will adopt, execute, monitor and report back on its particular ESG strategy is dependent on data. Numerous ESG data providers have emerged to service this market, but as they remain largely unregulated, there is considerable variation in the quality of the information they supply.

The lack of reliable data creates potential risks of greenwashing. Regulators have recognised this and have proposed that ESG data providers be regulated in a similar way to rating agencies, to protect the integrity of the data upon which institutions and consumers rely. Proposals have yet to be finalised, but it will not be long before they are in force.

Regulatory outlook

The regulations outlined above will see components of ESG, sustainability and climate risk applied to listed entities (corporate disclosures), entity level disclosures (managers, advisers, asset owners, insurers, banks), product level disclosures (ESG labels and related requirements) and investor-focussed sustainability profiling.

These initiatives are being supplemented by regulation covering physical and transition risks and their impact on regulatory capital requirements, so that avoiding, or minimising, ESG considerations becomes an operational cost of business.

ESG and impact on value

There has been much discussion about the impact ESG considerations will have on value, with some arguing that heightened compliance and related costs have led to lower returns. Others understand, however, that in the medium to long term, the cost of disregarding ESG, sustainability and climate risk is likely to increase operational costs in the form of higher insurance premiums due to physical risks and the impact on regulatory capital with prudential evaluation of ESG exposure in transactions.

Other costs may include the cost of lending where ESG, sustainability and physical risks in the credit process are not appropriately factored into stress and scenario tests, as well as the effects of potential investors transitioning away from conventional investments.

In many cases, ESG could be a value-enabler, rather than an inhibitor. Quite apart from environmental considerations, ESG also brings benefits in terms of the social impact of good governance in financial institutions, and the positive impact this has on investments, and the conduct of individual board members. This should lead to stronger and more accountable governance, which in turn could drive more sustainable and secure investments, adding the value, not diminishing it.

ESG impossible to avoid?

Given the activities outlined above, ESG has become almost impossible to avoid. Even if businesses are not caught by the mandatory implementation of new regulations, they may well be swept up in the wave of commercial or investor sentiment or be exposed to ESG through cross-jurisdictional business — be it fundraising from Europe (and related exposure to the SFDR) or supply chain considerations when engaging with EU-based counterparties. Institutions may either be initiating transactions or be part of a transaction cycle which itself may be exposed to various aspects of ESG across different jurisdictions.

Making ESG "fit"

There has been much discussion about how ESG can be made to "fit" into a financial system that is well-established part of society in most jurisdictions. The focus should perhaps rather be on ensuring that the system changes to accommodate ESG, and ensuring that it instils stronger reliance on governance — something that should, arguably, already be in place.

The following table provides a high level, non-exhaustive overview of regulatory focus areas in a range of jurisdictions: