Unveiling the EU's CSRD framework, Benjamin David navigates the pivotal shift in sustainability reporting and the integral role of asset managers in a transparent future.

In the evolving financial realm, ESG data is fast becoming fundamental for well-informed decision-making. This data encompasses varied metrics, such as a company's carbon footprint, employee welfare initiatives and ethical governance principles. When analysed, these metrics give rise to ESG ratings, providing a comprehensive view of a company's sustainable practices and standing.

Asset managers place significant emphasis on both ESG data and the resultant ratings. These tools assist them in evaluating the sustainability-related risks and benefits of potential investments. However, questions about the reliability of ESG metrics have arisen, leading many to question the accuracy of ESG benchmarks. Claims of 'greenwashing' — where companies exaggerate their green credentials — have raised concerns about the truthfulness of ESG data, compromising the sector's ESG image.

Victoria Leggett, equity fund manager and head of impact investing at UBP, underscores the ESG challenges that asset managers are facing: "In the absence of a standardised framework, asset managers must lean on a blend of ground-up research and a tapestry of data sources to form a well-rounded opinion on a specific entity or fund." 

"In the absence of a standardised framework, asset managers must lean on a blend of ground-up research and a tapestry of data sources to form a well-rounded opinion on a specific entity or fund." 

Highlighting the concerns raised by industry professionals, the UK's Financial Conduct Authority (FCA) recently conducted a review that revealed significant vulnerabilities surrounding ESG benchmarks. Benchmark administrators have shown lapses, from neglecting detailed ESG factor considerations to ambiguous ESG data methodologies. The FCA is now setting its sights on corrective actions, signalling a strict stance against any non-compliance.

Accordingly, the existing trust concern encircling ESG benchmarks has only expanded, given the plethora of issues flagged by the FCA. Damian Payiatakis, head of sustainable & impact investing at Barclays Private Bank, states that addressing the trust issues here and advancing the field will require "greater transparency and standardisation around ESG ratings and benchmark processes”. Moreover, he cautions against over-reliance on these ratings and benchmarks, emphasising that both "outsource investment thinking and decision-making to a third-party and their calculations." For him, the true strength of asset management lies in understanding and interpreting the underlying ESG data. He believes that "Asset managers who want to own their investment process, and credit for outcomes, should be more interested in better data rather than solely focusing on better ratings or benchmarks."

The absence of a standardised framework ostensibly lies at the heart of these challenges. However, with forthcoming initiatives like the Corporate Sustainability Reporting Directive (CSRD) set to redefine ESG reporting by 2024, the industry stands on the brink of a pivotal shift.

The FCA's Stance on ESG benchmarks and its recommendations

In September 2022, the FCA sent a letter to benchmark administrators, highlighting concerns about the quality and consistency of ESG benchmarks. The main concerns were regarding the subjective nature of ESG factors, the potential for poor disclosures due to this subjectivity and the risk of benchmarks not meeting the expectations of users and investors. 

A subsequent review by the FCA in early 2023, as already mentioned, found several shortcomings in benchmark disclosures, with many administrators failing to provide adequate detail on their methodologies or fully comply with regulatory requirements. The review also noted instances of poor implementation and oversight, leading to benchmarks being miscalculated. 

The FCA is urging administrators to undertake a comprehensive assessment of current ESG benchmark families, emphasising alignment with the latest regulatory directives. The recommendations' call for enhanced transparency in benchmark statements and methodologies is a significant highlight. This move is geared towards addressing potential greenwashing risks and ensuring clarity for users.

Moreover, citing the provisions of the Benchmark Regulation's (BMR) Article 12, the FCA has underlined the importance of methodologies being both robust and dependable. This recommendation comes after noted miscalculations attributed to erroneous ESG data inputs. The FCA's stance emphasises the critical need for fortified internal control mechanisms, particularly when incorporating third-party ESG data. This strategic direction aims to safeguard the interests of direct benchmark users and protect the broader investment and financial markets from potential misrepresentations, notes the FCA.

Yet, Sam Tripuraneni, head of sustainable outcomes at Aviva Investors, urges balance here, raising a critical perspective on ESG benchmarks. He argues, "ESG benchmarks, driven by ESG ratings, are not a reflection of ‘sustainable’ investment." He points out that these ratings are primarily influenced by "financial materiality" rather than measuring the actual "impact materiality" or achieving sustainable outcomes. Essentially, these benchmarks aim to enhance a portfolio's "ESG profile" more than genuinely promote sustainable investments. Tripuraneni underscores an essential consideration for investment managers: "A key point here is whether ESG or sustainable active funds should be managed against an ESG benchmark, as it potentially removes discretion from an active manager to make their own judgement of whether an investment is appropriate."

"A key point here is whether ESG or sustainable active funds should be managed against an ESG benchmark, as it potentially removes discretion from an active manager to make their own judgement of whether an investment is appropriate."

Moreover, he highlights that these benchmark calculation methodologies could unintentionally bias larger cap developed market (DM) companies due to weight, which may not align with "sustainable" objectives. Such a bias can put smaller caps, especially those in emerging markets (EM), at a disadvantage. Tripuraneni adds, "Therefore, the FCA’s work will be an important signpost but needs to ensure that even with the right intentions, they are aware of potential unintended consequences."

Notwithstanding these words of caution, Leggett reiterates the broader sentiment surrounding the FCA’s findings, noting that the FCA outlined concerns that resonate with what many investors have been expressing. The consensus is that benchmarks “need to describe the investment accurately and that transparency is key.”

To counteract these issues, the FCA has proposed regulation of ESG data and rating providers, given the finance sector's growing reliance on third-party ESG data. The FCA seeks to foster heightened transparency and trustworthiness in this domain. To this end, they're advocating for a voluntary Code of Conduct for these providers, a framework incorporating global standards and recommendations from the International Organization of Securities Commissions (IOSCO).

A deep dive into the EU's CSRD

CSRD is a new legislative framework set to become effective in January 2024, aimed at enhancing sustainability reporting transparency across the European Union. Broadening its scope from the former Non-Financial Reporting Directive (NFRD), the CSRD will influence roughly 50,000 companies, highlighting the growing emphasis on sustainability standards.

Three pivotal differences in CSRD compared to NFRD include:

1. Double materiality concept: The CSRD integrates the principle of double materiality, compelling organisations to divulge how environmental and social aspects influence their operations and, conversely, how their business strategies impact these issues beyond just financial repercussions.
2. Third-party assurance mandate: Unlike the NFRD, in which third-party verification was optional, CSRD mandates independent auditing of ESG data, reinforcing the need for genuine, data-backed sustainability claims.
3. Digital ESG data sharing requirement: The CSRD requires that ESG data be shared digitally, making information more accessible and standardised.

Introducing these measures in the CSRD addresses prevalent challenges companies confront, especially accusations of greenwashing. By mandating third-party audits and emphasising double materiality, the CSRD assures stakeholders of the authenticity and comprehensiveness of sustainability reports. This not only builds trust but aims to ensure companies are held accountable for their sustainability claims. With the broader scope and rigorous standards of CSRD, the EU aspires to establish a more transparent, credible and sustainable corporate landscape.

Karine Jesiolowski, head of responsible investing, UBP, sheds light on this, pointing out the pivotal role of third-party assurance. “The fact the CSRD has very clear disclosure requirements means that companies will no longer be able to cherry-pick what to disclose, which will also help lower risks of greenwashing.”

The sentiment agrees with Wilson Chan, CEO and Co-Founder of Permutable AI, who emphasises the irreplaceable value of external scrutiny. “Such external assessments serve as a critical safeguard, offering an objective evaluation of sustainability claims, thereby elevating transparency and credibility within the realm of ESG reporting and ultimately mitigating the prevalence of deceptive greenwashing practices.”

“Such external assessments serve as a critical safeguard, offering an objective evaluation of sustainability claims, thereby elevating transparency and credibility within the realm of ESG reporting and ultimately mitigating the prevalence of deceptive greenwashing practices.”

Yet, Neil Robson, partner at Katten UK, strikes a note of caution. “Allegations may arise during the ‘limited assurance’ period (i.e., before the reasonable assurance period), where conclusions will likely be provided in a negative form. Given the mandatory requirement for review/confirmation that there has been no material misstatement in a company’s disclosures, it should discourage unsubstantiated claims and thereby reduce greenwashing.” Additionally, he adds that the updated versions of the European Sustainability Reporting Standards don’t leave room for ambiguity, with each requirement linking to a specific law and/or framework to be followed. This will provide a new level of detail and granularity that will need to be followed.

The road ahead: Preparing for the CRSD and the role of asset managers

The EU stands poised for a monumental transformation in corporate sustainability reporting. The CSRD delineates a novel trajectory, zeroing in on unmitigated transparency and holistic reporting. The two-stage strategy for CSRD compliance is well-defined: inaugurate with large corporations in 2024 and cascade to the smaller players by 2028. This gradual deployment furnishes organisations with ample preparation time, simultaneously amplifying the unequivocal commitment to sustainability across the business spectrum.

In the looming shadow of CSRD's expansive ambit – encapsulating an estimated 50,000 companies, ranging from industry titans to those more restrained in scale – the need for leveraging sophisticated data systems and avant-garde technologies emerges paramount.

The expanded scope of ESG reporting will demand more data and data that is more accurate, accessible and actionable, explains Antonio Celeste, director of sustainable product management at Qontigo. “Therefore, investors should start updating their quantitative portfolio construction models in anticipation of the arrival of new data while also considering fund-reporting documents to incorporate the newly available data.” He says the ability to integrate the new ESG data will be crucial.

Payiatakis draws attention to an imperative shift in perspective, "Foremost, asset managers need to start, or rather hopefully enhance, the concept of double materiality in their investment process and outcomes. Thus far, most focus has been on asset managers considering how the world can affect investment performance. Adding the expectation to account for how companies impact the world is a considerable shift requiring a new mindset and capabilities." Elaborating on the shift in understanding, Payiatakis adds, "CSRD recognises and platforms the importance of this real-world impact. Interestingly, from client conversations, we discern that private investors intuitively combine both aspects in their understanding and expectations around sustainable investing."

Chan interjects a note of urgency: "Asset managers must pivot towards CSRD compliance without delay. A holistic double materiality assessment is indispensable, encompassing both the financial repercussions and the broader sustainability impact on stakeholders." He stresses the quintessential role of understanding the European Sustainability Reporting Standards (ESRSs) that weave in an extensive spectrum of ESG concerns – from climate dynamics to human rights. "Integral to this equation is unerring ESG data, a cornerstone for both rigorous compliance and the alignment of risk strategies with genuine sustainability," Chan underscores, cautioning against the deceptive allure of greenwashing.

Reinforcing this sentiment, Jesiolowski highlights the CSRD's game-changing perspective, equating non-financial narratives with their financial counterparts. For her, the call to action is unmistakable: "Companies, asset managers included, need to recalibrate their ethos, bestowing the same gravity to both reporting paradigms." She elaborates on the pragmatic steps forward: "A comparative analysis of current reports against CSRD's benchmarks can illuminate areas ripe for enhancement. From here, a double materiality exploration becomes imperative, laying down a roadmap to ascertain material topics. This will then scaffold the identification of salient key performance metrics, resonating with the ESRS's ethos."

Charting the next steps in EU sustainability reporting

The impending introduction of the EU's CSRD marks a transformative moment in the sustainability reporting landscape, emphasising transparency, responsibility and rigour. Central to this shift is the understanding that accurate and trustworthy ESG ratings are integral to asset managers' decision-making processes. Yet, obstacles remain, most notably the greenwashing trend where firms embellish or misrepresent their sustainable initiatives.

To counteract these challenges, the CSRD will enforce mandatory third-party evaluations and usher in the concept of double materiality. This will require organisations to expound on their environmental and societal impacts and, in turn, how these external factors influence their operations. Moreover, the directive's stipulation for the digital distribution of ESG data ensures that such information becomes uniformly accessible and interpretable.

Given the broad scope of the CSRD covering an estimated 50,000 EU entities, asset managers and corporations must proactively prepare for detailed, substantive reporting. This preparation demands advanced data systems and methodologies to fulfil the directive's criteria, and organisations are urged to transition promptly to assure true sustainability and adhere to the new regulatory standards.

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