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Regulation: ESG’s regulatory struggle

ESG_earthEuropean ESG laws are maturing, but regulators still have to grapple with difficult topics. A specialist panel at the Societe Generale Securities Services European Investor Summit argued that transparency is paramount.

ESG investing, which gained ground enormously during the Covid-19 pandemic, now faces disruption in the wake of Russia’s invasion of Ukraine.

Figures from Morningstar show that flows into ESG funds globally slumped 36% in the first quarter of 2022, with Bank of America analysts calling it the worst showing since before the pandemic began.

This was accompanied by a bounceback on the part of fossil-fuel companies due to the conflict in Ukraine and a recovery in transport and wider energy demand, which has bolstered these shares. Even BlackRock – which has launched dozens of ESG funds in recent years, backing moves to decarbonise the economy – has signalled a change in tone. Earlier this summer, it suggested some short-term boost to fossil-fuel output was required, despite its broad support for net-zero objectives.

This may not be a permanent phenomenon, rather a temporary interruption. Turning back the clock is unlikely. The challenge instead is to ensure that asset managers have a robust framework to assess companies for ESG risks, price risk appropriately, and more generally to comply with regulation and mitigate the impact of greenwashing and green inflation.

These were the main themes at SGSS’s European Investor Summit’s panel, called ‘Building Portfolios in an ESG World: Mission Impossible’.

Despite the current market situation, the paradigm has shifted. Fundamental changes have taken place over the past five years, driven mainly by regulation from the European Union and growing investor demand, according to Martina McPherson, visiting fellow at Henley Business School and head of ESG product management financial information for SIX, the exchange group that operates the Swiss and Spanish stock exchanges. SIX provides data, analytics and index solutions, including regulatory risk frameworks and data feeds for ESG and sustainable finance.

At the summit, McPherson pointed to the Bloomberg Intelligence forecast that ESG assets are on track to exceed $50 trillion by 2025, representing more than a third of the projected $140.5 trillion in total global assets under management.

The European Union has been ahead of the curve with its Sustainable Finance Action Plan, a ten-point programme first laid out in 2018. The framework also includes a rollout of new ESG legislation, such as the Sustainable Finance Disclosure Regulation (SFDR), which aims to better classify the sustainability credentials of investment funds.

There is also the EU Taxonomy, which hopes to redirect capital flows to more sustainable outcomes by establishing consistent criteria for identifying ‘green’ economic activities and investment projects.

What is authentic and what is not?
Although the greater transparency and disclosure is welcome, George Latham, managing partner at WHEB Asset Management, suggested that the new rules have introduced an extra layer of complexity.

“I have a rather controversial view of regulation,” he said. “It has to step in where industry has failed – and it is critically needed as everyone is rushing into ESG – to control the greenwashing. We need to find what is authentic and what is not.

“However, the approach that regulation has taken in terms of how we should operate may curtail innovation and could even lead to greater box-ticking.”

Latham cited the EU Taxonomy as a case in point. As the historical BBC sitcom Blackadder once noted, when the writer and poet Samuel Johnson compiled the first English dictionary in the 1700s, he could not possibly include every word. Likewise, the Taxonomy is at risk of becoming outdated very quickly as technology and solutions evolve.

“It is already over 1,000 pages long and it cannot define everything that is green, because the industry is constantly changing and innovating,” said Latham. “What is needed is greater transparency and clarity in language that people use, as well as better communication between investors and clients to allow for diversity of actions and processes.”

ESG pricing and green inflation
Luisa Florez, head of sustainable finance research at OFI Asset Management, added a further concern – about whether the SFDR will help the industry improve the pricing of ESG risks.

“The SFDR has 16 key performance indicators (KPIs) that everyone has to look at. If financial markets integrate these, then maybe prices will be adjusted and that will generate an impact. Now, regarding the Taxonomy, there will be issues with implementation because only two of the six objectives have been published and there is a question as to whether they will be published on time according to all the geopolitical challenges.”

Will regulation be able to curb greenwashing in any case, or indeed to mitigate green inflation? This question was raised by SIX’s McPherson. “Can regulation help, enhance or clarify, or would it just be another additional layer of risk of non-compliance when all activities cannot be explained or disclosed?” she asked.

Latham believes that intermediaries and consultants are better placed to root out those investors who engage in greenwashing, while Florez thinks full transparency is the only way to ensure that fund managers are aligning their investments with their ESG practices.

Overall, the challenges should not be underestimated. “They are systemic and in response, we need systemic solutions,” said Latham. “In the science-fiction comedy The Hitchhiker’s Guide to the Galaxy, 42 is given as the answer to life, the universe and everything. But no one knows what the question is.

“In a similar way, the financial service industry likes standardisation to make analysis simpler and more quantifiable. However, if we just look for one number to benchmark everything against, we risk losing sight of the problem we are trying to solve. We need holistic approaches.”

Read our full report from the SGSS European Investor Summit here.

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