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ESG – What is it? What does it mean? & Why does it matter?

We love a good three letter acronym in finance and whilst ESG is not exclusive to financial services it is gaining increasing traction. You cannot read a daily briefing without a nod to this, or like me, you may have jumped on a webinar (or three) to try and get your head around this subject.

Whether you are interested about it from a personal investment stance, concerned about how your money in your pension pot is being invested or whether you are starting to see the impact on your job as a result of all things ESG, it is clearly a topic here to stay and one we should all upskill our understanding on.

The trifactor of heighted awareness of ESG metrics, regulatory change and demand to reduce risk, whilst delivering superior returns has put ESG up the financial services agenda.

What is ESG?
Let’s start by deciphering the E, S & G to try and understand it a little more. The most obvious way to do this is through a risk lens.

Environmental risks created by business activities have actual or potential negative impact on air, land, water, ecosystems and human health. Activities such as preventing pollution, reducing emissions and climate impact, and executing environmental reporting or disclosure are important points of analysis here.

Social risks refer to the impact that companies can have on society. They can be addressed by activities such as promoting health and safety, protecting human rights and focusing on product integrity.

Governance risks concern the way companies are run. It addresses areas such as corporate risk management through company governance activities such as increasing diversity and accountability of the board, protecting shareholders and their rights, and reporting and disclosing information. This is something finance is well aware of, think back to the myriad of misconduct issues and the resultant regulatory initiatives such as SMCR brought in to directly address accountable at all levels of an organisation. It is worth noting that employees also increasingly want to work for a company that can prove they are purpose driven with excellent governance.

ESG & Investing

Environmental, Social and Governance refers to a type of investing that is also known as “sustainable investing.”

Think of this as an umbrella term for investments that seek positive returns AND long-term impact on society, environment, and the performance of the business.

There are several different categories along the sustainable investing spectrum. They include:

  • Impact investing – putting social returns ahead of financial
  • Socially responsible investing (SRI) – often exclusionary, screening out and not investing in certain companies
  • ESG and values-based investing – return focused but with a broader definition and approach

Blackrock defines it as: Companies with strong profiles on material sustainability issues have potential to outperform those with poor profiles. In particular, we believe companies managed with a focus on sustainability should be better positioned versus their less sustainable peers to weather adverse conditions while still benefitting from positive market environments.

But let’s be clear this is not simply about going long good ‘ESG’ and short ‘Poor ESG’, it’s much more nuanced than this, in fact capital injections into firms that are transitioning away from poor practice is also vital.

Listed companies in sectors that play a key role in climate change mitigation and adaptation will want to know how their investors and financiers see and analyse them. If such companies cannot convince investors about their investability then there could be a significant impact on their ability to raise capital in future.

Investors

Investors themselves are becoming increasingly engaged on matters relating to ESG and sustainability and driving a lot of the movement and reaction from managers of money.

A 2019 PwC global survey of investors identified that as a group, investors placed ESG ahead of fees, relationships and operational strength.

This of course poses the question – as an investor how can one deem a company to be ‘investable’ when it comes to ESG? Fear not, there is a package of regulatory reforms waiting in the wings!

The EU’s ESG Package

The driving force behind the EU’s ESG legislative package was the European Commission’s Action Plan on Sustainable Finance, which was released in March 2018.

The plan had three main objectives:

1.  Reorient capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth

2.  Mainstream sustainability into risk management

3.  Foster transparency and long-termism in financial and economic activity

With these objectives in mind, a package of regulations was proposed in May 2018, comprising:

Disclosure Regulation

The Disclosure Regulation focuses on integrating sustainability into the investment and decision-making processes of financial market participants (including Asset Managers, AIFMs, UCITS and investment firms providing portfolio management) and financial advisers.

The Disclosure Regulation focuses on two sets of disclosure requirements:

(1) requirements that apply at an entity level and

(2) those that apply at a product level

At an entity level, firms will need to disclose certain details on their websites, including:

  • the integration of sustainability risks into the investment decision-making processes;
  • how remuneration policies are consistent with integration of sustainability risks;
  • whether/how the principal adverse impacts of investment decisions on sustainability factors have been considered

At a product/strategy level, asset managers will need to include information evidencing how sustainable objectives are met and how environmental/social characteristics are delivered in their pre-contractual disclosures and ongoing reporting.

The purpose of these disclosures is to facilitate market-wide transparency on each firm’s ESG profile and capabilities and enable investors to make informed decisions.

Note that these obligations will apply to all EU firms, not only ESG-focused ones.

Taxonomy Regulation

Objective; Define what is green and what is not!

The EU taxonomy is a classification system, establishing a list of environmentally sustainable economic activities.

It aims to provide appropriate definitions to companies, investors and policymakers on which economic activities can be considered environmentally sustainable.

To be included an economic activity must contribute substantially to at least one environmental objective, AND do “no significant harm” to the other five environmental objectives.

The Taxonomy Regulation establishes six environmental objectives

  1. Climate change mitigation
  2. Climate change adaptation
  3. The sustainable use and protection of water and marine resources
  4. The transition to a circular economy
  5. Pollution prevention and control
  6. The protection and restoration of biodiversity and ecosystems

The Taxonomy Regulation also includes the following disclosure/reporting requirements which are in addition to the requirements in the Disclosure Regulation:

Financial products which promote environmental characteristics will be required to:

  • include a specific statement on the do no significant harm principle; and
  • disclose the proportion of their portfolio meeting the environmentally sustainable standard

Financial products which do not promote environmental characteristics will be required to state in their pre-contractual disclosures and periodic reports that, “the investments underlying this financial product do not take into account the EU criteria for environmentally sustainable investments”.

Implementation will be staggered, with the first obligations applying from 31 December 2021.

Low Carbon Benchmarks Regulation

Provides a structure for benchmarks against which environmentally-focused strategies can be measured.

Buyer Beware

A common compliant from investors is with regard to greenwashing.

“Siri, what is greenwashing?”

Greenwashing is the process of conveying a false impression or providing misleading information about how a company’s products are more environmentally sound. Greenwashing is considered an unsubstantiated claim to deceive consumers into believing that a company’s products are environmentally friendly.

A recent Bloomberg article stated that in an age of accelerating climate catastrophe, companies are tripping over each other to claim green credentials. Yet, most asset managers, however, refuse to support environmental shareholder resolutions. It turns out that the money managers who actually signed a United Nations-backed pledge to incorporate ESG in their investing strategy are among the worst offenders. 

Data, Data, Data

A key issue facing firms is when, and how much, to engage with the requirements, particularly in light of concerns about the disclosure of the necessary underlying data.

For some firms as with all regulatory changes they will aim to be ahead of the pack, looking for that competitive advantage and a chance to distinguish themselves, gaining AUM.

Given the breadth of the definition of ‘sustainability’ firms are struggling to find the right balance between their ESG obligations and the fiduciary duties owed to their clients – e.g. to what extent should returns be reduced to mitigate sustainability risks?

Codifying It

Historically, few clients had ESG policies so firms would often agree to comply with the ESG policies of those that did if requested.

It will require investment in people, processes, and systems.

The demand from both investors and regulators for more transparency is clear. Asset managers in particular are already investing and building out teams dedicated to ESG; developing frameworks and considering solutions to assist them in ESG scoring.

It will be data capture, analysis and reporting where the focus will need to be.

Timing will be key

One particular issue that firms must consider is keeping on top of staggered compliance obligations and tight timeframes as the new regulations come into force in a piecemeal and overlapping way over the next few years.

For example, firms will need to reassess systems and procedures put in place to comply with the Disclosure Regulation and check whether these are also compliant with the disclosure requirements introduced at a later date by the Taxonomy Regulation.

Opportunities

Whilst this may sound like a complicated and long journey ahead for investment firms there are also opportunities.

According to Morningstar, inflows into ESG-related investments over the first three quarters of 2019 exceeded $4 billion in each quarter, far surpassing previous highs of $2 billion or less in previous quarters.

As trends in investing go, there is perhaps no sector gaining more interest than ESG.

Summary

As set out in its 2018 Action Plan on Financing Sustainable Growth, the European Commission wants private investing channelled towards climate and environmental goals.

EU Regulatory change will:

  • Impact the disclosure obligations of investments funds marketed in the EU
  • Help investors identify genuinely sustainable investment funds through two broad regulatory initiatives
  • Require EU asset managers to consider sustainability risks and adverse impacts on sustainability factors resulting from investment decisions

Stay Safe, Stay Curious and Keep Learning.

About this author

Matt Fotherby

Financial Markets, Compliance & Regulations

Matt Fotherby

Matt is our Founder and a passionate trainer.

His interest in education stems from his 10 years as an Account Executive looking after Global Hedge Fund and Asset Management clients. This led Matt to join the coveted Financial Markets Education team at UBS, a unique in-house education team that specialised in running a curriculum of financial market and product classes for both UBS employees and clients. Matt was responsible for building out the client offering; managing programs, creating content and teaching courses.

As financial markets entered a significant period of regulatory change Matt pivoted to take his client experience and market knowledge to focus on Regulations and Compliance topics.

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