As various bodies seek to establish a common taxonomy for ESG investing, Dewi John examines the tensions between the different approaches
Those working on environmental, social and governance (ESG) issues in the investment industry can get entangled in definitional complexities. The ecosystem of ESG terminology seems to grow daily. While it’s important, one should be able to see the wood for the trees, and the wood is this:
The latest Intergovernmental Panel on Climate Change (IPCC) report states: “The cumulative scientific evidence is unequivocal: Climate change is a threat to human well-being and planetary health. Any further delay in concerted anticipatory global action on adaptation and mitigation will miss a brief and rapidly closing window of opportunity to secure a liveable and sustainable future for all”.
Addressing this – mobilising sufficient capital to ensure a sustainable future before the window closes – is what the E in ESG is for. On the plus side, the theme of sustainability has taken hold of the UK market, as can be seen from ESG fund flows for last year (right).
No gold standard
One problem is that the lack of a global ESG taxonomy means there is no data ‘gold standard’. Information can therefore be highly inconsistent, making comparison difficult, which can facilitate greenwashing.
While the UN Conference on Trade & Development’s (UNCTAD) World Investment Report 2021 applauds the fact that “the rapid growth of the sustainable investment market confirms its potential contribution to filling the Sustainability Disclosure Requirements (SDG) financing gap”, it also warns: “There are persistent concerns about greenwashing and about the real impact of sustainability-themed investment products… Funds should report not only on ESG issues but also on climate impact and SDG alignment.”
Regulators are increasingly addressing these issues. The EU’s Sustainable Finance Disclosure Regulation (SFDR) is ahead of the pack. As with many first movers, however, there are teething problems and it’s worth looking at these before addressing the implications for the UK’s nascent SDR.
The SFDR has three fund categories: Articles 6, 8 and 9. Article 6 funds are those with no ESG goal. Article 8 funds promote environmental and/or social characteristics, provided that the portfolio companies follow good governance practices. SFDR Article 9 funds are “products targeting sustainable investments… where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark”.
There are about £1.5trn assets under management in Article 8 funds, and £154bn in Article 9 throughout Europe – roughly a 10-to-one ratio.
There are concerns that misapplication of SFDR designations will encourage mis-selling. An imminent MiFid II amendment requires distributors to ask investors if they want to take sustainability into account. Should the answer be yes, the distributor should then provide them only with Article 8 or 9 funds.
But there is concern that a focus on alignment with the regulation diverts from sustainable, measurable outcomes, which it is reasonable to assume that investors have in mind when asked the question. For example, an Article 8 fund only needs to promote ESG criteria within its portfolio management process: no measurable ESG benefit is required.
The saving grace is that Article 8 funds must state what percentage of their portfolio is aligned to the taxonomy, which may assist investors. But how many will both know to do that and be prepared to put the spade work in to find out?
There is risk that the proposed design principle and five-stage labelling system could also prove too Complex and difficult for consumers to understand
Arguably, the MiFid II amendment, though an improvement on the status quo ante, could still lead to a misalignment of both investor goals and outcomes, and outcomes versus Paris Agreement alignment.
Last November, the Financial Conduct Authority (FCA) published its Discussion Paper 21/4 – Sustainability Disclosure Requirements (SDR) and investment labels, defining terms such as ‘responsible’, ‘sustainable’ and ‘impact’. Its three fundamental proposals for fund flags are: ‘Transitioning’, ‘Aligned’ and ‘Impact’.
However, this has already raised fears that it will be difficult to map funds to this, given that data availability and reporting for corporates could lag that of the downstream reporting of asset managers – something that’s already been an issue with the SFDR.
In its response, responsible investment foundation Eiris stated: “Grouping funds according to [transition, alignment and impact] doesn’t work well when set against what funds are actually offering the consumer… The products or practices in a diversified portfolio will almost always contain a mixture of transition, alignment and potentially high-impact investments.”
The Investment Association’s response added: “There is risk that the proposed design principle and five-stage labelling system could also prove too complex and difficult for consumers to understand.” It added that the FCA-suggested categorisation doesn’t map well to the SFDR. This is an issue, given the need for consistent international standards, as raised in the UNCTAD report.
In summary, while progress has been significant, the SFDR indicates that most assets are going to investment strategies that mitigate risk from environmental and social issues rather than investing in the transition to a sustainable economy. This may not be well understood by those investors opting for ESG assets.
While the FCA’s labels may not make the final cut, they illustrate a tension between trying to improve on the SFDR and valid international comparisons.
Dewi John is head of research, UK & Ireland, Refinitiv Lipper