ESG disclosures: more clarification needed to turn grey areas into green
By Ruth Knox is global co-chair of the ESG & Sustainable Finance practice at Paul Hastings.
ESG disclosures: more clarification needed to turn grey areas into green
Tightening sustainability regulations means asset managers should act now to future-proof their disclosure processes, Ruth Knox writes
Environmental, social and governance (ESG) risks, impacts and opportunities continue to rise up the agenda for investors, but regulators are starting to examine in detail the sustainability claims of financial products.
As reports of companies 'greenwashing' proliferate, the last few years have seen the EU and the UK usher in new ESG regulatory (chiefly, disclosure) frameworks, designed to improve transparency and accountability, whilst protecting investors from misleading claims about ESG performance.
Although these regulations are a promising start, those holding the pen on these reforms need to edge towards greater clarity on key components before this brave new world can really begin.
From European Commission confusion...
At the centre of the EU's ESG regulation lies the Sustainable Financial Disclosure Regulation (SFDR), requiring funds to disclose against specific requirements pegged to different product categories. The product categories were created based on different approaches to factoring ESG risks, impacts and opportunities into investment strategies. These include Article 6 funds, which in principle would only look at sustainability matters for major deal risks, those under Article 8 (which aim to achieve environmental or social "characteristics" – definition still unclear), and Article 9 funds, where sustainable investment must be the core objective.
There is ambiguity in the boundary lines between the different products, where concerns have been raised by managers over the potential for allegations of greenwashing (or 'greenhushing') if funds are deemed not to disclose against the proper category. This uncertainty was exacerbated earlier this quarter when DG FISMA published a consultation paper on potential wholesale reform to the SFDR regime on 14 September. The questions raised in the paper go to the central tenets of the system created five years ago, raising eyebrows amongst financial market participants and advisors alike.
The hope is that this review leads to decisive and harmonised action from the Commission and the enforcement agencies of the SFDR, the European Supervisory Authorities, who have published elements of guidance which appear to go against the principles enshrined in the Commission's delegated regulations. This comes at a critical point in the evolution of the regime, and will be necessary in order to restore confidence and prompt action, which could be achieved by shedding a brighter light on indicative definitions for characteristics and Article 9 products.
...to FCA action
The FCA, meanwhile, has shown pragmatism in the development of a new package of measures to improve the ESG regulatory landscape in the UK. These include a new anti-greenwashing rule for authorised firms to ensure sustainability claims are "fair, clear, and not misleading".
The rule, due to come into effect from 31 May, 2024, provides a much-needed clarification that the FCA's anti-greenwashing guidance extends beyond retail firms and should be factored into fund strategies for all UK asset managers.
"When operating under these highly dynamic regulatory regimes, asset managers must be proactive in anticipating the shifts in expectations on compliance"
In response to market feedback on the need for greater flexibility in labelling products, the FCA has also created a "sustainability improvers" category for financial products that seek to move businesses in their transition to more sustainable outcomes. A new specification that a minimum of 70% of the product's assets must be invested in accordance with the chosen sustainability objective will however still be challenging for managers to meet, particularly in respect of (although not limited to) blind pool vehicles.
Products using ESG integration or basic ESG tilts will not qualify for a label. Given existing ambiguity under the SFDR, the EU may follow in step to provide more specific criteria for each corresponding category.
How should asset managers prepare?
In anticipation of the FCA anti-greenwashing rule coming into force next year, and of potential updates to the SFDR, managers who make sustainability-related claims should:
Stress-test oversight and controls, including due diligence for asset selection, to ensure robust and methodologically compliant systems underpinning ESG disclosures (with support from ESG counsel;
Ensure that those in charge of external positioning on ESG performance are identifying, managing, and mitigating the risks of misleading or inaccurate information in a consistent way which matches the emerging principles and prescriptive requirements of the new regimes.
When operating under these highly dynamic regulatory regimes, which blend both ESG and financial services regulatory concepts, asset managers must be proactive in anticipating the shifts in expectations on compliance and seek to ensure that investments and processes fulfil sustainability and disclosure criteria.
At the same time, the onus also remains on regulators to ensure that obligations are well-defined and watertight, to enable the growing sustainable investment market.
Ruth Knox is global co-chair of the ESG & Sustainable Finance practice at Paul Hastings.