ESG – a trend turned regulation

If you maintain a sustainable lifestyle and set out to buy both tomatoes and an investment fund, you will quickly notice that your purchase decision regarding the vegetables is grounded in more fact than the one for the fund.

Labels such as “organic” or “fair-trade” for food are well-established in consumer’s minds and are often strictly regulated by government law. On the contrary, a wealth of definitions and criteria for sustainable investments started to sail under the flag of ESG – the acronym for environmental, social and corporate governance factors. These uncertainties, combined with a double-digit market growth in sustainable investment products, triggered financial authorities to tighten their grip on sustainable investing.

The rise of ESG

Indeed, the real turning point for ESG investing came in the current century - more specifically, in the past five years. It was triggered by a new generation of investors for whom sustainability and purposefulness became commonplace values in a society increasingly spurred by environmental, health and safety awareness. This quickly materialized in increasing volumes of traded funds and ETFs, managed along ESG criteria. However, without a global standard for defining an ESG asset, the attempt to size the growth of ESG investing is made difficult, with research revealing a wide range of contradictory figures. And with that, we've arrived at the core of all regulatory efforts – the goal to develop a standardized taxonomy and criteria for ESG.

ESG is an increasingly influential factor in the financial reporting of companies and investment process of investors. However, the lack of standardized rules for the disclosure of ESG factors by companies impedes the consolidation of ESG data and its integration into investment tools. Given the significant market momentum, most regulators now recognize the importance of common rules for the ESG investment market and have started to outline ESG rules for the financial reports of companies. Some regulations will not stop at the companies’ annual reports and will further define the labelling and transparency of investment products, whether they sail under the flag of ESG or other promises of sustainability. The market has reached a point where not only consumers ask for binding criteria, but also institutional investors and asset managers realize that the current uncertainty is a limiting factor for further business growth. A good reason to dive into a review of current growth and regulation efforts in some of the world’s major financial markets.

ESG investing in the US

The share of ESG-mandated assets in the US has risen to 26% in 2018, with Deloitte expecting that figure to reach 50% of all professionally managed assets by 2025. The current volume of USD 12 trillion is only exceeded by the sum of investments in Europe, where USD 14.1 trillion are invested into ESG conform assets. While the Europeans hold the highest absolute amount of ESG investments, the recent growth in this space was fuelled by double-digit CAGR of the US market.[1]

As early as 2018, some institutional investors asked the Securities and Exchange Commission (SEC) to develop rules to harmonize ESG investments. They felt that a consistent taxonomy for “environmental,” “social,” and “corporate governance” will help generate more efficiency between public companies and asset managers, as well as between asset managers and their clients. The efforts came to fruition in January 2020, when Congress tasked the SEC to build a “Sustainable Finance Advisory Committee” with the mission to define binding SEC disclosure rules for the reporting of ESG factors. The committee is expected to come up with a proposal by mid-2021. [2]

Besides the newly-formed committee, a growing number of Democratic senators, like Chuck Schumer or Elizabeth Warren, and private NGOs and accelerators, such as the Ceres Accelerator for Sustainable Capital Markets, are keeping the pressure high on the SEC and other regulatory commissions. [3] We can conclude that, while climate change and sustainability remain controversial topics on a governmental level, the US financial industry has started to recognize the importance of ESG disclosure rules. An aligned view on ESG disclosure rules is a precondition for building an offering that meets private and institutional clients’ future demand for ESG conform investing.

ESG investing in Switzerland

ESG investing has reached the Swiss market in force. A study by Swiss Sustainable Finance (SSF) reports CHF 1,163 billion (USD 1,269 billion) of sustainable investments in 2019 - an increase of 62% compared to the previous year and representing an almost exponential growth in the past 5 years, with no end in sight. [4]

The Swiss Federal Council has set the ambitious climate target of reducing carbon emissions to net zero by 2050. While this goal does not yet contain specific obligations for the financial sector, the government expects Swiss investors to invest in such a way as to not counteract climate goals. Currently, only two legislative frameworks on a national level are linked directly with sustainable investing. The Executive Pay Provision sets disclosure rules and other corporate governance principles in the field of top management compensation. The Federal Act on War Materials limits the export of armaments goods and a pending public initiative that will be voted in November 2020 seeks to ban investments of pension funds and the Swiss National Bank in the weapons industry altogether.

Back in 2019, the Swiss government tasked an internal workgroup to examine Switzerland’s participation in international sustainable investment initiatives and how developments in the EU (see next chapter) will affect the Swiss financial centre. The workgroup published an in-depth report in June 2020 [5], with an assessment of international ESG initiatives. The report will be instrumental in the processing of current and future parliamentary requests and postulates. In 2019 alone, 28 such items were submitted by the Swiss Parliament and will keep ESG investing at the top of current legislation topics. [6]

ESG investing in the European Union

As mentioned in the comparison with US figures, the ESG investment volume in Europe is estimated by Deloitte at USD 14.1 trillion in 2018. [1] This is backed up by other sources, such as the Global Sustainable Investment Alliance [7] reporting assets of EUR 12.3 trillion for Europe in 2018 and a Compound Annual Growth Rate (CAGR) of 6% since 2014.

As it did with the PSD2 regulation to foster open banking, the EU has set out to define rules and create a framework to bring ESG investments to flourish. The approach is far-reaching and detailed, as we have come to expect from previous EU financial regulation. Announced by the European Commission in 2018, the European Securities and Markets Authority (ESMA) has outlined two major elements for their ESG regulatory framework. The two key sets of rules are the EU Taxonomy Regulation (2018/0178 (COD)) and the Regulation on Disclosures (EU/2019/2088) – referred to as the Sustainable Finance Disclosure Regulations (SFDR).

The Taxonomy Regulation aims to establish an EU-wide classification system to provide clarity on the degree to which economic activities of a company can be considered environmentally sustainable. It will harmonize standards for the classification of investment products labelled as “green” or “sustainable” and sets an end to companies’ efforts of “green-washing” their businesses. The Taxonomy Regulation will apply from December 31, 2021.

The SFDR also has direct consequences for all companies, including investment firms and asset managers. It requires the firms in scope to disclose ESG factors during their investment decision-making processes for all investment products within the EU. Additional requirements apply when the products are specifically praised as sustainable, green or have set ESG factors as part of their investment objectives. The majority of the SFDR provisions will apply from 10 March 2021. Investment firms will need to declare, at product level, the likely impacts of sustainability risks on the returns of each financial product or explain why they consider sustainability risks not to be relevant for a particular product. This has far-reaching consequences for the investment process and will be reflected in amendments of MiFID, AIFMD and UCITS regimes. The European Commission published first drafts of the amendments in June 2020.

The EU regulatory frameworks on ESG are far-reaching and will help to standardize sustainable investing over the coming years. However, the high level of detail and the accelerated implementation prevents the market from developing its own definitions along the forces of supply and demand.

ESG investing in Asia

Differences exist in the adoption of sustainable investing in the various Asian markets. While asset volumes are still observed to be lower than in Europe or the US, growth picked up speed over the last few years. Some reports even attest three-digit growth rates to markets such as Japan. [8] Besides the asset volume, motivations to invest in sustainable assets reveal the current movement in the market. Completely altruistic intentions, such as helping to create a better future or helping save the environment, are supplemented by the goal of achieving better returns. Clearly, Asian investors started to embrace the idea that unsustainable businesses constitute a long-term investment risk and many sustainable assets contain a chance of outperforming traditional assets. The motivation to “do good while earning a profit” is amongst the highest in Singapore and Mainland China, where authorities started to foster ESG disclosure of companies with new regulation.