Commentary

Scrutiny is Set to Stay

Andromeda Wood, Vice President of Regulatory Strategy at Workiva, charts the rising importance of sustainable investment policies.

The European Union’s (EU) Sustainable Finance Disclosure Regulation (SFDR) signifies the grouping’s intention to spearhead a war on ‘greenwashing’. ESG factors ranging from a company’s record on improving diversity to its environmental footprint must now be disclosed to funds and investors. This can directly impact how much investment it attracts.

The EU has increased the pressure on asset managers – through the disclosure regulation – to present clients with the ESG data that is provided by businesses when building sustainable investment portfolios and making investment recommendations. This, in turn, is powering institutional change within Europe. Although the EU is leading the charge in sustainable finance regulation, it’s a matter of when, not if, similar regulations are adopted globally, raising the profile of ESG investing worldwide.

Pressure from different sides – regulation and investors

Alongside regulation, it is important to note that general awareness of social, ethical, and environmental causes has grown in recent years, in line with a societal shift. A recent survey from Workiva highlighted this when it found that half of retail investors in the UK (50%) now want to know whether a company lives up to their own beliefs before they invest in it.

Individual investors now wield a great deal of power, with the trend towards ethical investing forcing businesses (and the funds that support them), to re-evaluate how and where they invest. In the UK, for instance, over one-third of people (35%) believe financial and ESG data are equally important when making investment decisions. Pension funds have reacted to this trend by increasingly offering policies that prioritise ESG factors, in a bid to appeal to the modern investor.

This demand has also flowed upwards to institutional investors, with those responsible for placing investments on behalf of end-beneficiaries under more pressure to align with their values. This high-profile pressure signifies how ESG is directly impacting the robustness of investments. Shareholders have even, in some circumstances, threatened to pull their support from funds due to ESG concerns.

Widely adopted minimum standards, such as the target for Organisation for Economic Co-operation and Development (OECD) countries to phase out coal by 2030, have also placed ESG higher on the agenda for shareholders, with concerns about the potential reputational and financial damage associated with non-compliance.

Addressing (dis)trust in sustainable investing

Retail investors are keen to make the right decisions with their money and will work with asset managers to determine which companies represent a sound investment. Historically, it was tough to distinguish between the organisations that were greenwashing from those genuinely prioritising corporate social responsibility (CSR) and sustainability issues. Teams tasked with figuring out what now makes up the E, S and G of ESG often worked in siloes and had to navigate several different data sources, numerous reporting frameworks, and non-standardised terminology, all of increased the potential for confusion.

Therefore, a key challenge when building portfolios came from how asset managers interpreted the data presented to them by companies. The investors themselves still struggle to trust the ESG information they are presented with – a legacy of poor reporting standards. The same Workiva survey found that in fact only one in three (31%) retail investors trust ESG performance when it is presented through numbers and data, rather than qualitative descriptions and assessments.

Reinforcing trust is the EU Taxonomy Regulation, which sets out an EU-wide framework for investors and businesses to measure certain economic activities against sustainability objectives. As part of this, companies are required to disclose certain financial metrics in line with the taxonomy (EU Taxonomy Regulation, Article 8). Therefore, organisations in the EU must include ESG-based breakdowns of activities and use data to demonstrate performance. A key overall aim of European sustainable finance legislation is to tackle the trust issues caused by greenwashing, encouraging companies and the funds investing in them to present the ESG data informing their investments.

ESG data must be unified from across an organisation to make the business stand out as an attractive investment option. From here, fund managers can build sustainable investment policies further empowering companies to transparently report their ESG data. With ESG disclosure becoming a basic requirement in the EU, discussions in this market are more mature; criticisms are around the consistency and quality of disclosures. Elsewhere, funds and their shareholders should encourage companies to use EU (and, where available, national) ESG regulations as a benchmark to bring together data sets and sources, so as to measure the long-term sustainability of investments.

In presenting this data transparently, asset managers can reinforce trust among investment funds, shareholders, and their end-beneficiaries, with a clearer quantitative framework for ESG reporting.

A matter of ‘when’, not ‘if’

Global trends point towards increased standardisation of ESG regulations, as governments continue to place emphasis on environmental concerns at COP26 this week. As world leaders publicly unite behind common UN Sustainable Development Goals at the conference, it will further raise awareness among retail investors – who will not hesitate to wield their power to effect change.

If asset managers fail to transparently report on the ESG disclosures of the companies they are investing within, then, ultimately, they risk bringing volatility into the returns that can be expected from the investment. In this respect, it is promising to see ESG concerns being treated with the increased importance they warrant.

This scrutiny is set to stay. ESG is a priority across all levels of the investment chain – from how funds, and the businesses they invest in, operate and report on ESG, to the shareholders and end-beneficiaries demanding change.

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