In 2019, the EU adopted a new Disclosure Regulation on sustainability-related disclosures in the financial services sector, which is due to come into force on March 10th, 2021.
The Disclosure Regulation sets out detailed rules for fund managers, financial advisors, and many other regulated firms in the EU as well as those who market their funds in the EU to take greater accountability of sustainability risks in their operations. Here Oliver Syvänen – Sales and Account Manager at FA Solutions, explains what it’s all about.
The aim of this new disclosure regulation is to enhance transparency regarding the integration of environmental, social, and governance (ESG) matters into investment decisions and recommendations and funnel private investments towards genuinely sustainable economic activities, as investors constantly seek to avoid putting cash into firms that contribute to environmental and social harm.
The official mandate of the regulation will now be finalized before the entry into application of the regulation in March 2021. This new regulation, however, is only a framework – there will be a second and third level to this regulation in the next five years, much like Mifid and Mifid II.
ESG index portfolios becoming the go-to choice
According to recent data from global funds network Calastone’s Fund Flow Index (FFI), investor appetite for sustainable investing has exploded, with July seeing record inflows into ESG. The data also shows that ESG funds have accounted for one-third of inflows to global funds overall in the previous year, given ESGs global focus. A February report from Morningstar shows that 360 new sustainable funds were launched in the last year alone.
Scrubbing out greenwashing
To this date, there have been approximately 2,000 ESG recommendations or mandatory disclosure laws that have been passed globally, so reporting and rating methodology can vary greatly from provider to provider. While it’s a step in the right direction that we’re more concerned about ESG-related risks and investing in sustainable funds, it means that there’s no consistent standard for calculating and reporting ESG ratings.
This lack of consistency has led to a new phenomenon known as “greenwashing”, where companies and funds claim to be environmentally and socially responsible but calculating it can be hard to prove. The new Disclosure Regulation will set a uniform law in the EU, and the UK, on how ESG ratings are calculated and reported. Financial products that are marketed as ‘green’ will receive an extra level of scrutiny to determine this.
The Boohoo scandal in the UK is a prime example of the greenwashing issue in ESG. An undercover investigation of the company by The Sunday Times in July reported that factory workers were being paid less than half of the minimum wage, with a separate report raising concerns that factory conditions put workers at risk of Covid-19. It was further revealed that over 20 ESG funds had invested in the fashion retailer, and the company was even given an AA rating by MSCI for above-average labor standards just weeks before the allegations were made.
While the case is still being investigated and disputed, many investors were quick to pull their stakes in the company. The scandal has lead to a call for better-quality ESG data and ratings. The new regulation due to come in next year should help to alleviate the discrepancies between ESG ratings and create a more uniform standard, while the extra scrutiny is a welcome move to further improve the transparency of the industry. While perhaps not as important as returns, funds, and companies that have poor ESG ratings will struggle to get outside investors.
New regulation to affect policies and disclosures
Once enacted, the regulation will affect the policies and procedures, website disclosures, and pre-contractual disclosures of the companies affected.
All financial companies will have to write a memo or official policy document on how they’re screening different companies, how they’re related to the ESG scores, and how they’re analyzing each new investment.
Having the right software in place will help to establish the policy and run the procedure of the step-by-step requirements. It will also automatically audit the trail, including the pre-trade compliance check, to prove that you have performed each required step.
For companies who wish to disclose their ESG rating on their own website, there should be automation that uses an API to show this, as this needs to be updated on a daily basis. However, the ESG rating for companies will be calculated on a quarterly basis and won’t take historical data into consideration.
Time to get ready
The EU is considered to be at the forefront of regulatory change, and the rest of the world is taking note, with the US reportedly enacting similar legislation. The ESG rating of an investment will become a crucial decision factor for investors, second only to returns, so it’s important to ensure your ESG risk and rating disclosure is on the money from the get-go.
While there may be some slight discrepancies in companies’ ESG ratings, possibly to due the misreporting of their practices, the new regulations are a welcome step to further increase the transparency and scrutiny of ESG related funds, particularly as new levels are implemented further down the line.