The EU’s proposed Environment, Social, and Governance (ESG) framework for asset managers, pension funds, and insurers could have global implications and demonstrates the EU is taking the lead on regulation, says Sean Tuffy, Head of Regulatory Intelligence, Citi Custody & Fund Services, Citi.
With almost $23 trillion in assets, ESG products accounted for nearly 26% of global assets under management at of the start of 2017, according to the Global Sustainable Investment Alliance. The surge in assets has pushed policymakers to draft new regulations to help support the growth of the sector and protect investors.
As part of its sustainable finance action plan, the European Commission has proposed ESG rules for asset managers, pension funds, and insurers. Taking the lead on ESG regulation, there are four key components of the Commission’s proposal:
- Taxonomy: Create a harmonized taxonomy to categorize environmentally sustainable economic activity, based around six environmental considerations, to help investors to better identify ESG activity.
- Disclosures: Enhance disclosures on how ESG risks are integrated into the investment and advisory process, along with how they are expected to affect the returns of the investment product. These disclosures apply to all financial products, even if they do not pursue an ESG strategy.
- Benchmarks: Create new low-carbon and positive carbon impact benchmarks to improve the ability to assess a fund’s ESG performance
- Advice: Require investment firms and insurance distributors to integrate ESG considerations into the advice given to clients.
The proposals have been cautiously welcomed by the industry. Elements such as the taxonomy and benchmarks have the potential to help support the growth of the sector, by making it easier for investors to compare the ESG elements of funds.
Standard ESG definitions could help allay investors’ fears of firms engaging in green washing, and improve investor confidence in the ESG sector.
"The ESG regulations that are being fast tracked by European policymakers and could be finalized as early as April."
Despite the potential upside to the ESG regulations, the industry does have some concerns. There are fears that the mandatory disclosures could become check-the-box exercises and make it harder for true ESG products to differentiate themselves.
Some also worry that the timing of the new client advice requirements will not align to the completion of the taxonomy. It is hard to ensure that clients are getting the correct ESG advice, if the definition of ESG has not been agreed.
Finally, there are concerns about the costs of integrating ESG factors in the investment decision-making processes for non-ESG funds.
Like the recent experience with the Markets in Financial Instruments Directive 2 and the General Data Protection Regulation, certain elements of the EU’s ESG rules are likely to become the de facto global standard.
"Despite the potential upside to the ESG regulations, the industry does have some concerns. There are fears that the mandatory disclosures could become check-the-box exercises and make it harder for true ESG products to differentiate themselves."
Absent of any official local standards, many institutional investors may adopt the EU taxonomy and benchmarks in their ESG assessment process. It is common practice for US managers to maintain parallel funds in the US and EU that have the same investment goals and policies.
If EU funds are forced to adopt ESG disclosures, for simplicity’s sake, many managers may end up adopting the EU’s ESG disclosures for their parallel US funds.
The future will be here sooner than you think
The ESG regulations that are being fast tracked by European policymakers and could be finalized as early as April. After that, the next step will be for the European Supervisory Authorities to draft the specific rule to implement the regulations.
While there will be an opportunity for the industry to provide feedback on the implementing measures, the die will have already been cast on the high-level framework. All things considered, certain elements of the ESG rules could go live as early as 2020.
"With almost $23 trillion in assets, ESG products accounted for nearly 26% of global assets under management at of the start of 2017, according to the Global Sustainable Investment Alliance."
Given the potential global reach of the EU’s ESG rules, regardless of where they are based, firms should be paying close attention to the ongoing debate.