Once a relatively niche product, sustainable investment funds have proliferated globally in the last couple of years, with new funds springing up almost daily. According to the Global Sustainable Investment Alliance, there are now more than $30 trillion in assets under management (AUM) globally using environmental, social, or governance (ESG) criteria. In the US alone, ESG funds pulled in more assets in the first half of 2019 than in all of 2018.

With rapid growth rates and increasing popularity, the restraining hand of oversight cannot be far behind. Global regulators and policymakers are scrambling to draft cogent guidelines to ensure that fund managers who incorporate ESG considerations into their investment strategies can provide end investors with a transparent understanding of their methodology. This increased focus on prescription primarily aims to address the clouds of cynicism that hang over these strategies from those who say the rules and requirements are ill-defined.

No longer voluntary

So far, most of the global asset management ESG guidelines have been voluntary and largely self-policed, but that is about to change. The United Nations-backed Principles for Responsible Investment (PRI), a coalition of asset managers, has given its members until March 20, 2020 to adopt mandatory climate-related financial disclosures or face loss of their accreditation – an accreditation that has become an important factor in proving legitimacy to enquiring clients.

For now, the rules adopted by the PRI are easiest to meet and are probably the most uniformly accepted accreditation within asset management. The organization was formed by a group of 20 asset managers in 2005 in response to a request from former UN Secretary General Kofi Annan for business to take a stronger role in development issues like the environment, working conditions, and human rights. Because of its association with the UN and its wide membership, the PRI imprimatur carries considerable weight in the court of public opinion. For asset managers, meeting the membership qualifications also helps insulate them from charges of “greenwashing,” meaning offering funds that are mostly ESG in name only.

Perhaps more importantly, following the EU Commission’s Action Plan on Sustainable Finance, the European Securities and Markets Authority (ESMA) has adopted a sweeping set of sustainable finance rules that apply to all asset managers under their jurisdiction, whether they offer ESG-branded products or not. These are targeted revisions to a set of foundational regulations across Europe, namely MiFID, UCITS, and AIFMD. As the EU's rules come into force by the end of 2020, impacted asset management firms will need to publish their policies on the integration of sustainable risks in their investment decision making process and the extent to which ESG risk is expected to impact financial returns. Global players, such as US managers who sell into Europe, will also need to comply.

A big challenge for fund managers and regulators alike is that there still is no consensus on what exactly constitutes suitable standards of ESG investing activities. In an effort to address this problem, an EU committee of technical experts released a 414-page “taxonomy” in June 2019 that attempts to define scores of activities and their ESG benefits or risks.

The benchmark problem

Another big hurdle that needs to be overcome is how to measure ESG even after there is agreement on terms. Many of the large benchmark firms such as S&P Global, Morningstar, and MSCI, as well as specialty ESG boutiques, offer their clients hundreds of data points that rank individual company ESG performance, but many of these unavoidably entail an element of subjective human judgement. These competing service providers don’t coordinate, so end investors may receive materially different assessments of the same holding depending on which ESG rating agent they choose.

With over 2,300 signatories by August 2019, PRI's members have agreed to a list of six principles of ESG investing and disclosures, all of them voluntary. But critics have recently argued that PRI's bar was too low and the requirements too vague to implement or to be universally accepted across the market. So PRI has taken steps to enhance their requirements focusing on three climate-related issues – for the moment ignoring enhancement of social and governance elements – and made it mandatory for asset managers to answer 20 additional questions about how they integrate climate scenarios into their investment decisions. After March 2020, firms will have to demonstrate that they meet these standards to join the PRI and existing members will have to show every year that they are living up to them to retain membership.

A defense against greenwashing

PRI says 480 asset managers have already shown that they are in compliance with the standards, which are based on climate reporting rules adopted by the Task Force on Climate-related Financial Disclosures, which was established by the Basel-based Financial Stability Board in 2015 to help investors understand their exposure to climate risk. PRI's guide to the requirements can be found here.

While many large asset managers have embraced the PRI initiative, there has been considerable debate about aspects of the EU's efforts to compel inclusion of ESG factors into all areas of investment, not just ESG-branded funds. A lot of managers think the new rules are too prescriptive and should leave more leeway for practical application.

For example, after fund companies asserted that they have clients with principled or fiduciary reasons for not using ESG factors, the EU created an exception to the requirement, but said these funds must carry a clear warning that they are not ESG compliant. Those managers now worry that such a dire “health warning” could make their funds toxic to new and existing investors.

A global wave

When it comes to ESG, Europe does not hold a monopoly on the sustainable finance debate or policy making. In the US, there have been congressional hearings to discuss whether the Securities and Exchange Commission (SEC) should establish standards on ESG disclosures that will apply to all US public companies. And while federal level rulemaking seems unlikely in the short term, states are taking it into their own hands. Notably, the California Public Employees' Retirement System, known as CalPERS, one of the world's largest pension funds with $344 billion AUM, moved to incorporate ESG criteria into all of its investment strategies. New York state is also planning to double its retirement fund’s sustainable investments over the next ten years.

This theme of large pension schemes or other institutions increasing their integration of sustainability of investments is also evident in Asia. Japan’s Government Pension Investment Fund (GPIF) is the largest pension fund in the world and it applies an ESG filter to all their investment decision making. While a significant portion of their assets are passively managed, the GPIF is a signatory to the UN PRI standards and is a strong advocate of applying rigorous stewardship and engagement with companies it is invested in, particularly on matters relating to climate change and governance.

In China, sustainability has also risen to the top of the agenda. China’s economic scale and industrial significance make it the world’s largest emitter of carbon dioxide, but China is also working hard to reduce its emissions and transition to a more sustainable economic model. This shift in mindset has spilled into the Chinese financial sector. There are already 29 Chinese firms listed on the UN PRI list of signatories and more are looking to join. On a regulatory level, the China Securities Regulatory Commission (CSRC), in collaboration with China’s Ministry of Environmental Protection, has also introduced new requirements which by 2020, will mandate all listed companies and bond issuers to disclose ESG risks associated with their operations.

Across the world, investors and regulators are looking to integrate more sustainable investment models to help deliver better societal and environmental outcomes. The movement has momentum and we expect pace will only pick up from here. As such, it is imperative that any formal rule making must strike a delicate balance between flexibility within a rule set and the rule set being firm enough to earn legitimacy across the market. When the UN’s PRI rules take effect six months from now, the world will be watching to see how sustainable these new rules are.

Compliance Notes:
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. Pursuant to information regarding the provision of applicable services or products by BBH, please note the following: Brown Brothers Harriman Fund Administration Services (Ireland) Limited and Brown Brothers Harriman Trustee Services (Ireland) Limited are regulated by the Central Bank of Ireland, Brown Brothers Harriman Investor Services Limited is authorised and regulated by the Financial Conduct Authority, Brown Brothers Harriman (Luxembourg) S.C.A is regulated by the Commission de Surveillance du Secteur Financier. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2019. All rights reserved.