Embracing the Future: Rule fragmentation and inconsistent definitions

ESG is Everywhere, But What Next?

February 09, 2022
  • Investor Services
Adrian Whelan looks at the top 10 themes in environmental, social and governance investing that could influence rulemaking in 2022.

I miss the River Shannon, And the folks at Skibbereen, The moorlands and the meddle, With their forty shades of green.



– Forty Shades of Green, Johnny Cash, 1959

I live near the foothills of the Dublin Mountains in Ireland, which is referred to as the Emerald Isle due to its vast greenery throughout the Island. It inspired musician Johnny Cash, who travelled across the landscape and wrote the iconic song “Forty Shades of Green”. By contrast today, investment managers are trying to determine which of the many shades of green apply to their funds. While environmental, social and governance (ESG) themes permeate the entire finan­cial industry globally, rule fragmentation and inconsistent defini­tions mean fund managers run the risk of being accused of greenwashing.

What is true is that ESG is everywhere and staying abreast of the ever-evolving policy landscape on a national, regional, and global basis is far from easy. Luckily, there are 10 consistent themes, which can help us understand the main regulatory focus areas for 2022.

Top 10 ESG Themes

  • 1

    ESG Data, Scoring, and Ratings Providers

  • 2

    Global Taxonomies and Standards

  • 3

    Policy Fragmentation

  • 4

    Proxy Voting and Stewardship

  • 5

    Don’t Forget the G in ESG Investing

  • 6

    Ethics, Conduct and Accountability

  • 7

    ESG Labelling

  • 8

    Diversity, Equity, and Inclusion

  • 9

    Point of Sale Rules

  • 10

    ESG Disclosure

1. ESG Data, Scoring and Ratings Providers

There has been much commentary on the role of ESG data providers and this intense focus is only likely to increase. For the most part, they are unregulated, however they often play a significant role in the ESG strategies of asset managers and banks. They normally have proprietary models for the acquisition and calculation of ESG data which are used to rate underlying companies on various metrics. ESG data providers also purport that their models are based on a large body of objective research which can find links and causation between higher ESG scores and financial performance.

As such, they play a key role in asset managers’ risk manage­ment and return goals. However, the divergent designs of their proprietary models (which create different outputs), make it difficult for regulators and investors to compare investments for ESG qualities as using different models will inevitably produce different results.

Regulators are therefore earnestly looking to classify ESG data providers to increase the transparency of the models used to pro­duce ESG scores. On February 3, 2022, the European Securities and Markets Authority opened an industry consultation where it called for evidence on market characteristics for ESG ratings providers.1 Almost two months earlier, in November 2021, the International Organization of Securities Commissions released a report on ESG data providers.2 In addition, the triangula­tion of the EU Taxonomy, the Sustainable Finance Disclosure Regulation (SFDR)3 and Corporate Sustainability Reporting Directive (which will require many EU organizations to report against ESG metrics) looks to reframe the ESG data model and ensure consistent and comparable methods of weighing and measuring ESG criteria.

2. Global Taxonomies and Standards

Regulatory-driven ESG taxonomies are important classification systems and help bridge the gap between the absence of globally agreed sustainability standards and a uniform method for calculating and comparing ESG characteristics of different investments on a relative basis. They establish an objective list of environmentally sustainable economic activities, enabling regulators and investors to benchmark investments using the same standards and principles of ESG measurement.

The concept of ESG taxonomy has branched out from Europe4 to include the U.K., Singapore and China. While national and regional versions grow, global convergence on ESG taxonomies is necessary to avoid confusion and provide regulators and investors with assurance of consistency. This will allow them to make meaningful comparisons to enable sustainable integration across global capital markets. The debate on whether gas and nuclear should be included within the EU Taxonomy, highlights the difficulty in reaching agreement on certain taxonomy criteria. Nevertheless, the concept of taxonomies as classification sys­tems will remain a hot topic globally for the foreseeable future.

Taxonomies are not the only show in town for classifying ESG investments. The establishment of the International Sustainability Standards Board (ISSB), announced at the 26th United Nations Climate Change Conference (COP 26) in Glasgow in November 2021, aims to bring an element of harmony to global ESG report­ing standards. ISSB will look to set consistent and mandatory accounting standards for entities in 140 countries worldwide.

This is an ambitious way of dealing with fragmentation in the way that these entities are currently weighted, including initiatives such as the Task Force for Climate-related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), the United Nations Principles for Responsible Investing (UNPRI) and the Global Reporting Initiative (GRI), the Carbon Disclosure Project and the Climate Disclosure Standards Board.

3. Policy Fragmentation

ESG is everywhere, but divergent standards present challenges for cross-border asset managers, many of whom prefer to oper­ate consistent business models on a global basis. Without a sin­gle global regulator making the rules, fragmentation is inevitable.

This fragmentation can be burdensome for asset managers op­erating globally, as non-identical rules from country to country require them to alter their operational processes and compliance policies and procedures. The greater the divergence, the greater the risk, costs, and complexity. Fragmentation is thus the single most dynamic and challenging area of policy for global asset managers in 2022.

That said, supranational bodies such as the Financial Stability Board (FSB) and the International Organization Securities Commission (IOSCO) are collaborating on a global basis to frame guidelines and principles.

4. Proxy Voting and Stewardship

One of the greatest debates in the sphere of ESG investing is about identifying the most effective mechanism for driving tangible and effective change through security ownership. There are three primary schools of thought:

  1. Divestment in the securities of a company which fails to meet certain ESG characteristics to advance financial, ethical, or political objectives.
  2. Engagement in the form of dialogue between investors and companies where the investor aims to positively influence the corporate behaviors and strategy of the company to foster sustainable returns over the long-term.
  3. Proxy Voting or “active ownership” to exercise voting rights on company management/ shareholder resolutions, as well as submitting resolutions, to formally express approval (or disap­proval) on relevant matters which might advance.

While each method of driving change at investable companies forms part of the ESG rulemaking roll out we are witnessing, a recent tilt has seen much greater regulatory focus on proxy voting practices. The EU has already implemented its revised Shareholder Rights Directive to increase transparency between issuers and their shareholders and encourage investors to engage in share­holder voting activities and events. The U.K.’s Stewardship Code also sets very high standards of transparency for asset owners and managers on their proxy voting elections and policies and pro­cedures that underpin their proxy voting activities.

In the U.S., the Securities and Exchange Commission (SEC) has proposed changes to its proxy voting advice rules. The changes seek to address investor concerns that existing rules hinder both the timeliness and independence of proxy voting advice from third party firms and subject those firms to undue litigation risks and compliance costs. How asset managers vote on ESG issues is increasingly seen as a test of their ESG credentials.

5. Don’t Forget the G in ESG Investing

While much of the focus on ESG investing has been on environ­mental sustainability (the “E”) and social themes (the “S”), there is a disproportionate lack of focus on the G, or corporate gover­nance. Corporate governance may be defined as the manner, principles, and process by which an organization is directed and managed and is therefore perhaps the most important strategic aspect of driving sustainability change in the corporate sphere.

Poor corporate governance practices have stood at the core of some of the biggest corporate scandals.5 They can lead to reputational damage and financial risk by being inattentive to the most important drivers and forces affecting a business model. The general shift towards sustainability itself is one of the biggest business drivers across all industries and if the governance of the firm doesn’t address this fact that could be indicative of misman­agement itself.

6. Ethics, Conduct and Accountability

A firm being judged on ESG should have robust and effective poli­cies for anti-money laundering, cybersecurity, conflicts of interest, insider trading, whistle blowers, and political contributions. There are several interspersed regulations around the globe which home in on ethics, conduct and senior leader accountability.

However, sometimes law and regulation are the lowest bars to clear. In recent years, regulators have cited culture as a key lead indicator of well-run firms. Many of the enforcement actions prosecuted by global regulators have “poor culture” and the absence of ethics or senior leader accountability at their core.

In addition to the firm itself, their senior staff could be held per­sonally accountable for not just their own personal actions but of those under their command.

In the U.S., at the heart of the fiduciary duty is the SEC’s Regulation Best Interest, a new rule that aims to provide clarity for consumers across the financial services industry by impos­ing a higher standard of care rules for asset managers.6 The as­sessment of value in the U.K. which now also permeates the European landscape enshrines the concept too. While the con­cept of individuality accountability regimes has flourished, the U.K.’s Senior Manager & Certification regime (SM&CR), and the Central Bank of Ireland’s Senior Executive Accountability Regime (SEAR) stand out. In addition, similar regimes have been rolled out globally including the Monetary Authority of Singapore’s Individual Accountability & Conduct Guidelines (IACG) and Hong Kong’s Manager in Charge regime.

7. ESG Labelling

One aspect of the ESG ecosystem that continues to grow is “labels”. Part of the EU’s Sustainable Finance Action Plan is the development of an EU Ecolabel for financial products. There have also been national labelling exercises such as the French govern-ment’s SRI label (Label ISR de L’Etat Francias), Belgium’s trade body Febelfin and Luxembourg’s privately-led Luxflag. In fram­ing its forthcoming Sustainability Disclosure Requirements, the U.K.’s Financial Conduct Authority has also included investment labels to further define funds’ specific characteristics.

Adherence to certain global frameworks and standards are also used generally as “labels” of quality assurance so funds aligned with the TCFD, the UN Principles for Responsible Investment and SASB and the Global ESG Benchmark for Real Assets (GRESB) are also often seen as quality marks for sustainability. In addition, with the SFDR and its categorization of funds in articles 6, 8 and 9, the market has also begun to label funds with these designations as an indication of their commitment to sustainability standards.

These labels might be useful tools to designate and identify the ESG credentials of an asset manager and its funds. However, it is important that they don’t remove the traditional investment and risk management rigor essential in capital allocation. Labels might serve a purpose, but they only serve as another signal of an asset manager’s or funds’ ESG credentials.

8. Diversity, Equity, and Inclusion

Diversity, equity, and inclusion (DE&I) has become an increasing­ly important ESG theme, with a myriad of measures put in place to rectify inequality. Regulators are increasingly vocal in sug­gesting that it can help in the reduction of risk by combatting so called “groupthink”, which can often lead to sub-optimal decision making.

Yet, despite the marketing approaches employed by many asset managers on the topic, there may be some way to go in making DE&I de rigueur in actual policies. A European Banking Authority (EBA) report published in February 2020 found that 40% of banks had not yet adopted a diversity policy and two-thirds of boards were composed only of men. In July 2020, the Central Bank of Ireland published a thematic review which showed similar sober­ing statistics on board composition.

Regulators globally are keen to address this. In March 2020, U.K. FCA CEO Nikhil Rathi stated that diversity will be crucial in the FCA’s supervisory considerations. In France, the obligation for company boards to have at least 40% female members was ex­tended from listed companies to companies with at least 250 em­ployees and sanctions were strengthened. In the U.S., the SEC has approved rules to improve diversity on company boards and its Asset Management Advisory Committee (AMAC) has presented recommendations to address the very evident absence of gender and racial diversity within the U.S. asset management industry.

DE&I will increase in focus among regulators and investors throughout 2022.

9. Point of Sale Rules: Suitability and ESG Appetite assessments

Another interesting point about ESG is not just how it will impact portfolio compositions and investor appetite, but it also has a dis­cernible effect on the traditional investment advisory and distribu­tion model. Regulators are directing this area too. Through certain revisions to the EU Markets in Financial Instruments Directive (MiFID) requirements, investment advisors and portfolio managers will soon be required to incorporate clients’ ESG preferences into their product suitability assessments.

Additionally, the EU SFDR demands detailed disclosure require­ments for both principal adverse impacts sustainability state­ments, additional disclosure requirements for Article 8 (those funds that promote E or S characteristics but do not have them as the overarching objective) and Article 9 funds (those funds that specifically have sustainable goals as their objective as well as the addition of certain mandatory disclosure templates for funds). It is also important commercially to avoid negative regulatory scrutiny and that all salespeople in the chain of distribution are at least conversant on the ESG criteria and credentials of the funds they are selling.

Likewise, in the U.S., the concept of ESG integration and fiducia­ry duties as well as the implementation of the SEC’s Regulation Best Interest now means that where a fund purports to be ESG, the registered investment advisor needs to be able to articulate the mechanisms used to justify this designation. The spectre of both mis-selling and greenwashing loom large if advisors cannot provide investors comfort that the fund truly does stand up to its ESG promises. The funds sales and distribution game just got a whole lot more complex globally.

10. ESG Disclosure

Across all major financial jurisdictions, regulators in different markets are introducing new ESG disclosure rules compelling funds and asset managers to disclose information on their ESG footprint within annual reports and mandatory regulatory reporting. However, in the absence of a universally agreed upon global standard for reporting, it can be unclear which rules to follow when reporting, once more raising the challenge of rule fragmentation.

The International Organization of Securities Commissions (IOSCO) has weighed in on the topic. The global regulator stress­es the need for investors to have comparable ESG data, based off certain universally agreed reporting standards. The establish­ment of the ISSB to develop global standards based primarily off disclosure standards of the TCFD could ultimately form a global baseline of sustainability disclosure.

Regulators in individual jurisdictions are also moving on disclosure. The EU leads the disclosure space race with its SFDR, but in the U.S., SEC Chairman Gary Gensler has said he wants mandatory disclosure on climate risks. The U.K. is also a fast follower with the publication of a triumvirate of ESG disclosure related documents in late 2021:

While staying abreast of the ever-evolving ESG policy landscape on a national, regional, and global basis presents a challenge to asset managers, they can be guided by these universal themes that will influence rulemaking in 2022. Given the strides of regulators to collaborate further on global standards for ESG disclosure, reporting and measurement one thing looks clear: thematically convergence on ESG rulemaking is gathering pace and asset managers can hope for more consistent shades of green when it comes to ESG rulemaking.

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1 https://www.esma.europa.eu/press-news/esma-news/esma-launches-call-evidence-esg-ratings
2 https://www.mayerbrown.com/en/perspectives-events/publications/2021/12/iosco-report-highlights-esg-data-deficiencies-calls-for-oversight-and-makes-remedial-recom-mendations
3 https://www.intuition.com/what-is-the-sfdr-sustainable-finance-disclosure-regulation/
4 https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en
5 https://en.wikipedia.org/wiki/List_of_corporate_collapses_and_scandals
6 https://www.forbes.com/advisor/investing/regulation-best-interest/
7 January 2020

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