The beginning of the ESG regulatory journey The beginning of the ESG regulatory journey The beginning of the ESG regulatory journey

The winds of change began to stir virtually every economic sector when the UN Paris Agreement was signed by world leaders in 2016, not long after the UN adopted their Sustainable Development Goals (UN SDGs). Those winds have since intensified for the asset management industry, first whipping up investor demands then regulatory pressure regarding their sustainability or environmental, social and governance (ESG) practices, and now in the light of COVID-19.

The European Commission has issued an array of regulations that touch every type of asset manager and investment fund, and other types of financial services firms. Asset managers must satisfy both regulatory and investor demands to change the way they invest and report, and the products they offer.

Given that asset managers are both issuers and users of financial and non-financial ESG information, these regulations bring both complexity and clarity — and possible competitive advantage — to firms that can ride the winds of change.

The landmark Paris agreement, building on the UN Framework Convention on Climate Change, was a defining moment for the global response to the threat of climate change. Its core aim — to limit global temperature rise — clearly implies the need to re-allocate global capital towards low-carbon and carbon neutral investments. The daily evidence of climate change has added urgency to regulators’ and investors’ calls for change.

The European Commission released an Action Plan for Financing Sustainable Growth in March 2020 which included clarifying institutional investors’ and asset managers’ duties, incorporating sustainability into the suitability assessment of financial instruments, and increasing transparency of sustainability benchmarks.1

The Technical Expert Group on Sustainable Finance established to advice on the "how to" of elements of the plan suggested various actions focused on improving ESG corporate governance and sustainable finance activities by financial firms, and also a taxonomy defining environmentally-sustainable activities, a European standard for green bonds and an eco-label for financial products. The Commission is now consulting on a renewed sustainable finance strategy, which takes forward these points.

The result of this legislative flurry is a range of rules of significance to an asset manager, either as a publicly-listed company with new ESG disclosure requirements, or specifically relating to its role in the design, delivery and sale of financial services and products. Depending on the nature of their business, type of client and activities, asset managers face new requirements at the corporate governance, process and product levels.

This constellation of rules reflects regulators’ attempt to catch up with investor demand. For example, by March 2020, the number of asset owners, investment managers and service providers that are signatories to the Principles for Responsible Investment had reached 2,515, up nearly 30 percent from 2018², and it is estimated that global socially-responsible investments grew by 34 percent to US$30.7 trillion from 2016 to 2018, with significant growth in the US and Japan³.

Such surging demand for responsible investments is critical to help meet the Paris Agreement and the UN SDGs, but it also speaks to the need for shared regulations and guidelines to channel capital effectively.

Asset managers are at the center of this challenge but face diverse approaches and inconsistent definitions of sustainability concepts by asset owners, jurisdiction, business sector, and professional or industry standards-setting bodies. Without consistent definitions, it is difficult to determine the data points required to set comparable targets, monitor investments, and measure and compare performance against peers, let alone across the financial services sector, industries, and national or regional borders.

Moreover, asset managers must perform this in-depth data collection to satisfy their own corporate reporting requirements, to conduct appropriate investment and risk management decisions, and to make disclosures to clients and fund investors.

The challenge is compounded by the fact that, for a typical asset manager that invests in multiple, distinct asset classes, industries and geographies, there are endless subsets of relevant ESG considerations, which depend on underlying data for informed and accurate decision-making.

Although this shift to integrate sustainability into investing may seem overwhelming, it is critical to recognize it as a journey or transition, rather than an immediate outcome. Every asset manager should establish its overarching vision and strategy, identify opportunities and risks, and adjust its investment principles and process to achieve those goals. Investors will expect nothing less.

An in-depth business-driven roadmap can then be developed, to manage the business opportunities and risks that sustainable finance and responsible investment brings. The roadmap will cover ESG integration into governance and organization, as well as key business processes such as compliance, risk management, product development, investment management, data management and analysis, investee relations, investor relations, sales and reporting.

In order to set the ambition level and appropriate targets, a good understanding of the changes in the operational environment and internal capabilities will be needed. This is likely to include assembly and consideration of regulations, standards and good practice; analysis of client expectations; evaluation of peer approaches; analysis of current state with regard to work streams; and assessment of management views and the organization’s expertise.

Targets, actions and a monitoring plan can then be defined, and the necessary capabilities developed. These efforts should be synchronized across the asset manager’s business units, functions and asset classes, to ensure efficiency and consistency. Flexibility and adaptability are paramount, given that ESG rules, standards and stakeholder expectations will continue to evolve.

While most companies are seeking to absorb and incorporate the current compliance imperatives in their operations and reporting mechanisms, while simultaneously managing the impacts of COVID-19, are exploring ways to anticipate future direction of sustainable investment.

For example, some European financial services firms have already made attempts to apply the preliminary Taxonomy Regulation to their portfolios. This proactive approach enables firms to gain an early understanding of the changes needed to their operations and positions them as credible, trusted partners with regulators, to help shape future rules.

Asset managers’ journeys to full sustainable finance cannot be slow, given investor demands and mounting regulations. But the end-game is not known and the transition cannot be too quick. Expectations and standards are still evolving and abrupt change could pose risks for economies and individuals, and therefore for clients’ portfolios, against the difficult backdrop of post-pandemic economic recovery.

However, if the necessary convergence of regulations and standards can be achieved, asset managers could benefit from common rules that are clear but not unnecessarily prescriptive. And, with definite investor momentum behind sustainable investing, there is a real business opportunity — and competitive advantage — for those asset managers which make their way from a minimum compliance approach to the front of the pack, on the sustainable finance journey.