EU ESG Rules: Pack Leader or Lone Wolf?

Environmental, social, and governance (ESG) integration within asset management is a global phenomenon. That’s putting it mildly: recent investor interest has spurred a flurry of fund launches across the globe, with firms adding 525 new “socially conscious” funds in 2019, according to Morningstar. Our Global ETF Survey reveals a similar story: 74% of global ETF investors plan to increase their ESG ETF allocation this year. From a regulatory standpoint, however, not all regions are created equal when it comes to embracing (or even defining) sustainability and ESG in a consistent way.     

In terms of rulemaking commitments, the EU is the clear front runner, forging ahead of all other regions by a distance. At the heart of the EU’s environmental push is the adoption of a sweeping “Green Deal.” The EU openly acknowledges that the lofty political ambition represented within the Green Deal comes with a “hefty price tag,” as Commission Executive Vice President Valdis Dombrovskis said in a recent speech. The plan encompasses spending €1 trillion over a decade to reduce greenhouse gas emissions by 40 percent by 2030. The new European Commission president, Ursula von der Leyen, has described the deal as the region’s “man on the moon moment,” which shows the political will behind the effort to be carbon neutral by 2050. The moon landing analogy merits a second glance, as the financial commitment calls for the EU to mobilize as much as 260 billion euros ($283 billion) annually over the next decade to build out its green infrastructure. That’s not simply an Apollo program, it’s an Apollo program every year of the next decade. And that’s just a single part of the multi-faceted Green Deal. 

By placing ESG and sustainability right at the center of its political, social, and legislative agenda, the EU has taken on a leadership role at a time when governments and policymakers elsewhere have been far more circumspect about commitments to the sustainability agenda.  Asset management, like many other industries, is highly globalized and interconnected, and as such we must address the question of whether the EU is simply leading the global pack, or remains a lone wolf?  

Some of the measures that have been arranged to promote adoption of this ambitious agenda include:

  • A presentation of the so-called sustainability taxonomy, which will be led by the EU’s technical expert group on sustainable finance. The taxonomy document encompasses 400+ pages of sustainability terms and definitions. This work is likely to be concluded by the end of 2020 and is planned to go into force by the end of 2021.
  • Further technical screening for activities which substantially contribute to environmental objectives will be issued by December 2021 and apply from 31 December 2022.
  • A meeting on March 12, 2020 led by the European Commission to discuss both the taxonomy and a standard for “green” bonds, which will be required to disclose the percentage of their investments that are truly environmentally friendly.
  • A final decision on an EU-backed “Ecolabel” for green retail investments, similar to the stickers found on washing machines, attesting to the investment’s green legitimacy.
  • A three-month consultation by the EU Commission for a new Action Plan on Sustainable Finance, that will include expanded requirements for companies to disclose sustainability risks as well as their activities promoting environmental, social, and governance (ESG) issues.

In addition, asset managers will be directly affected by the Disclosure Regulation, which requires financial advisers (including MiFID investment firms, AIFMs, and UCITS management companies) to disclose at both a product and entity level how they incorporate sustainability into the services they provide, and how products with sustainability objectives or characteristics achieve those objectives or characteristics. The Benchmarks Regulation in turn establishes two new types of financial benchmarks relating to investments with carbon intensity profiles matching a particular climate transition pathway as envisaged by the Paris Agreement. Meanwhile, the Shareholders Rights Directive II (SRD II), while not officially part of the ESG package of reforms, remains  relevant, since it will oblige asset managers and institutional investors to disclose how they engage with listed investee companies on non-financial metrics, including ESG.

Not just an EU story

In the United States, ESG investing is also gaining momentum— funds that have an ESG label assigned saw $20.4 billion of new inflows in 2019, four times the amount in the previous year. Larry Fink, CEO of Blackrock, the world’s largest fund manager by assets, warned in his annual letter to CEOs that climate risk “is compelling investors to reassess core assumptions about modern finance.”

On the regulatory front, the Securities and Exchange Commission (SEC) is moving at a slower pace on sustainable investing than its European regulatory counterparts, however that doesn’t mean the phenomenon has passed them by. In fact, the opposite is true.   

Towards the end of last year, the SEC’s Office of Compliance Inspections and Examinations (OCIE) sent an initial document request to fund managers currently offering an ESG-labeled fund seeking to learn how they defined ESG for their funds and what screening methods they are using. This industry outreach is primarily to safeguard against what’s been called “greenwashing,” in which investments are claimed to be “sustainable” when they really aren’t. Whether this is a signal of a wider SEC policy review or not remains to be seen. 

SEC Chairman Jay Clayton spelled out the SEC’s approach to environmental and climate-related disclosure, as well as restated that the US regulatory framework stands independent: “In our efforts to coordinate with other regulators, particularly those from outside the United States, we must recognize that our regulatory regime stands apart from an investor protection perspective, as well as a public and private liability and enforcement perspective.”

In other words, it wouldn’t be a surprise to see the US rule set remain different to the EU on climate change regulation for the foreseeable future. For many fund managers who operate in both jurisdictions, it will mean implementation of a substantial body of work that doesn’t apply in the US. While the industry remains intensely focused on efficacy and economies of scale to reduce costs, there is not likely to be much harmonization of sustainability rules any time soon. 

Pack leader or lone wolf?            

Europe’s proactive approach on the sustainability agenda creates divergent possibilities. The first is that EU ESG regulations become a de facto global standard, with US and Asia following suit. The second possibility is that the EU stands alone as the only financial region to integrate ESG standards. There’s also a chance that other regions could develop their own standards that are wholly separate from the EU.  

Whether other regions follow the EU’s lead will have a sizeable impact on whether the global asset management industry remains broadly aligned on fund structuring and investment strategy. Other regions may look to emulate fund frameworks that allow for more flexible investment parameters. These changes could ultimately result in fragmentation of not just regulatory divergence but also a shift in asset allocations between EU and non-EU funds. 

Interestingly, a lone wolf by necessity is often stronger and more intelligent than pack wolves. But they also struggle to bring down large prey, so instead hunt smaller animals or scavenge to survive. EU funds could find themselves in a similar paradox: any fundamental deviation from global fund investment norms could mean they would have to go it alone.

On the one hand, investors who support the concept will likely increase allocations to such sustainable funds. EU funds, particularly UCITS, already currently sell in multiple markets far beyond the EU’s borders. On the other hand, there is a possibility that a mixture of investor sentiment and the onerous investment surveillance obligations leads to some asset managers looking to capital pools and fund structures beyond the EU as “lower hanging fruit.” 

With ESG integration in Europe clearly in motion, it remains to be seen whether the rest of the pack converge or diverge. That is the key question that will likely define many global asset manager’s future ESG plans.