The European Union is bringing rules into effect on Wednesday that seek to regulate the fast-growing sustainable-finance industry for the first time.
Managers of funds that invest in line with environmental, social or governance considerations, known as ESG, will have to put forward a tangible, measurable plan for how they will do so. This will apply to all asset managers that raise money in the EU, whether they are based within its borders or not, from March 10.
“Today there’s quite a bit of variability, too much variability” in how ESG investments are defined, said Jeff McDermott, managing partner of Nomura Greentech, a sustainable-infrastructure-focused investment bank that is part of Japanese financial services conglomerate Nomura Group. “Investors think they’re investing behind a manager doing ESG, but when you peel back the onion, it’s a different story.”
The rules, known as the Sustainable Finance Disclosure Regulation, or SFDR, address a long-running concern for the industry: ESG’s lack of supervision. There is no hard definition of what constitutes a sustainable investment and no watchdog to enforce it. Fund managers and ESG ratings firms have been free to set their own definitions, which has sparked concerns that claims may be exaggerated, a practice known as greenwashing.
This “is a first step in really trying to get to a place where companies are reporting data on a consistent basis,” Mr. McDermott said. “This is going to, I think, make it much more difficult to greenwash.”
Sustainable investing has attracted huge volumes of capital as the financial services industry has come under greater scrutiny for its role in pollution and climate change. Investors directed $152 billion into investments marketed as ESG in the fourth quarter of 2020, an 88% rise from the previous one, according to data from Morningstar.
ESG is cropping up in corners of finance that aren’t sustainability-focused at first glance. When Saudi Arabia held an investor call ahead of a euro-denominated government-bond sale last month, it touched on topics such as the rising number of women in its workforce and its cleaner gas-fired power stations, a banker involved in the deal said. The kingdom was able to raise money at a negative interest rate for the first time, although it didn’t label the bonds as green. Some money managers have included Saudi debt in ESG funds.
The rules dictate that all financial firms that have investors in the EU, including U.S. money managers, will have to put forward a new kind of disclosure to investors: how environmental, social or governance issues such as climate change or poor corporate ethics could affect the value of their investments. They will also have to put out a statement about the impact of their portfolios on the wider world such as the carbon emissions of companies they contain.
Private market funds are also included, marking a shift in the regulation of an opaque corner of finance that sells directly to investors without exchanges or public disclosure.
“When deciding what assets to buy or build, we will want to make sure that they work with these standards,” said Anthony Gordon, a partner at Avaio Capital, a New York-based private-equity fund. “If not, it could create a liability.”
The regulation of companies based outside the EU’s borders underscores the European Commission’s weight in global affairs and its ambition to lead in international efforts to curb climate change. This is the latest in a series of EU legislation with a wide-ranging impact, a list that includes the GDPR data-privacy law and the Mifid rules that govern securities markets.
In this case, the rules won’t be directly enforced by EU authorities in Brussels. Instead it will be up to the regulatory authorities in each member state. The Central Bank of Ireland, for instance, has put out guidelines for how to comply by March 10.
“We’re making sure our portfolio managers are familiar with the requirements and aware of the reputational risks associated with not meeting the standards,” said Jason Mitchell, co-head of responsible investment at Man Group, one of the world’s largest hedge funds. Man Group said it is now being more conservative about what it labels as ESG.
To be sure, some analysts say these first steps aren’t sufficient to regulate sustainable finance. Available data on a portfolio’s environmental impact is still patchy, as many listed companies don’t put out information about how much they pollute. The rules are also vague for less-mainstream securities such as derivatives, leaving some investors unsure about how to follow them.
“We have been preparing very intensely for this. It’s a significant milestone for the industry,” said Jenn-Hui Tan, head of stewardship and sustainable investing at Fidelity International, a Bermuda-based subsidiary of Fidelity.
Fidelity International will have to comply for a third of its funds that hold its $611 billion in assets under management.
View: More news