Op-Ed: Europe’s New ESG Rules Create an Opportunity for US Investors

Hari Bhambra

American asset managers with little connection to Europe might dismiss the European Union (EU)’s new sustainable finance regulations as irrelevant to their business. They would be mistaken to do so, however.

The regulations will have a tremendous impact on asset managers and firms operating outside the bloc. The EU might be the first to move on sustainable finance regulations, but its objectives are a harbinger of things to come around the globe.

To stay competitive in today’s borderless financial sector, everyone will have to take note of the zeitgeist. They’ll have to prove they are serious about sustainability and good governance, which may actually serve to enable them to capitalize on business opportunities—motivated by global concerted efforts of driving capital toward sustainable investments—that lie ahead. Investment with a purpose can have a real commercial value, and global investors will become the impetus to drive that change across the globe as a consequence of enhanced, consistent, and comparable disclosure.

Details, Details

The new rules for European financial products, advisers, and managers came into force on March 10 through the Sustainable Finance Disclosure Regulation (SFDR). They are designed to help financial institutions meet the goals of the Paris Agreement on climate change by driving capital toward environmental, social, and governance (ESG) and similar impact investing.

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Specifically, the regulations will require financial market participants (FMPs) and financial advisers (FAs) within the bloc to integrate sustainability risks into their internal processes, including their portfolio management and product governance structures, and clarify how sustainability risks have been integrated into the respective remuneration policies.

Integration and disclosure also aim to stamp out “greenwashing.” The regulations mandate more standardized information so clients can more easily compare firms’ sustainability efforts and understand that they can also consider ESG factors in their investment choices.

Reading beyond the SFDR, it provides insight into a new standard for how financial firms do business. FMPs and FAs will start, across the EU, to disclose how their investment process and product governance function and, further, what their remuneration structure is, providing insight into the culture and manner in which personnel are rewarded within FMPs and FAs. Increasing information not just at the product level, but in how institutions conduct themselves will become a common data source for investors. Thereafter, any investor which is accustomed to disclosure of that nature may be reluctant to deal with managers or advisers that do not volunteer similar information.

The SFDR may be the catalyst that will enable investors to drive fundamental change across the industry—impacting institutions that want to do business with the EU, even if they aren’t based there.

From Niche to Mainstream

The SFDR shouldn’t be a surprise. The push for environmentally and socially conscious investing has been growing for years among regulators and investors alike.

Incorporating ESG into fund management and supporting services such as administration is no longer niche. It’s become mainstream largely because of changing regulatory landscapes such as the Financial Stability Board’s Task Force on Climate-Related Financial Disclosures (TCFD) and the Global Reporting Initiative (GRI). Some observers think ESG investing has spurred the biggest revolution in finance in years.

Client demand for sustainable investments has been growing steadily as people, especially those in younger generations, become more socially and environmentally conscious and aware of the financial risks that inequality, climate change, corruption, and other problems pose. The coronavirus pandemic has only highlighted these concerns.

One of the potential changes that can be predicted is governance. The SFDR requires disclosure at various levels, including a look-through to portfolio investments to examine and disclose ESG characteristics, with governance being a key pillar of consideration. Enabling investors to have clearer visibility on how investments, managers, and advisers are themselves governed could be a key driver in selecting a manager in the future. Some of the considerations include remunerations of board members and CEOs; gender diversity, which may further fuel the drive to require better governance; and more gender balance within financial institutions and investment portfolios. There are many other changes that may result as a consequence of the SFDR with the potential for other regulatory centers to implement an equivalent of the SFDR in their jurisdictions or managers to voluntarily adopt similar practices to remain competitive.

Investors have also noticed that ESG investments have performed solidly against standard investments over the past decade and especially throughout the pandemic. A Morningstar study from last year found that after holding their own in the fourth quarter, sustainable equity funds finished 2020 with a clear performance advantage relative to traditional equity funds.

For some investors, the lower risk offered by these investments makes them even more attractive. Stronger governance, as highlighted above, may also lead to sustainable businesses that could improve investor confidence. Investment with a value can actually result in strong and sustainable commercial value.

It’s Bigger Than the EU

Who should consider the implications of the European regulations now? Everyone, everywhere.

The new rules apply specifically to FMPs and FAs and financial products within the EU or marketing to the bloc. These “look-through” rules may even include service providers for ESG data and others, particularly those providing data metrics for ESG investments.

The US is not immune to the increased interest in ESG, and the SFDR will certainly apply to some US funds doing business in or marketing to Europe.

Beyond that, managers should expect a new push toward ESG under the Biden administration. The US government has already rejoined the Paris Agreement and incorporated ESG goals into its operations. And the Department of Labor (DOL) also recently announced it wouldn’t enforce a Trump-administration rule that discouraged ESG funds in 401(k) plans. Major American firms such as BlackRock have pledged to incorporate ESG approaches into their operations, too.

Similarly, while the UK is no longer an EU member, British funds are working hard to reduce friction with SFDR because London remains enmeshed with European financial markets, with the UK aligning with the TCFD’s disclosure regime.

Why You Should Be on Board

US funds have an opportunity to get ahead of the game by adopting systems and implementing processes that can respond to client demand as well as the coming regulations such as the SFDR and the TCFD regarding data and disclosure around the globe.

Instead of greeting more rules in the future with trepidation, funds should see them as an opportunity to attract capital from the growing number of investors who view ESG positively. In fact, integrating ESG early might suggest a firm’s seriousness about sustainability to potential client issues and could be the difference between attracting capital or losing it.

PwC recently noted that 77% of institutional investors planned to stop purchasing non-ESG products. More than half of the investors who answered an Aviva survey, meanwhile, said the pandemic had motivated them to take ESG factors into consideration in their investing.

The Bottom Line

The SFDR promises to empower European investors to make clearer decisions about their money—putting additional pressure on firms to become more sustainable and more transparent as clients everywhere, and eventually regulators, too, come to expect data on how funds incorporate ESG goals.

Those resisting ESG may face more difficulty in seeking access to capital. Putting the interests of investors first may now very much align with putting the interests of the environment (both climate, social, and governance) first. Capitalism may be entering a new phase.

Hari Bhambra is global head of compliance solutions at Apex Group.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.