A journey to eliminate greenwashing
In recent years there has been a surge in responsible investing and ESG (environmental, social and governance) focused products. Alongside this positive shift comes an increased risk of greenwashing - the practice of making misleading statements or policies that can result in an investment, or a specific product, appearing to be more closely aligned to ESG than it actually is.
In order to avoid greenwashing and ensure that ESG considerations are effectively integrated within investment solutions and specific products, asset owners should consider the ESG credentials of their investments. Additionally, it is integral for government bodies across the globe to establish clear regulation and guidelines. We are currently experiencing the first wind of change and a key group of topics for market participants is the upcoming Sustainability Finance Disclosure Regulation (SFDR)1, set to come into force from 10 March 2021. SFDR is part of a wider package of EU sustainability regulations which are being phased in throughout 2021 and 2022.
Despite the challenges of implementing the incoming regulations, we believe that this brings good news for asset owners, driving greater transparency and accountability to the financial market’s ESG offering.
What do the EU’s sustainability regulations mean for investors?
The European sustainable fund market reached a milestone in the third quarter of 2020 with almost £800 billion (€882 billion) of assets under management.2 This surge in sustainable assets can be attributed to a few factors, including greater awareness brought about by the coronavirus pandemic, which increased focus on the role of good business practices in society.
As government bodies across the globe tighten regulations and guidance on responsible investing and sustainability, including requirements around transparency and disclosure, the rise in assets under management is likely to continue.
The shift to greater transparency will be a welcome change for asset owners, who to date have been bombarded with so-called green funds that hold themselves out to be socially and environmentally responsible. From 10 March 2021, asset owners will have access to the information needed to make more informed decisions when building out their responsible investing implementation plan, thanks to the detailed disclosures required by SFDR. However, this is just the beginning.
The UK Treasury has announced that it will not be onshoring SFDR but has confirmed that it will implement some form of ESG regulation – so, watch this space. In the absence of UK regulation, Russell Investments’ UK entities will publish online disclosures relating to how they integrate sustainability risks into their investment decisions (which correspond to the firm-wide obligations under SFDR). Additionally, Russell Investments UK will adjust its disclosures accordingly as the UK’s regulatory position becomes clear but will continue to consider the EU standards.
Below, we provide a summary of the key pillars of the EU Sustainable Action Plan, highlighting some key information you can start to expect from your asset manager over the course of 2021. We strongly encourage investors to be aware of the changing landscape so that they can make informed decisions when implementing responsible investing strategies.
The EU Sustainable Action Plan: What to expect
In December 2019, the European parliament introduced an EU Sustainable Action Plan; a package of measures to create an ESG regulatory framework with three key drivers in mind:
- Create a financial market which truly integrates sustainable finance by financing economic growth and supporting ESG considerations at the same time.
- Transform the EU economy into a greener, more resilient system with a reduced carbon footprint. Investment from the private sector will be required to meet these targets.
- Increase transparency and consistency to prevent greenwashing and enable investors to make informed decisions about sustainability.
The guidelines set out by the European Securities and Markets Authority (ESMA) include the following key pillars.
Pillar 1 - SFDR
The SFDR introduces three new concepts of Sustainable Investments, Sustainability Risk and Sustainability Factors:
- Sustainable Investments3
An investment in an economic activity:
- Which contributes either to an environmental objective or a social objective
- Do Not Significantly Harm any of those objectives; and
- Ensures the investee company(ies) follows good governance practices
An environmental, social or governance event or condition which, if it occurs, could cause an actual or potential material negative impact on the value of investments.
Environmental, social and employee matters, respect for human rights, anti-corruption, and anti-bribery matters.
From 10 March 2021, market participants who are subject to SFDR must disclose the following information:
- Sustainability Risk Policy
- At a firm-level, market participants must disclose their policies on integrating Sustainability Risks into their investment decision-making processes.
- At a firm-level, market participants must also disclose how their remuneration policies are consistent with their Sustainability Risk Policy.
- At a product-level, market participants must disclose how Sustainability Risks are integrated into the investment decisions for that product and the likely impacts of Sustainability Risks on the returns of the product. Or alternatively, market participants must explain why Sustainability Risks are not relevant.
- Adverse Sustainability Impact
- Market participants must disclose whether or not they consider the principal adverse impacts of their investment decisions on Sustainability Factors.
- The regulator is expected to publish technical standards6 which will set out: (i) which indicators demonstrate “principal adverse impacts” on Sustainability Factors; and (ii) the detail on how to comply with this requirement.
From 10 March 2021, asset owners can expect to see qualification of financial products (i.e. funds or portfolios), into three main categories:
- Article 9, or Dark Green: a product that has Sustainable Investment as its objective.
- Article 8, or Light Green: a product that promotes environmental or social characteristics and invests in companies which follow good governance practices.
- Article 6: all other products.
Pillar 2 - Taxonomy regulation7
The European regulator has established a classification framework, to determine whether economic activity is an Environmentally Sustainable Investment. In order to be deemed an Environmentally Sustainable Investment, an economic activity must meet four criteria:
- It must substantially contribute to the one or more listed environmental objectives: these are climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, waste prevention and recycling pollution prevention and control, and protection of healthy ecosystems.
- It must not do significant harm to any of the other listed environmental objectives
- It must be carried out in compliance with minimum social safeguards.
- It must comply with the regulatory technical screening criteria and technical standards, which define what it means to substantially contribute and do not significant harm.
The outcome of the four tests must place a product or activity, with regard to its environmental and sustainability objective, into the following Positive and Neutral sectors:
- Positive – the product is environmentally sustainable when assessed against the taxonomy.
- Neutral – the product does not have a significant sustainability impact when assessed against the taxonomy.
Article 8 and Article 9 products will need to include in its pre-contractual disclosures and periodic reports which relate to environmental objectives or promote environmental characteristics. The ESG labelling must offset out how the product’s investments comply with the taxonomy.
Pillar 3 - Changes to MiFID, UCITS and AIFMD
The newly implemented regulation will alter how MiFID II firms assess the suitability of their products and services for clients by ensuring that the client’s ESG preferences are taken into account, where relevant. Amendment of existing MiFID II process and control infrastructure will include; the collection and documentation of the clients’ or prospects’ ESG preferences and the investment proposals must reflect these preferences.
Delegated Acts will amend the UCITS Directive, AIFMD and MiFID II regulations in the areas of; organisational and governance requirements to require that firms take into account Sustainability Risks and Sustainability Factors.
The bottom line
The responsible investing landscape is evolving, and asset owners need to stay abreast of these changes, watching out for potential pitfalls and greenwashing. Despite the challenges that asset owners may continue to face when incorporating ESG factors into their investments, the spotlight on responsible investing also presents an array of opportunities in both the public and private sectors.
At Russell Investments, we believe that transparency and investing responsibly can help deliver attractive investment returns and meet client objectives in the long-term. In 2021, our investment team are establishing a Sustainability Risk Policy and Practice, as we believe that financially-material risks related to ESG issues are relevant to our investment practice. Furthermore, our internal reporting and oversight includes multiple industry standard metrics, along with our own proprietary metrics such as the Material ESG Score. To find out more about how we integrate ESG considerations into our investment practices, visit our dedicated responsible investing webpage.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.
1 EU Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector.
3 Article 2(17) of EU Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector.
4 Article 2(22) of EU Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector.
5 Article 2(24) of EU Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector.
6 Since writing this blog, the European Supervisory Authorities have published a final report and draft regulatory technical standards on disclosures under SFDR.
7 Regulation (EU) 2020/852 (Taxonomy).