ESG: It's Complicated

Lauren Anderson of Irish Funds explores the complicated world of ESG and the challenges the financial services industry has encountered as a result.

When I took my first steps into the world of ESG, I had a sense that while complex, it was an incredibly important endeavour. Little did I know just how complicated and essential it really is.  

Our climate is changing. We have all heard that global temperatures are rising and glaciers are retreating1, but the evidence of rapid climate change is becoming more and more evident in our everyday lives. From unpredictable flooding to record-breaking heat, our planet feels unrecognisable at times and yet, according to climate scientist, this is in line with what the climate models have long predicted2.  

In 2015, recognising the dangers of these climate predictions, 196 Parties signed onto the legally binding international treaty on climate change known as the Paris Agreement. The goal of the treaty is to ensure “the increase in the global average temperature to well below 2°C above pre-industrial levels” and to support efforts “to limit the temperature increase to 1.5°C above pre-industrial levels”3. To achieve the Agreement, the United Nations set out a roadmap to 2030, which outlined 17 Sustainable Development Goals (SDGs)4 achieve these goals, nearly every industry would need to act and thus, the European Commission developed the Sustainable Finance Action Plan (SFAP, 2018) which aims to influence European and global finance to better and protect both the environment and society. While an integral part of the Capital Markets Union (CMU) Action Plan, and is central to the financial services sector, SFAP is a piece of the broader European climate plans5.  

On the surface, is seems rather straightforward – climate change is an issue and the SFAP’s comprehensive strategy would further connect finance with sustainability through ten key actions grouped into three categories6.  

Reorienting capital flows towards a more sustainable economy by: 

• establishing an EU taxonomy7, a classification system for sustainable activities,  

• creating an EU Green Bond Standard8 and labels for green financial products, 

• fostering investment in sustainable projects,  

• incorporating sustainability in financial advice,  

• and developing sustainability benchmarks9. 

Mainstreaming sustainability risk into management by:  

• better integrating sustainability in ratings and market research,  

• clarifying asset managers' and institutional investors' duties regarding sustainability,  

• introducing a 'green supporting factor' in the EU prudential rules for banks and insurance companies.  

Fostering transparency and long-termism:  

• strengthening sustainability disclosure and accounting rule-making;  

• fostering sustainable corporate governance and attenuating short-termism in capital markets. 

From the action plan emerged concrete measures, including the now familiar Taxonomy Regulation and Sustainable Finance Disclosure Regulation (SFDR). These transparency-focused regulatory frameworks were designed to actualise SFAP’s objectives by developing an EU-wide classification system and enacting requirements around how financial market participants and financial advisers must communicate sustainability information to investors10. 

Eight years after the Paris Agreement entered into force, five years after SFAP was published, and two years after SFDR came into application, the climate is still in crisis and the regulation in disarray. No one expected the planet’s great dilemma to be solved by now (like we said, the climate models predicted this), nor did we expect the financial services industry to solve the climate’s crisis alone, but we did expect better…better regulation, better clarity, better collaboration, and better compliance. To put is simply, a complicated problem has been muddied by complicated solutions.  

Today we have SFDR, DNSH, PAI, CSRD, EET, EFRAG, Green Deal, EU Taxonomy, TSC, SRD, ISSB, GRI, IFRS, PRI, SASB, TCFD, TNFD… a list of regulations, principles, criteria, initiatives, documents, and associations among other things. In the few years since the financial services industry began its formal ESG journey, a complicated web has developed, and concern has emerged as whether it is really helping achieve the climate goals of the Paris Agreement.  

Take SFDR for example, the mandatory ESG disclosure obligations for asset managers and other financial market participants (FMPs) came into effect in March of 2021. From the outset, the regulation was flawed. Key concepts such as “sustainable investment” were (and still are) unclear, causing in problems with interpretation. Different interpretations of both SFDR and Taxonomy have created uncertainty around the calibration of sustainability in financial products and undermined the credibility due to the lack of comparability. As a result, the European Supervisory Authorities (ESAs) have repeatedly requested the European Union clarify the meaning and scope of the provision in SFDR, “such as the meaning of the term ‘promotes’ in Article 8 SFDR, and the scope of the disclosure obligations, and the interpretation of ‘sustainable investment’ in article 2(17) of SFDR”11. However, the continual updates and clarifications (i.e., Directive Regulations, Regulatory Technical Standards [RTSs], Technical Screening Criteria, and Q&As) has created complexity for compliance which requires more resources.  

Incorporating ESG considerations into investment processes and decision-making is a complicated task as fund managers need to establish a robust framework for evaluating ESG risks and opportunities to integrate them into their investment strategies. Without the clarity of regulation or the access to high-quality reliable data to meet disclosure requirement or internal risk assessments, the incentive for ESG investment is diminished. There is an investor demand for ESG products12, and we can not let the challenges and costs of compliance inhibit investment in ESG. 

To achieve the commitments made at the Paris Agreement, to ensure the increase in the global average temperature is well below 2°C above pre-industrial levels, the existence and expansion of ESG in the financial services sector must be achievable. We are all aligned in our goals, and it is important to remember what it is we are seeking to achieve, together. 

References

1 https://climate.nasa.gov/evidence/ 

2 https://www.theguardian.com/environment/2023/aug/28/crazy-off-the-charts-records-has-humanity-finally-broken-the-climate  

3 https://unfccc.int/process-and-meetings/the-paris-agreement#:~:text=Its%20overarching%20goal%20is%20to,above%20pre%2Dindustrial%20levels.%E2%80%9D  

4 https://sdgs.un.org/goals  

5 Danny Busch, EU Sustainable Finance Disclosure Regulation, Capital Markets Law Journal, Volume 18, Issue 3, July 2023, Pages 303–328. 

6 https://finance.ec.europa.eu/publications/renewed-sustainable-finance-strategy-and-implementation-action-plan-financing-sustainable-growth_en 

7 https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/eu-taxonomy-sustainable-activities_en

8 https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/european-green-bond-standard_en 

9 https://finance.ec.europa.eu/sustainable-finance/disclosures/eu-labels-benchmarks-climate-esg-and-benchmarks-esg-disclosures_en  

10 https://finance.ec.europa.eu/sustainable-finance/disclosures/sustainability-related-disclosure-financial-services-sector_en  

11 https://blogs.law.ox.ac.uk/oblb/blog-post/2023/06/eu-sustainable-finance-complex-rules-and-compliance-problems-review-banking

12 https://www.ft.com/content/5763c866-3437-4b66-8467-09486454a162