Environment, Social, Governance. These words have become rather ubiquitous in recent years, with just about every firm or financial institution touting their ESG practices. The United States ESG investment market alone grew 42% from 2018 to 2020, contributing $17.1 trillion of the $35.3 trillion total across five major investment markets.
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Unfortunately, these claims of sustainability or social consciousness can be shallow at best, deliberately misleading at worst, and governing bodies are starting to intervene. In the EU, for example, the Sustainable Finance Disclosure Regulation (SFDR) went into effect in March, 2021, requiring more detailed data reporting to add clarity for inventors when assessing the sustainability of investments. The U.S. is also considering similar regulations and penalties for false or inaccurate claims.
While many firms may initially look at such policies as an administrative burden, increased ESG regulation could have numerous benefits for firms, investors, and the communities they serve. We’ll take a look at the existing and forecasted regulations on ESG investing and how such policies can benefit the industry moving forward.
What Is ESG Finance?
Before we dive into the regulations and their impacts, a note on terminology. ESG may have become somewhat of a buzzword, but what does it actually mean? Or rather, what is it supposed to mean?
ESG as a concept has been around since at least the 1960s, though the name was coined in the early 2000s as an umbrella term for socially responsible investing practices. The E, S, and G refer to the following:
- Environment: This area is concerned with resource usage, pollution, and climate change. For example, how do companies perform on things like greenhouse gas emissions and waste reduction across the supply chain.
- Social: This refers to how companies interact with and impact the communities in which they operate. It includes everything from the health and safety of their employees and their suppliers’ employees to involvement in conflict regions.
- Governance: By this, we mean corporate governance - how are companies investing in diversity, ethics, etc. through their internal decision making. For example, equal pay, diversity of board members, and auditing for corruption would all be necessary for strong corporate governance.
Where Do ESG Regulations Currently Stand?
The European Union has taken a number of concrete steps to regulate sustainable investing. The aforementioned SFDR imposes mandatory disclosure obligations for asset managers and investment firms. It introduces the term Principal Adverse Impacts (PAIs) as a unit of sorts, defined as the negative impacts on sustainability that an investment decision could have. In other words, if a firm advises a client to invest in a certain stock, how harmful could that decision be in terms of the environment, society, employees, human rights, corruption, etc.
With that in mind, the regulation mandates data disclosures including:
- How an entity integrates sustainability risks into their investment decision‐making or advising
- A statement of their policies on PAIs
- Proof that remuneration policies are made with sustainability risks in mind
- Evidence of pre-contractual disclosures on sustainability risk integration
The EU is also implementing the Sustainable Finance Action Plan, aiming to redirect capital towards sustainable companies and green bonds and away from sectors involved with fossil fuels and other unsustainable practices. Finally, there is the EU Taxonomy Regulation which went into force in July, 2020, providing a classification system of conditions companies must meet to be considered environmentally sustainable. From January, 2022 onward, companies will be required to report how their financial products align with the Taxonomy.
The US Securities and Exchange Commission has committed to developing similar regulations in the future, though what exactly those will contain has not been formalized.
All in all, these types of regulations formalize requirements for ESG finance much like GDPR’s impact on data collection and PCI-DSS’s impact on the payment card industry. Any future regulations will only add more nuance to these broad regulations, further holding firms accountable for proving sustainable practices.
How ESG Regulations Can Help
SFDR and similar policies are not the first example of increasing government oversight of industry giants in recent years, and it will not be the last. So, it’s in the best interest of stakeholders to consider how such regulations can benefit their companies and their customers.
There is no doubt that erroneously claiming ESG practices is a form of greenwashing, a harmful practice of overestimating the sustainability or eco-friendliness of a product or company. The ethical implications of this are hopefully obvious, both in terms of misleading clients and of the environmental and societal determinants.
Therefore, a cultural shift to decrease financial greenwashing is ultimately beneficial because it gives credit where credit is due. If firms who are inflating their ESG compliance are called out, it will highlight the ones who are taking legitimate efforts to consider PAIs in their financial advising and internal decision-making. Over the longer term, clients will recognize this differentiating factor and align themselves accordingly.
Force Firms To Look Internally
While mandated ESG reporting will require additional input at the outset, it can also help firms reevaluate some of their current practices. For example, some firms may realize that investor relations are not prioritized in their current operations.
Similarly, preparing for ESG data reporting will highlight the importance of maintaining transparent, responsible accounting practices, including using software that comes with critical features such as transaction monitoring and comprehensive reporting. Without using the right tools, firms will have a more difficult time assessing and proving their ESG compliance.
Take the new regulations as an opportunity to develop an in-depth roadmap of your business risks, opportunities, partners, etc. Look at who you work with and how it reflects on your business. By auditing yourself and your partners before regulations become fully mandatory, you will be better situated to meet industry standards and improve your reporting, data management, risk management, investor relations, and more.
Improve Outlooks In The Long Run
When it comes to the finance market, while there are some more consistent trends, there is also a lot of uncertainty. That’s because market fluctuations are largely based on future trends - in a sense, attempting to predict the future. And lately, it appears that one of those trends is an increasing push for making ESG mandatory.
Over the past 50 years or so, it has been a voluntary action, but with regulations increasing, it is becoming less so. This means there will only be greater scrutiny towards unsustainable sectors moving forward, and companies will need to respond if they hope to survive.
For example, the tech sector has been criticized by environmental groups and even their own customers and investors for high consumption levels due to the electricity needed for data storage and processing. This and other industries are now pushing to reduce their carbon emissions. Many companies are also making other ESG steps a priority, such as increasing the diversity of the still overwhelmingly white, male leadership of the sector.
These efforts show that companies will respond to pressure, even if change can be slow. Reporting these efforts is important to encourage firms to factor in ESG risk as a determining factor in how investors can find value in a company.
What’s more, firms should take note that younger generations - namely Millenials and Gen Z - are increasingly socially conscious consumers. According to industry expert Alex Williams of Hosting Data, savvy investors are now taking advantage of online trading to educate themselves and invest responsibility.
“It's not possible to make a stock exchange without a broker,” says Williams. “There's nowhere to visit to make a trade yourself. Most trading is done this way, even though - on television - you see people making purchases in New York's financial district.”
Younger generations are well aware of this, and they are starting to invest earlier in life than their parents and grandparents, aided by digital resources. Therefore, ESG reporting will encourage increased accountability, which could in turn reward sustainable companies with new customers and growth potential in the future.
What the EU has started will undoubtedly spread elsewhere. This means, along with recent trends like increased cryptocurrency regulation and similar government interventions, ESG regulations may be the next policy surge for firms to comply with. What began with data disclosure could end in even more significant policy shifts across the finance sector. Firms must be ready to adapt if they hope to be compliant and competitive in an increasingly socially conscious market.