Asia must avoid EU’s missteps in regulating ESG space
REGULATING sustainable investments can be a messy task, and few attempts have been as messy as Europe’s Sustainable Financial Disclosure Regulation (SFDR) regime.
The “Level 2” SFDR rules are finally in place after the new year following delays as the industry struggled to comply. Fund managers hoping to market to investors in Europe now have to provide additional disclosures about the principal adverse impacts of their investments on sustainability factors; about the environmental or social characteristics of their funds; and about the sustainable investment objectives of the funds.
The fund industry – and the investors trying to invest responsibly – have struggled to navigate the rules, hampered by ambiguity in definitions, highly ambitious but unfeasible requirements, and moving goalposts. There are two lessons here for Asia’s financial sector regulators as they try to shape their markets for environmental, social and governance (ESG) objectives.
The first is that the ESG-related rules and how they are implemented must pay heed to the practical realities on the ground. Level 2’s one-year delay was necessary because most funds had no way to comply earlier amid significant challenges in obtaining data.
The second is that regulating ESG requires a systemic approach to address complexities in data, standards, assurance and disclosures. For instance, BNP Paribas has kept the strictest Article 9 designation for US$20 billion of mostly thematic, actively managed equity funds using an interpretation of “sustainable investment” that differs from what is used in most of the rest of the industry.
In the third quarter of 2022 alone, Morningstar found that 383 funds had been reclassified in terms of whether they were compliant with – in increasing order of sustainability requirements – SFDR Articles 6, 8 or 9. These shifting markers make it harder for well-meaning investors to deploy capital towards ESG objectives.
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Solving those issues might require cooperation from other parts of government as well as industry, academia and civic society. Landmark net-zero pathways in the United States, for example, have been done by academics, but in close collaboration with private companies and the public sector. These lessons will be especially important in 2023 as the International Financial Reporting Standards’ International Sustainability Standards Board publishes key accounting guidelines on sustainability and climate reporting.
In Asia, implementation of the new accounting standards must take into account the region’s level of development on sustainability matters. The lack of data – especially from the small and medium-size businesses that make up the bulk of Asian economies – needs addressing, otherwise rules on indirect emissions disclosures (also known as Scope 3 in industry jargon) will not be meaningful. A phased approach will be necessary for many markets.
Failure to manage ESG regulations properly can have a chilling effect on the market. According to Morningstar, sustainable funds attracted US$147.6 billion of net new money globally over the first three quarters of 2022, a 72 per cent year-on-year drop. Poorly designed rules also raise compliance costs, which eat into the returns on green investments, in turn inadvertently punishing investors who are trying to be responsible.
This should not be read as an invitation to temper ambition. Indeed, the acceleration of climate change and biodiversity destruction in today’s world leaves no room for timidity. But it’s one thing to want to boldly go to one’s destination; it’s another to figure out how to get there.
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