The EU Commission along with other key European institutions, including the European Supervisory Authorities (ESA), has made a herculean effort since 2018 to implement the first phase of the HLEG recommendations.
For example, the process so far has led to a new EU taxonomy, adjustments to the Insurance Distribution Directive (IDD) and Markets in Financial Instruments Directive (MiFID) to introduce sustainability-focused suitability tests and progress in reforming the Non-Financial Reporting Directive (NFRD).
These initiatives have created more consistency around how sustainability is defined and disclosed to investors and broader society. Another HLEG-related rule now requires index providers to disclose how they incorporate (or not) alignment with the Paris Agreement on climate change into the development benchmarks – a critical component of portfolio construction and investment performance attribution.
Elsewhere, the overarching (Level 1) requirements of the Sustainability-related Financial Disclosure Regulation (SFDR) regime have encouraged more comprehensive integration of ESG factors into investment processes and even remuneration practices of asset managers and many other regulated financial firms.
In spite of these early positive moves, however, we have identified three broad areas of concern about the current status of the EU sustainability program and its trajectory.
First, the reforms rest on a disappointingly narrow definition of sustainability that highlights simple exclusionary approaches to investment instead of the more considered ‘stewardship’ approach of leading asset management firms.
Stewardship means “the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society”. We believe only stewardship of investment assets, combined with government and corporate policies, can deliver the kind of action we need to meet the major challenges facing the world, such as those outlined in the UN Sustainable Development Goals (SDGs) and the Paris Agreement on climate change.
If society is to address issues like climate change and inequality, then whole companies and industries need to change - and rapidly: the strongest tool investors have to drive this change is to use ownership rights to engage.
We suggest the EU sustainability program needs to set minimum expectations for stewardship – covering actual engagement and impact reporting, for instance – that require a higher degree of governance from financial supervisors. The EU could significantly improve the coming round of its sustainability action plan by introducing a new region-wide ‘Stewardship Code’, building on global best-practice foundations established under the Shareholder Rights Directive II.
Second, the overly prescriptive draft Level 2 Regulatory Technical Standards (RTS) set under the SFDR are not fit-for-purpose: as they stand the proposed rules won’t achieve the changes in investment behaviour envisaged by the high-level legislation – and indeed the HLEG itself.
In particular, the ‘principle adverse impact’ (PAI) reporting requirements of the RTS offer the worst of both worlds, proving too prescriptive in some respects and not nearly detailed enough in others.
The RTS and PAI indicators, as currently drafted, leave little scope for investment managers to set out how they identify key PAIs but more importantly, perhaps how they are working to mitigate them through engagement or advocacy. Instead of a nuanced set of standards designed to encourage and highlight real-world improvements through a more holistic approach to understanding ESG factors of relevance to the long-term value of investments, the current proposed approach is more akin to a box-ticking exercise.
Again, we would prefer a more principles-based approach to the SFDR that allows scope for sustainability practices to evolve and recognises the importance of using ESG integration to inform stewardship and advocacy practices at firms.
The RTS proposals also need to align with the newly developed EU taxonomy to enhance clarity and consistency across the whole regime. Fortunately, under a revised timetable the RTS rules won’t take effect now most likely until January 2022, allowing time to resolve the flaws and misalignments we have highlighted.
And finally, the EU must address taxonomy and timing inconsistencies throughout its sustainability action plan that threaten to undermine the effectiveness of the proposals.The SFDR (which regulates the users of the information) and the NFRD (which regulates the providers of the information) need to be linked through common use of the EU taxonomy, which should underpin reporting expectations. Without this confusion and potential delays to implementing the action plan properly are risked.
As explained above, the RTS start-date has already been pushed out but we expect the ESAs working with the European Commission will have to extend other reporting deadlines to ensure a smooth, logical transition to the new sustainability regulatory environment.