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June 14, 2022

Of Woods, Trees, and ESG

by Dewi John.

Those working on ESG issues in the investment industry can get entangled in definitional complexities. The ecosystem of ESG terminology seems to grow daily. While it’s important, one should be able to see the wood for the trees, and the wood is this:

The latest Intergovernmental Panel on Climate Change (IPCC) report states: “The cumulative scientific evidence is unequivocal: Climate change is a threat to human well-being and planetary health. Any further delay in concerted anticipatory global action on adaptation and mitigation will miss a brief and rapidly closing window of opportunity to secure a liveable and sustainable future for all”.

Addressing this—mobilising sufficient capital to ensure a sustainable future before the window closes—is what the “E” in ESG is for. On the plus side, the theme of sustainability has taken hold of the UK market, as can be seen from ESG fund flows for last year (below).


Chart 1: Asset Class Flows, ESG v Conventional, 2021 (£bn)

Source: Refinitiv Lipper


Except that much of this cash isn’t going to do much to address the crisis that the IPCC highlights—something that may not be apparent to end investors.


Greenwashing and Gold Standards

One problem is the lack of a global ESG taxonomy means there is no data “gold standard”. Information can therefore be highly inconsistent, making comparison difficult, which can facilitate greenwashing.

While it applauds that “the rapid growth of the sustainable investment market confirms its potential contribution to filling the SDG financing gap”, the UN Conference on Trade & Development’s World Investment Report 2021 warns: “There are persistent concerns about greenwashing and about the real impact of sustainability-themed investment products… Funds should report not only on ESG issues but also on climate impact and SDG alignment.”[1]

Regulators are increasingly addressing these issues. The EU’s Sustainable Finance Disclosure Regulation (SFDR) is ahead of the pack. As with many first movers, however, there are teething problems, and it’s worth looking at these before addressing the implications for the UKs’ nascent Sustainability Disclosure Requirements.

SFDR has three fund categories: Articles 6, 8, and 9. Article 6 funds are those with no ESG goal. Article 8 funds promote environmental and/or social characteristics, provided that the portfolio companies follow good governance practices. SFDR Article 9 funds are “products targeting sustainable investments … where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark”.

There are about £1.5trn assets under management in Article 8 funds, and £154bn in Article 9 throughout Europe—roughly a 10/1 ratio.


Unintended Consequences

There are concerns that misapplication of SFDR designations will encourage mis-selling. An immanent MiFid II amendment requires distributors to ask investors if they want to take sustainability into account. Should the answer be yes, the distributor should then provide them only with Articles 8 or 9 funds.

But there’s concern that a focus on alignment with the regulation diverts from sustainable, measurable outcomes, which it’s reasonable to assume that investors have in mind when asked the question. For example, an Article 8 fund only needs to promote ESG criteria within its portfolio management process: no measurable ESG benefit is required.

The saving grace is that Article 8 funds must state what percentage of their portfolio is aligned to the taxonomy, which may assist investors. But how many will both know to do that and be prepared to put the spade work in to find out?

Arguably, the MiFid II amendment, though an improvement on the status quo ante, could still lead to a misalignment of both investor goals and outcomes, and outcomes versus Paris Agreement alignment.


Following On: The UK’s SDR

Last November, the FCA published its Discussion Paper 21/4 – Sustainability Disclosure Requirements (SDR) and investment labels, defining terms such as responsible, sustainable, and impact. Its three fundamental proposals for fund flags are Transitioning, Aligned, and Impact (see below, from p15 of the DP).


Chart 2: The FCA’s Proposed Approach to a Sustainable Product Classification and Labeling System

Source: FCA


However, this has already raised fears that it will be difficult to map funds to this, given that data availability and reporting for corporates could lag that of the downstream reporting of asset managers—something that’s already been an issue with SFDR.

In its response, responsible investment foundation Eiris stated: “grouping funds according to [transition, alignment, and impact] doesn’t work well when set against what funds are actually offering the consumer … The products or practices in a diversified portfolio will almost always contain a mixture of transition, alignment, and potentially high impact investments”.

The Investment Association’s response added “there is risk that the proposed design principle and five-stage labelling system could also prove too complex and difficult for consumers to understand”, and stated that the FCA-suggested categorisation doesn’t map well to SFDR. This is an issue given the need for consistent international standards, as raised in the UNCTAD report.

In summary, while progress has been significant, SFDR indicates that most assets are going to investment strategies that mitigate risk from environmental and social issues rather than investing in the transition to a sustainable economy. This may not be well understood by those investors opting for ESG assets.

While the FCA’s labels may not make the final cut, they illustrate a tension between trying to improve on SFDR and valid international comparisons.

[1] https://unctad.org/system/files/official-document/wir2021_en.pdf



This article was originally published in Personal Finance Professional.

Refinitiv Lipper delivers data on more than 330,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.

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