As ESG becomes a core driver of asset allocation globally, the regulatory and legislative momentum behind ESG is intensifying. Up until last year, ESG disclosure and reporting had been largely voluntary, driven by growing demand from investors for increased transparency and information on sustainability and climate change. Regulators are now beginning to implement disclosure requirements aimed at boosting transparency and standardization, as investors and businesses struggle to navigate the ESG technicalities.
2021 has brought a proliferation of ESG related developments. The EU and the UK have been ahead of the US in adopting ESG-focused regulatory standards and disclosure requirements. In the US, most ESG disclosures are being made on a voluntary basis, driven primarily by investor demand, but the Biden administration is expected to usher in fast paced shifts.
EU Taxonomy and Sustainable Finance Disclosures - first of their kind
The most important ESG issue today is making sense of ESG data and disclosures. There are a multitude of ESG data providers and data points in the market. We currently do not have standardized methodology for evaluating or reporting ESG data, nor disclosing ESG information that various stakeholders may find useful.
This issue is being addressed by the adoption of the EU Taxonomy in Europe. The EU Taxonomy is a the first of its kind, comprehensive set of rules that will help investors, companies and issuers to navigate the transition to a low carbon economy. Its adoption will change the way we are looking at market financing and corporate activities. The EU Taxonomy is a list of economic activities within different sectors, with technical screening criteria to substantially contribute to and not to significantly harm environmental objectives. It describes what can be considered "green" and what can't, ending all subjectivity on the matter. European institutional investors and asset managers will have an obligation to disclose how their sustainable fund aligns to the EU Taxonomy. This legislation may well be incorporated by regulators across the world.
The other important piece of regulation, again from Europe is The Sustainable Finance Disclosure Regulation (SFDR). Introduced in March 2021, it requires mandatory ESG disclosures from asset managers and other financial market players. These rules mandate the financial market participants and advisers to integrate sustainability risks into their internal processes. The rules aim to help the investment sector meet the goals of 'The Paris Agreement' by stamping out greenwashing and driving capital towards environmental, social, and governance goals.
Expect the Biden administration led Securities and Exchange Commission (SEC) to formalize ESG disclosures with strong focus on climate regulation
The US SEC launched its own Climate and ESG Task Force earlier this year to focus its work on the sector, particularly regarding investment funds marketed as ESG-friendly. We await details, but it would be fair to assume that the US may also transition towards a formal rules based approach to ESG, similar to what we have seen in Europe.
The move to BRSR (Business Responsibility and Sustainable Reporting) from BRR (Business Responsibility Reports) will aid disclosures in India
In India too, we have seen some shifts in regulation and transparency around ESG reporting, with SEBI prescribing the BRSR as the new reporting format replacing the existing BRR. The BRSR has placed substantial thrust on environmental compliances by mandating many quantitative and qualitative disclosures with respect to energy consumption, water withdrawal, air emissions (including greenhouse gas emissions), waste management, sustainable sourcing etc. Recognizing the increased focus of investors seeking businesses to be responsible towards the society as well as in compliance with the United Nations Guiding Principles on Business and Human Rights, the BRSR lays down comprehensive reporting requirements regarding the measures undertaken for the well-being of employees, quantifying gender and social diversity indicators, performance and career development policies, health and safety management, accessibility of workplaces, equal opportunity, turnover rates and welfare benefits.
With a transition towards rules based and compulsory ESG regimes now underway, we will see manifold implications for investors, asset managers and corporates. The benchmark regulations will pave the way for standardised and detailed disclosures around sustainability factors.
The definitions of "green" and the related screening criteria that taxonomies offer will be useful tools to give financial institutions and investors clarity and certainty on the environmental sustainability of different types of investments. They can help to facilitate measurement and monitoring of sustainable financial flows.
The SFDR regulations will help investors by providing more transparency on the degree to which financial products have environmental or social characteristics, invest in sustainable investments, or have sustainable objectives. This information will now be presented in a more standardised way.
The world of ESG is shifting fast indeed.
Authored by: Abhay Laijawala, MD and Fund Manager, Avendus Capital Public Markets Alternate Strategies LLP