How ESG Investing Is Regulated Globally: Rules vs. Principles
As detailed on its website, ISS ESG provides climate data, analytics and advisory services to help financial market participants understand, measure and act on climate-related risks across all asset classes.*
The firm recently published an extensive analysis of the current state of environmental, social and governance investing from a global perspective, drawing various parallels and distinctions between the way different regions and individual countries treat the evolving ESG topic.
According to ISS ESG, responsible investment has moved from being a niche activity to a mainstream investment proposition. While this move has been associated with record inflows and strong returns, it brings with it increased scrutiny from regulators and stakeholders. As such, one key section of the ISS ESG analysis zooms in on the role of regulation in shaping sustainable investing practices around the world. The section was authored by Lydia Sandner, associate vice president in regulatory affairs and public policy for ISS ESG.
As Sandner writes, sustainable finance regulation has developed significantly in the last few years, not only in terms of geographical spread and topics addressed but also in terms of the depth and detail of the requirements. At the start, regulations in any given region have broadly set out to improve transparency and reporting, as is currently the case in the United States, where the Securities and Exchange Commission has now put forward three distinct rulemaking proposals related to ESG-focused disclosures on the part of stock issuers, investment advisers and fund managers.
Thinking globally, Sandner writes, the very divergent product offerings in the sustainable investment space and growing concerns about “greenwashing” have caused regulators to feel a need to address this issue with more prescriptive requirements regarding product information and classification.
“Recent developments indicate that regulation might be moving a step further, with regulators looking at setting minimum criteria for product categories,” Sandner writes. “There thus seems to be an evolution from transparency regulation to a more prescriptive content regulation. At the same time, while some regulators prescribe exact key performance indicators and metrics, other jurisdictions appear to prefer a more flexible, principle-based approach to sustainable finance regulation.”
Rules Based Approaches
Sandner’s analysis compares the approaches being embraced by regulators in different regions of the world. For example, she notes how the European Union has chosen a rule-based approach, with many detailed regulatory initiatives spanning a significant breadth of topics.
“The EU has the most detailed taxonomy and related disclosure requirements,” she posits. “There are comprehensive technical screening criteria for each of the 13 sectors and 98 underlying activities covered by the Taxonomy, including precise quantitative thresholds. In addition, thorough criteria are in place to check for ‘do no significant harm’ criteria at the activity level, as well as provisions to ensure minimum social safeguards.”
Under the EU model, not only do issuers have to report on their “Taxonomy-aligned revenue” in their annual statements. Investors also need to publish statements of Taxonomy-alignment for their financial products, referencing environmental objectives to be attained as well as categories of enabling and transition activities. Specific templates have been created for both types of disclosure.
According to Sandner’s analysis, these requirements are far from the only ones that investment services providers must consider. For example, a benchmark regulation has also been put in place setting up two climate benchmarks and prescribing comprehensive minimum requirements for various types of green financial products. These are so far meant to be voluntary in nature, Sandner writes, but negotiations among the European Union’s co-legislators have seen calls for making them mandatory, however, if not immediately then at least in the future.
Sandner says the European Union’s approach has been criticized for overregulation as well as “unfortunate sequencing,” with investors having to disclose information that is not yet available from issuers, as regulation for both is being developed at the same time. In any case, the level of prescriptive regulation in the E.U. far outstrips anything embraced yet by U.S. market regulators. For its part, the United Kingdom is taking a similar approach to the EU, with its green taxonomy under development and its proposed labelling system for sustainable investment products. Under the proposed labelling system of the Financial Conduct Authority, products could fall under different sub-categories of “sustainable,” each with a series of predefined minimum criteria.
Sandner notes that, outside of Europe, there are also regulators that are choosing the rule-based route. In India, she writes, the Securities and Exchange Board of India (SEBI) is developing guidelines for ESG funds and looking into whether such funds should only include investments in securities that report against the Business Responsibility and Sustainability Reporting framework. The BRSR requires mandatory sustainability reporting for the top 1,000 listed companies in India from 2022 onwards, and it entails concrete sustainability metrics and a reporting template.
Principles Based Approaches
In parallel, Sandner writes, there are countries and regions that are opting for a more principle-based approach to sustainable finance regulation. These regulators prefer not to be prescriptive, she explains, and they instead leave certain flexibilities due to concerns around potentially hindering market innovation and technological development.
The application of such principles-based regulation may be on a comply or explain basis, Sandner explains. One example of this approach can be seen in Japan, where the Financial Conduct Authority is taking a flexible approach to the disclosure of transition strategies.
“Science-based roadmaps will be created but individual companies can then develop their own transition strategies based on the roadmaps,” Sandner writes. “This approach allows for diversity in pathways depending on the circumstances of each region, sector and company, as well as changes over time as technology advances. The credibility of the transition strategies will be assessed by external evaluation organizations based on a set of criteria.”
Separately, the FCA is formulating guidance on engagement with portfolio companies regarding climate risk management, the report notes. This guidance will contain basic concepts and case studies, but investors will be able to decide their own engagement strategies.
Sandner says the United States, via the work being done at the Securities and Exchange Commission, has so far chosen “a very individual and flexible approach to opposing greenwashing.” Instead of defining minimum standards and requirements for various categories of ESG funds, the SEC is checking funds for their ESG claims, she explains, thus leaving it to financial market participants to decide on adequate underlying criteria and approaches and whether they are disclosing these sufficiently. As noted, the SEC is currently considering substantial changes to its approach, with some critics saying the recently proposed regulations could be overly rules-based.
“While the approaches chosen by regulators around the globe differ significantly, especially with regard to the obligations they place on financial market participants, they share the same objectives,” Sandner concludes. “In 2022 it is likely that we will start to see evidence of which approach proves to be the most effective. It also remains to be seen whether there is an evolution from principle- to rule-based approaches as sustainable finance regulation becomes more extensive and mature in various markets, and whether there will be further development from disclosure to content regulation as well as from voluntary to mandatory application.”
*Editor’s note: PLANADVISER Magazine is owned and operated by Institutional Shareholder Services (ISS).