SECTION 4 : ESG REGULATION
the minute details of how such policies will work in practice – and the past year has shown ESG does not lend itself to common understanding .
By December 2021 , the EU was already stating it would have to delay the implementation of SFDR ‘ level two ’ – which requires more granular disclosure on 18 principle adverse impacts statements ( PAIS ) among others – until January 2023 due to its “ length and technical detail ”, having initially been billed for January this year .
Since the delay , individual countries have also contested the content of SFDR categories . With nuclear and natural gas set to enter the EU taxonomy of sustainable activities in 2023 , the European Supervisory Authorities ( ESA ) were asked to suggest disclosure requirements for the energy sources to be used under the SFDR from next year .
This could create divergence on how the regulation is treated on a national scale , with Austria and Luxembourg previously threatening to bring a lawsuit against the EU for including nuclear in its taxonomy . Meanwhile , although climate transition benchmark ( CTB ) -aligned ETFs are allowed to have fossil fuel exposure and are often categorised under Article 9 , the Danish Finanstilsynet ( FSA ) previously said ‘ dark ’ green funds have no excuse investing in high polluters .
Looking away from the regulators and toward the parties they are trying to regulate , it is clear the fog has not been lifted on ESG data gathering and how these metrics are transmuted into ratings and subsequently , indices .
By the end of 2021 there were more than 600 ESG rating frameworks , according to thinktank SustainAbility , and by summer this year there were 59 ESG data providers operating in the EU , as per the European Securities and Markets Authority ( ESMA ). On the rating process that turns raw data into scores used to weight securities in benchmarks , French regulator Autorité des Marchés Financiers ( AMF ) in June called for regulation requiring transparency on rating methodologies , underlying data used , conflict-of-interest management and product objectives .
A month later , ESMA said it had received 154 pieces of industry feedback lamenting ESG ratings providers ’ opacity and a lack of granularity in their underlying data .
In August , the EU published responses to its proposal to regulate the ratings sector , with 80 % of 168 private companies , central banks , public authorities and NGOs supportive of some
“ THIS PAINTS A VERY DIFFERENT PICTURE TO ASSET FLOWS IN Q2 WITH INVESTORS APPEARING TO LOSE FAITH IN ARTICLE 8 PRODUCTS AFTER PULLING € 30.3BN , ACCORDING TO DATA FROM MORNINGSTAR ”
form of intervention while 90 % identified a lack of transparency as their main concern within the sector .
Unsurprisingly , dominant ratings providers such as MSCI , Morningstar – owner of Sustainalytics – and London Stock Exchange Group – owner of FTSE Russell and Refinitiv – were among the largest opponents to ratings regulation , instead favouring non-binding principles of good conduct .
Interestingly , the FCA added to the debate in September with its ‘ Dear CEO ’ letter , which noted it would further scrutinise the construction and labelling of ESG benchmarks as the subjective nature of how data and ratings are turned into investment products could create a “ trust deficit ” in passive ESG funds . Last year , the Treasury considered bringing data and ratings providers within the scope of FCA regulation .
As it stands
After a trying but necessary year of reflection , it is clear investor enthusiasm for ESG and the EU ’ s SFDR has been tempered .
In March , the Brown Brothers Harriman annual ETF investor survey found SFDR Article classifications were the number one tool used by professionals when selecting ESG ETFs .
This paints a very different picture to asset flows in Q2 with investors appearing to lose faith in Article 8 products after pulling € 30.3bn , according to data from Morningstar .
Such an exodus likely owes to a lack of gatekeeping on Article 8 , with 700 products switching to the ‘ light ’ green category over the first nine months of 2022 alongside zero downgrades to Article 6 – prompting Morningstar to note 23 % of Article 8 funds now do not meet the criteria of an ESG fund .
The hope is ‘ level two ’ of SFDR will be a moment of reckoning for greenwashing culprits which are not able to live up to the criteria for Article 8 and 9 membership based on more granular reporting requirements , however , there is a possibility that reporting on the majority of ETFs falls short , which could force regulators to backtrack .
It also bears remembering that to remain aligned , SDR will likely have to implement its own phase two in due course . Even if this is done successfully , the transition period of the EU ’ s Benchmark Regulation ( BMR ) ends in January 2024 , meaning all non-BMR compliant indices will be inaccessible to EU investors . ESMA expects more index administrators in the UK to apply for recognition but at present , only 3 % of third country indices used in the EU have BMR authorisation .
Elsewhere , the IFRS ’ s slower-moving ISSB has issued two disclosure standards on sustainability-related financial information and climate-related disclosures . ESMA said the EU ’ s regional and IFRS ’ s international frameworks must “ go hand-in-hand ” but unfortunately , the ISSB has more of a single materiality focus versus the EU ’ s double materiality approach to ESG .
One hope if that the European Single Access Point ( ESAP ) – a free-to-access portal of corporate data to be launched in 2024 – will feed into ESMA and create a machine-readable and standardised database for sustainability and more , however , this and standardisation of ESG in Europe , remain a long way off .
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