Unpacking European ESG Regulation
Solutions for sustainability investing
Head of EMEA, ICE Data Services
EMEA Index Business Development, ICE Data Services
Investing with an eye to Environmental, Social and Governance (ESG) factors has grown in recent years, with many investors telling us this will be a focus for the foreseeable future. Where does this interest come from? One driver is regulation. Over the last two years 170 ESG-related regulations have been adopted worldwide – more than the six previous years combined1.
Two international agreements are key to this proliferation of new regulations:
- Agenda 2030 (2015), a United Nations 15-year plan to implement 17 goals. Agenda 2030 looks at ESG as a whole, considering, for instance environmental issues as well as education, social inclusion, and partnerships to achieve its Sustainable Development Goals (SDGs).
- Paris Agreement (2016), part of the United Nations Framework Convention on Climate Change (UNFCCC). The Paris Agreement sets objectives to combat climate change by mitigating greenhouse gas emissions.
Not only have these agreements spawned many more regulations, but the principles behind them are being taken into consideration by a growing number of investors under the broad concept of “sustainability”. As a result, a diversity of approaches to sustainable investment has sprung up in recent years, for example:
- ESG integration: incorporating ESG factors into investment decision making and analysis to improve returns and reduce risk
- Negative screening: excluding securities that do not comply with certain ESG criteria (i.e. tobacco, controversial weapons etc.)
- Impact investing: investments into securities that have social and environmental impact
Many aspects of these approaches overlap. Fortunately, to help with the growth of interest in sustainable investing there has been a corresponding expansion of data to support it, particularly ESG ratings and rankings data. This data has offered investors insight for security evaluation and selection, but has also added an element of confusion. For example, there is not always agreement on what is considered “ethical” or “socially responsible”, as this can depend on perspective, or approach. As a result, the same company may have widely divergent ESG ratings from different providers2. In addition to the complexity introduced by different scoring methodologies, another risk undermining the credibility of ESG investments is so-called “greenwashing,” where certain criteria or metrics give the appearance of a company or investment adhering to a higher standard of sustainability than is actually the case.
Increasing Transparency
One possible answer to the challenges posed by inconsistent ESG scores is direct access to underlying raw data. Investors are turning to more granular metrics to help sort through what may actually be behind ESG ratings. ICE ESG Reference Data can offer assistance with just that, with hundreds of ESG attributes and indicators that may be financially-material, such as greenhouse gas (GHG) emissions reported, board diversity, benefits and many others, sourced from both company and publicly-available third-party sources. Using systematic monitoring technology to continuously check for source updates and teams of ESG data analysts applying rigorous research and validation processes helps ensure data integrity. To facilitate efficient research, comparison and decision making activities the data is presented in a consistent, normalized structure and linked to individual securities.
Investors are not alone in the desire for increased transparency. Regulatory bodies have been busy in relation to ESG, with both MIFID and UCITS (Undertakings for the Collective Investment in Transferable Securities) for instance, helping advance disclosure and investor protection. As a result, ESG will be considered a fundamental risk indicator, increasing the pressure for ESG-related disclosures in financial product prospectuses, whether or not the manager has been considering ESG as an investment factor.
But the original question comes back again: what can be considered as ESG-related activity? To answer this question the EU has been working on the EU Taxonomy. The EU Taxonomy (2020) seeks to define what activities can be considered “environmentally sustainable” to bring more transparency in financial product documentation regarding sustainable investment. It includes requirements for disclosure of how investments contribute to 6 defined environmental objectives and are aligned with sustainable economic activities.
Like the Sustainable Finance Disclosure Regulation (SFDR)3 the EU Taxonomy Regulation applies not only to product providers (i.e., UCITS managers, MiFID portfolio managers, pensions and insurance providers) but also to other financial market participants (FMPs). The new EU Taxonomy Regulation will be phased in, starting from Jan 2022 until Jan 2023, and the European supervisory authorities are tasked with developing additional technical standards.
What else is required from FMPs?
SFDR requires FMPs to make a number of disclosures to investors. Among other things, FMPs must publish on their websites information disclosing their policies regarding the integration of sustainability risks in their decision-making process. FMPs’ remuneration policies must also include information on how those policies are consistent with that integration. In addition, a statement must be made regarding policies in relation to any “principal adverse impacts” of investment decisions on sustainability factors, and details of how these were considered, and if not why. “Principle adverse impacts” will also be required to be disclosed by larger firms against products/investments in periodic disclosures once the Level 2 Regulatory Technical Standards (RTS) are adopted.
Similarly, additional disclosures covered in SFDR specifically address marketing and investment information materials starting from March 2021. For example, fund prospectuses (for UCITS and authorised AIFs) or other pre-contractual disclosures (for other financial products) must include descriptions of:
- how sustainability risks are integrated into the FMPs’ investment decisions and an assessment of the likely impacts of sustainability risks on the product’s return, or an explanation of why the FMP deems these risks not to be relevant;
- whether and how a product considers principal adverse impacts on sustainability factors (i.e. the negative impact of investment decisions) in qualitative or quantitative terms;
- where a product promotes environmental and/or social characteristics, (an “ESG-promoting product”), information on how these characteristics are met (including certain details on any index used);
- where a product has a sustainable investment objective and uses an index (a “sustainable product”), detail on how the index is aligned with the objective and how it differs from a broad market index (or where no index is used, an explanation on how the objective is to be attained);
ICE is scheduled to incorporate EU Taxonomy data disclosed by companies as well as other metrics in our ESG Reference Data model, which can be used as inputs to assessments and disclosures under SFDR.
Implementing Sustainability
While the EU Taxonomy initiative strives to increase transparency for sustainable investing, the European Green Deal provides an action plan to implement change. The European Green Deal is the European Union’s plan to make the EU’s economy sustainable. The action plan in summary is to:
- boost the efficient use of resources by moving to a clean, circular economy
- restore biodiversity and cut pollution
By targeting these goals the EU aims to be “climate neutral” by 2050. In support, the EU proposed a European Climate Law to turn this political commitment into a legal obligation. In order to achieve its objectives, the European Green Deal recognizes the importance of sustainable investment to allocate resources accordingly.
ESG has become a critical risk assessment element, and is also one of the goals of international cooperation. Indices are widely recognized as one of the tools that will help investors implement their sustainable investment objectives. ICE Data Indices, LLC (IDI) has a family of sustainability indices4 designed to help investors implement sustainability strategies ranging from those focused on ESG factors, to carbon reduction or green bonds.
There are many ways to create indices around ESG factors, but the primary approaches used for index qualification apply the following approaches: “screening”, “tilting” and “best-in-class”. Our new ESG indices start with a standard parent index. “Screening” is a basic technique whereby issuers are filtered out if they have exposure to certain activities. “Tilting” is a method that shifts weight away from issuers with worse (higher) ESG risk scores to those having better (lower) scores. “Best-in-class” is a method for selecting and shifting weight towards issuers with better ESG scores on a sector by sector basis so as to match the sector exposure of the starting index.
Beyond ESG factor scoring, there are many other ways to build indices around sustainability investing, and one of those is to lower exposure to countries with high carbon emissions. These indices seek to achieve a lower “carbon footprint” of a given parent index while maintaining similar risk or structural attributes. Details of our fixed income indices methodology can be found on the ICE Index Platform. IDI’s sustainability index family now includes more than 60 indices and continues to grow. Custom indices can be designed for client needs around thousands of available data fields from a number of providers.
1 https://www.ftadviser.com/investments/2020/05/18/esg-regulations-and-their-impact-on-advice/
3 Not applicable to the UK market at this time unless marketing products in the EU
4 Sustainability Indices do not take into account the EU Taxonomy disclosures nor the EU criteria for environmentally sustainable investments. Please refer to the Methodology for each of the IDI Sustainability Indices for additional information: /market-data/indices/sustainability-indices