Why the UK wants to be an ESG leader post-Brexit

The UK has a chance to draw first blood in the post-Brex­it war over sus­tain­able invest­ment report­ing. After leav­ing the Euro­pean Union, the UK quick­ly iden­ti­fied this area as a reg­u­la­to­ry bat­tle­ground, announc­ing its refusal to align with upcom­ing EU leg­is­la­tion and inten­tion to become a glob­al green finance leader.

But it is a risky move. Many UK fund man­agers warn that diverg­ing from EU rules could force them to nego­ti­ate clash­ing reg­u­la­tions. This could cre­ate uncer­tain­ty and weak­en their posi­tion in the lucra­tive field of sus­tain­able invest­ing. Diver­gence could also make the com­plex field of sus­tain­able invest­ing even hard­er for con­sumers to under­stand.

The stakes are high. Euro­pean assets invest­ed in envi­ron­men­tal, social and gov­er­nance (ESG) strate­gies are fore­cast to over­take those in con­ven­tion­al funds and reach a colos­sal €7.6 tril­lion by 2025, accord­ing to PwC.

The EU’s Sus­tain­able Finance Dis­clo­sure Reg­u­la­tion (SFDR), com­ing into force this March, could grow this even fur­ther as it effec­tive­ly forces man­agers to dis­close ESG issues.

In Novem­ber, UK min­is­ters made their first pow­er­play by refus­ing to align with the SFDR because tech­ni­cal aspects of the rules have been post­poned and not yet pub­lished. How­ev­er, they clear­ly see this delay as a chance to gain com­pet­i­tive advan­tage.

Instead, the UK announced plans for its own regime, in which it would become the first coun­try in the world ful­ly to man­date cli­mate dis­clo­sures for com­pa­nies and finan­cial insti­tu­tions. Many believe this stricter approach will spark a race to the top on ESG report­ing reg­u­la­tion.

The ESG race to the top

Sus­tain­able invest­ing has long been plagued by patchy or con­fus­ing mea­sure­ment and report­ing. Some asset man­agers’ claims have been over­ly pos­i­tive, known as green­wash­ing, leav­ing investors dis­il­lu­sioned. But as ESG becomes more main­stream, investors will demand more and bet­ter infor­ma­tion, and asset man­agers will have to respond. 

Sus­tain­abil­i­ty dis­clo­sures from com­pa­nies and fund man­agers have improved in recent years through vol­un­tary report­ing frame­works such as the G20’s Task Force on Cli­mate-Relat­ed Finan­cial Dis­clo­sures and Glob­al Report­ing Ini­tia­tive.

We want the UK gov­ern­ment to enhance sus­tain­abil­i­ty dis­clo­sures, with strong tax­onomies that dri­ve us in the direc­tion of net zero

SFDR is set to strength­en these inter­na­tion­al frame­works in the EU. But it does not force dis­clo­sure. Instead, play­ers can choose not to com­ply and explain why. Giv­en the huge and grow­ing pop­u­lar­i­ty of ESG invest­ments, they will have lit­tle choice in prac­tice. But the UK believes it has an oppor­tu­ni­ty to boost its green cre­den­tials in com­par­i­son by forc­ing all com­pa­nies to dis­close such infor­ma­tion, with no com­ply-or-explain option.

The EU’s post­pone­ment of the SFDR’s tech­ni­cal reg­u­la­tions, pos­si­bly until the end of this year, is nec­es­sary to ensure rigour in the con­sul­ta­tion process, but the delay is caus­ing uncer­tain­ty and might have hand­ed the UK gov­ern­ment anoth­er chance to grab the upper hand. 

Improving sustainability disclosures

James Alexan­der, chief exec­u­tive of the UK Sus­tain­able Invest­ment and Finance Asso­ci­a­tion (UKSIF), which rep­re­sents UK fund man­agers, says most of his mem­bers have some EU oper­a­tions. As such, they already align with SFDR as much as pos­si­ble or plan to.

“Some of our mem­bers have report­ed sus­tain­abil­i­ty well, some less so,” he says. “SFDR allows for a wide inter­pre­ta­tion; you can com­ply by doing a lot or slight­ly less. It is also not enough to get us to net-zero car­bon emis­sions.

“We want the UK gov­ern­ment to enhance sus­tain­abil­i­ty dis­clo­sures, with strong tax­onomies that dri­ve us in the direc­tion of net zero and that ensure lead­ers in ESG report­ing can dif­fer­en­ti­ate eas­i­ly from those who are doing less. That will make us the world leader.”

Anoth­er crit­i­cism of SFDR is it focus­es on dis­clos­ing infor­ma­tion about fund man­agers’ intent on ESG issues, rather than out­comes, which are hard­er to mea­sure but ulti­mate­ly more impor­tant.

Louisiana Salge, senior sus­tain­abil­i­ty spe­cial­ist at UK advi­so­ry firm EQ Investors, says EQ is already meet­ing SFDR dis­clo­sure stan­dards and will con­tin­ue to do so regard­less of Brex­it.

“We aim to lift fund man­agers to apply best prac­tice on ESG inte­gra­tion, process­es and report­ing,” she says. “These new stan­dards are a sig­nif­i­cant step towards achiev­ing that goal. 

“Most invest­ment man­agers have been lag­ging on trans­par­ent report­ing of sus­tain­abil­i­ty out­comes, leav­ing investors to doubt they are deliv­er­ing on their inten­tions. For exam­ple, we still see asset man­agers cal­cu­lat­ing car­bon emis­sions in ways that paint a wrong pic­ture of cli­mate change con­tri­bu­tion and risk.”

Salge says the EU tax­on­o­my – a set of def­i­n­i­tions that will help man­agers report ESG issues more con­sis­tent­ly with­in SFDR – will stream­line dis­clo­sure on funds’ intent.

“But that is just the intent,” she says. “Report­ing on tan­gi­ble impacts and out­comes is still miss­ing, though it would be high­ly ben­e­fi­cial.”

Will Brexit impede green cohesion?

Brex­it manoeu­vres must be seen in the con­text of glob­al sus­tain­able invest­ment report­ing ini­tia­tives. Region­al rules must har­monise with inter­na­tion­al stan­dards if the indus­try is to reduce com­plex­i­ty and inef­fi­cien­cy.

Sev­er­al ini­tia­tives are work­ing to increase glob­al cohe­sion and clar­i­ty. These include the Unit­ed Nations-backed Prin­ci­ples for Respon­si­ble Invest­ment, Inter­na­tion­al Plat­form of Sus­tain­able Finance and pro­posed new Sus­tain­abil­i­ty Stan­dards Board. 

Fur­ther­more, the Big Four account­ing firms have launched inter­na­tion­al ESG met­rics that aim to align exist­ing stan­dards. And final­ly, five stan­dard set­ters, which togeth­er guide most sus­tain­able invest­ing glob­al­ly, have agreed to align their frame­works.

In this con­text, the UK gov­ern­ment has pledged to match the lev­el of SFDR and align with glob­al stan­dards, a move wel­comed by UKSIF.

Andy Mason, senior ESG ana­lyst at Aberdeen Stan­dard Invest­ments, believes Brex­it will not affect these glob­al col­lab­o­ra­tions. “There’s an alpha­bet soup of ini­tia­tives and stan­dards,” he says. “Though we are UK list­ed, we have invest­ments glob­al­ly, so we need a sin­gle glob­al stan­dard. Mul­ti­ple region­al stan­dards lead to report­ing fatigue and sti­fle inno­va­tion.”

There will be a race to the top in prac­tice and dis­clo­sure. But the mar­ket is mov­ing fast.

But Julia Dreblow, direc­tor at con­sul­tan­cy SRI Ser­vices, says Brex­it is imped­ing bet­ter inter­na­tion­al rules. “The EU rules are help­ful but com­pli­cat­ed, high­ly pre­scrip­tive and use­ful parts of a puz­zle, rather than a mag­ic wand for deliv­er­ing net-zero car­bon,” she says.

“To deliv­er net zero, we will also need high­er-lev­el prin­ci­ples that avoid mis­lead­ing clients and ensure fair­ness and inter­na­tion­al­ly agreed stan­dards to steer us towards that tar­get. Both are being worked on. But Brex­it has slowed this activ­i­ty sub­stan­tial­ly and been a headache for many investors.

“For exam­ple, we were expect­ing to wel­come oth­er EU rules that oblig­ed finan­cial advis­ers to dis­cuss sus­tain­able invest­ment with their clients. But they seem to be on hold. The EU has been a pos­i­tive force in this area. Thank­ful­ly, the UK gov­ern­ment has sig­nalled a desire to match their aims and indeed lead in this area. So we hope these imped­i­ments will be short-term glitch­es, rather than any­thing more sub­stan­tial.”

Sarah Gor­don, chief exec­u­tive at the Impact Invest­ing Insti­tute, says that while SFDR is wel­come, the UK can go much fur­ther. “The EU tax­on­o­my address­es envi­ron­men­tal expo­sures com­pre­hen­sive­ly, but only touch­es on the vast spec­trum of social issues super­fi­cial­ly, with lit­tle more than a do-no-harm require­ment,” she says.

“There is much more to do. The UK has an oppor­tu­ni­ty to lead devel­op­ment of Euro­pean and glob­al think­ing on a social or ‘just tran­si­tion’ tax­on­o­my, which pro­vides a frame­work for con­nect­ing cli­mate action with an inclu­sive econ­o­my. The UK can build out the soci­etal impli­ca­tions of the green tax­on­o­my well beyond ‘do-no-harm’.”

Longer term, Gor­don expects Brex­it to spark a race between the UK, EU and oth­er coun­tries to boost green finance mar­ket cre­den­tials by pro­vid­ing the most effec­tive reg­u­la­tion.

“It is inef­fi­cient to oper­ate two stan­dards, so there will be a race to the top in prac­tice and dis­clo­sure,” she says. “But the mar­ket is mov­ing fast. This moment rep­re­sents an oppor­tu­ni­ty to take advan­tage of the momen­tum around sus­tain­able invest­ing and show glob­al lead­er­ship.”

Reshaping the asset management industry

Experts expect the SFDR to trig­ger an invest­ing rev­o­lu­tion by forc­ing all finan­cial mar­ket play­ers to dis­close infor­ma­tion on ESG  issues. 

Unless providers give good rea­sons for opt­ing out, the SFDR will oblige them to dis­close the sus­tain­abil­i­ty risks and adverse impacts in their invest­ments and their over­all approach to ESG.

For prod­ucts defined as ESG or sus­tain­able, SFDR will also require asset man­agers to report invest­ment goals before a sale and reg­u­lar­ly there­after. These require­ments will force many man­agers to rad­i­cal­ly change their approach to sus­tain­able invest­ing.

Though the main reg­u­la­tions will come into force in March, the Euro­pean Com­mis­sion has delayed pub­lish­ing tech­ni­cal details. This is because it needs extra time to con­sid­er the huge num­ber of respons­es to its con­sul­ta­tion on SFDR, under­lin­ing the sig­nif­i­cance of the changes to the indus­try and wider soci­ety.

This delay is caus­ing uncer­tain­ty for man­agers around how they will apply the new rules in March. But it is unlike­ly to dilute the commission’s deter­mi­na­tion that SFDR should align the finance indus­try with the EU’s Green Deal tar­gets, espe­cial­ly as 98 per cent of con­sul­ta­tion respons­es urged the com­mis­sion to uphold this ambi­tion.

Rodol­fo Fra­cas­si, co-founder and man­ag­ing direc­tor of con­sul­tan­cy Main­Street Part­ners, says SFDR will be a “game-chang­er” for asset man­agers because it oblig­es them to com­mu­ni­cate on how they inte­grate sus­tain­abil­i­ty risks, cal­cu­late adverse sus­tain­abil­i­ty impacts, and explain how they con­sid­er and pro­mote envi­ron­men­tal or social char­ac­ter­is­tics in their invest­ment process­es.

For prod­ucts defined as ESG or sus­tain­able, addi­tion­al require­ments will include report­ing on spe­cif­ic and ver­i­fi­able met­rics.

Any man­agers mar­ket­ing their funds in the EU will have to com­ply, says Fra­cas­si. “The alter­na­tive is to ignore ESG risks and com­mu­ni­cate that deci­sion, with poten­tial­ly severe busi­ness con­se­quences, giv­en the increas­ing demand for ESG prod­ucts.”

The reg­u­la­tions could also sift out weak­er ESG play­ers, due to the heavy invest­ment nec­es­sary for com­pli­ance.

“Mar­gins are already under pres­sure from pas­sive rivals, oth­er reg­u­la­to­ry bur­dens and tech­no­log­i­cal devel­op­ments,” says Fra­cas­si. “Com­mit­ting to this invest­ment will test the met­tle of many active invest­ment firms, espe­cial­ly small bou­tiques that lack the scale for large ESG invest­ments. 

“There are rewards; glob­al assets in ESG-dri­ven invest­ments are now over $40 tril­lion. But investors’ require­ments of firms that claim to sat­is­fy their ESG needs are sig­nif­i­cant and will only increase in future.”

Boosting global cohesion

New inter­na­tion­al met­rics from the World Eco­nom­ic Forum (WEF) for sus­tain­able val­ue cre­ation have boost­ed the momen­tum behind glob­al cohe­sion in ESG stan­dards. How­ev­er, some warn that suc­cess of the met­rics will depend on how com­pa­nies and investors use them.

WEF teamed up with the Big Four account­ing firms to devel­op the met­rics, which aim to help com­pa­nies and investors align report­ing on ESG fac­tors. Since their launch last year, more than 60 com­pa­nies, includ­ing Bank of Amer­i­ca, Mas­ter­card and Dell, have com­mit­ted to using the met­rics.

Cru­cial­ly, the stan­dards are based on exist­ing stan­dards and dis­clo­sures, and align with the Unit­ed Nations Sus­tain­able Devel­op­ment Goals’ four pil­lars of gov­er­nance, plan­et, peo­ple and pros­per­i­ty. This is help­ing accel­er­ate con­ver­gence between stan­dard set­ters around the world.

Dreblow says: “The 2008 finan­cial cri­sis and COVID-19 pan­dem­ic have high­light­ed the need for investors to remove their blink­ers and look at the sus­tain­abil­i­ty of com­pa­ny oper­a­tions. By work­ing with the Big Four, along­side oth­er excel­lent ini­tia­tives, the WEF recog­nised audi­tors’ role in long-term val­ue cre­ation and hold­ing com­pa­nies answer­able for their impacts.

“But if com­pa­nies focus on soft­er issues, such as vol­un­teer­ing and ‘engage­ment’ with stake­hold­ers, the met­rics will strug­gle to prove their worth. If they focus on car­bon emis­sions, and dif­fi­cult issues like diver­si­ty and fix­ing fail­ures in the inter­na­tion­al tax regime, they will be worth their weight in gold.”

James Alexan­der, at the UK Sus­tain­able Invest­ment and Finance Asso­ci­a­tion, says the asso­ci­a­tion and its mem­bers strong­ly sup­port the WEF’s promis­ing ini­tia­tive.

“The focus on the UN’s four pil­lars is vital in help­ing for­ward-think­ing investors recog­nise the inter­re­la­tion of eco­nom­ic, envi­ron­men­tal and social fac­tors in long-term val­ue cre­ation,” he says. “We want increased con­sis­ten­cy in report­ing to help meet the over­whelm­ing demand from investors for sus­tain­abil­i­ty-relat­ed dis­clo­sures.”

Sarah Gor­don, at the Impact Invest­ing Insti­tute, says all efforts to improve ESG report­ing, trans­paren­cy and account­abil­i­ty are wel­come, and the com­mit­ment by major com­pa­nies demon­strates the progress main­stream busi­ness­es and investors are mak­ing in this area.

“Ulti­mate­ly, all busi­ness­es and investors will have to dis­close their pos­i­tive and neg­a­tive impacts, so con­sis­tent glob­al stan­dards are the goal,” she adds.

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