Environmental, social and governance (ESG) issues are increasingly central to fund managers’ investment strategies, and ESG investment has been on the rise for several years.
Deloitte predicts that at their current growth rate, ESG-mandated assets are on track to represent half of all professionally managed assets globally by 2024.
In Europe, for example, much of the anticipated growth will likely be driven by the adoption of new disclosure regulations in the European Union.
Since March last year, the Sustainable Finance Disclosure Regulation (SFDR) created three fund designations (Article 6, Article 8, and Article 9) based on the level of the investment manager’s incorporation of ESG characteristics in their investment decision-making process.
In short, the legislation creates three tiers of categorization for investment vehicles, with different disclosure requirements for each one.
Article 6 covers funds that don’t integrate any ESG factors into their strategies, while Article 8 covers the majority of today’s ESG funds. And at the strictest level, funds that fall under Article 9 include what are known in the industry as “dark green” funds, that is, those that specifically target the most sustainable investments.
Although ESG rating agencies have been around since before SFDR, with ESG reporting now required for all EU funds, they have become an essential component of the European investor’s toolkit.
With this in mind, the European Securities and Markets Authority (ESMA) has been investigating the market structure for ESG rating providers in the EU.
Following a call for evidence on the topic, the ESMA recently concluded that:
“The feedback we have received on the market for ESG rating and data providers is indicative of an immature but growing market, which, following a number of years of consolidation, has seen the emergence of a small number of large non-EU headquartered providers. In our view this market structure bears some resemblance to that which currently exists for credit ratings. Similar to that market, there are a large number of smaller more specialized EU entities co-existing with larger non-EU entities who provide a more comprehensive suite of services.”
Lessons from 2008
By drawing parallels between ESG rating providers and credit rating agencies (CRAs), the ESMA will likely appeal to a growing appetite in Brussels for regulatory safeguards for ESG rating products. It was with potential regulation in mind that the European Commission asked the ESMA to investigate the topic in the first place.
The comparison is a critical one for the EU, which only moved to regulate CRAs after the financial crisis of 2008.
Back then, the “big three” rating agencies were largely blamed for the U.S. subprime mortgage bubble, which in turn contributed to the subsequent eurozone debt crisis. In the wake of 2008, the EU established a regulatory framework for CRAs and introduced an oversight regime that included the creation of the ESMA.
The European Commission’s current interest in ESG rating providers and the ESMA’s comparison between the markets for ESG and credit ratings suggests that the EU learned an important lesson from the financial crisis. Namely, that allowing important investment processes to become concentrated in the hands of a small number of unregulated entities poses a risk to financial stability.
Just as investors in debt securities markets are often required by law and their own internal policies to hold only the safest securities, i.e. those that rating agencies designate triple-A, in the new landscape of ESG investing, investors bound by the new criteria of SFDR rely on ESG ratings.
But like credit scores, ESG ratings are complex to come by. To take just one example, Refinitiv, a subsidiary of London Stock Exchange Group, collects data on over 630 company-level metrics to calculate its overall ESG scores.
So, whereas the U.S. mortgage bubble was created by CRAs overestimating the creditworthiness of borrowers, in the context of ESG ratings, the risk is that providers inaccurately report companies’ performance on fronts as diverse as their carbon emissions, employment policies and human rights records.
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