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ESG Regulations are Here - Are Firms Prepared

Consumers, NGOs, the media, shareholders and larger institutional buyers including retail, brands and manufacturers have been pressuring firms to disclose their environmental, social and governance (ESG) practices.

This has

come in the forms of corporate reports as well as within disclosures in financial documents. However there has been very little in the form of a consistent methodology and approach which can lend itself to some firms, fund managers and rating firms to game the practice and/or provide misleading claims also known as greenwashing.

However, all this is about to change. Earlier this year, the European Union (EU) established the Sustainable Finance Disclosure Regulation, or SFDR. The EU now requires all fund managers that raise money in the 27-country bloc and claim a socially conscious aspect in their offerings to disclose exactly how they address environmental, social or governance considerations. This includes MiFID investment firms that provide portfolio management, alternative investment fund managers (AIFMs), and UCITS (or their management companies).

The areas of ESG focus can span from greenhouse gas reductions, solar investments, green chemistry to social diversity efforts.

The SFDR policy was commissioned by the EU’s High-Level Expert Group (HLEG) on sustainable finance which created roadmap for the EU to pursue two goals: (1) Integrate sustainability considerations into the financial system, and (2) Steer the flow of capital towards sustainable investments.

These new rules apply to money managers doing business in the EU-it does not matter what country the money manager is based-therefore U.S. managers will be affected. Additionally, there could be further momentum. Recently, the Biden Administration's Department of Labor (DOL) also recently announced it wouldn’t enforce a Trump-administration rule enacted at the end of his administration that discouraged ESG funds in 401(k) plans. Major American firms such as BlackRock have pledged to incorporate ESG approaches into their operations and the UK while no longer part of the EU has indicated they will align with the EU policies.

So what is required?

For Companies, they must disclose:

  • Information on how an entity integrates sustainability risks in its investment decision‐making process or financial advice;

  • A statement on policies about how an entity considers Principal Adverse Impacts or "PAIs" on sustainability factors.

  • Information on how remuneration policies are consistent with the integration of sustainability risks;

  • Pre-contractual disclosures on sustainability risk integration, including assessments of how the performance of financial products may be affected by those risks.

And for their products, companies must:

  • Consider PAIs, an explanation of how financial products account for these impacts should be provided. This applies to all the firm’s products, whether they are intended to meet sustainability goals or not;

  • For ‘Article 8’ products that promote “Environmental” or “Social” characteristics, there must be additional information on how these are met, including disclosure on the degree of Taxonomy alignment of underlying economic activities

  • For ‘Article 9’ products that have sustainable investment as an objective, there must be an explanation on how the objective is achieved as well as additional disclosure on alignment with the EU Taxonomy Regulation.

The Importance of ESG

A recent report by US SIF Foundation indicates that the amount of professional money managed using all three ESG criteria has risen sharply and now represents 33% of the $51.4 trillion in total U.S. assets under professional management - a 42% increase over 2018.

And the pressure by shareholders on companies and their executives to address social and environmental issues. In fact, even during the pandemic there were 21 shareholder resolutions receiving the majority of support by investors related to social or environmental issues which is an increase from the prior years.

ESG investing is only going to continue to grow-now the systems, processes and transparency must follow.

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