Environmental, Social and Governance (ESG) refers to the three key criteria when measuring the sustainability and ethical impact of an investment in a business or company. When thinking about ESG, environmental issues such as protecting ecosystems and climate change spring to mind however ESG goes beyond environmental factors. The term is also colloquially known as socially responsible investing, ethical investing and is essentially any investment strategy that focuses on financial returns whilst simultaneously doing social good. ESG has become very popular in recent years following the financial industry’s bid to provide sustainable finance.
The three key criteria are as follows:
- Environmental – Environmental issues or considerations pertaining to the functioning of the natural environment and systems e.g., deforestation and resource depletion.
- Social – Social issues or considerations relating the rights, wellbeing and interests of people and communities e.g., working conditions and protecting local communities.
- Governance – Governance issues or considerations relating to how a firm governs itself e.g., board diversity and executive pay.
The ESG framework is a subset of non-financial factors that determine how far advanced companies are with incorporating sustainability. What constitutes to an appropriate ESG criteria is subjective and can be based on various elements such as impact, sustainability, and own corporate/personal values. As the world is changing, investors are also changing therefore new risk factors are constantly being introduced as global sustainability challenges increase. As a result, new laws and regulations are implemented to prevent issues resulting from risks such as greenwashing.
EU Taxonomy regulation and SFDR
The core parts of the ESG regime are the EU taxonomy regulation, SFDR and amendments to AIFMD, UCITS and MiFID. The EU taxonomy regulation permits investors to determine whether an economic activity falls under one of the ESG components thereby discouraging the act of greenwashing. In June 2020, the European Commission proposed changes to incorporate ESG considerations into the AIFMD, UCITS and MiFID regimes. The SFDR comes into effect in March 2021 and the aim is to enhance the disclosure and transparency around products with legitimate ESG credentials. SFDR acts as a pathway to other regimes and product specific obligations that will trigger further obligations necessary to disclose under the EU taxonomy regulation. A new harmonised approach, in turn, prevents ‘greenwashing’ which is the act of marketing a financial product as environmentally friendly when it is not.
The scope of SFDR is very broad and applies to Financial Market Participants (FMPs) and Financial Advisors (FAs). In other words, all EU regulated firms that are subject to AIFMD, UCITS and MiFID regimes. The regime will require firms to make disclosures at product and firm level.
- An article 9 product is a product that has sustainable investment as its investment objective. Sustainable investment is defined in SFDR as an economic activity that contributes to an environmental objective or a social objective provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices.
- An article 8 product promotes, among other characteristics, environmental or social characteristics or a combination of both, provided that the companies in which the investments are made follow good governance practices.
- Out of scope products are essentially the products that do not fall into article 8 or 9 and therefore, sustainability is not a mandatory part of the investment process.
The regime requires firms to make more detailed and extensive sustainability-related disclosures in pre-contractual documents, periodic reporting and on websites.
- Public disclosures must be available on the firm’s website which includes a description of environmental or social characteristics/sustainable investment objectives.
- Information on the methodologies used to assess and measure impact including data sources and screening criteria.
- Private disclosures in the form of pre-contractual agreements between firms and investors must show how environmental/social characteristics are met for article 8. For Article 9, this will highlight how the investment objective will be attained.
- Periodic reports will need to be updated to show the extent to which the environmental and/or social characteristics are met.
Firms with more than 500 employees are required to disclose their policy on the integration of sustainability risks into investment decision making and advisory processes. FMPs must publish a policy on the integration of sustainability risks in investment decision-making. Similarly, FAs must publish a policy on the integration of sustainability risks in their advice.
Additionally, these firms must consider and disclose the principal adverse impact of sustainability factors on investment decisions and investment advice. There must also be a clear explanation whether and how each financial product considers these adverse impacts on sustainability.
Firms with less than 500 employees have a choice to comply however are required to issue a statement explaining why they have not obliged. However, all firms regardless of size must update their existing remuneration policies to confirm how those policies are in line with the integration of sustainability risk.
It was assumed that the UK government would onshore the equivalent of SFDR and the EU taxonomy regulation however as the UK is approaching the Brexit deadline, there has been no mention of SFDR or the EU taxonomy regime yet. Therefore, it can be assumed there will be no March 2021 deadline for UK authorised firms operating in the UK. However, it is likely the UK will introduce its own course of action around ESG disclosures and greenwashing post-Brexit.
How can we help?
Complyport can assist you with any ESG-related regulatory enquiries. We can assess and identify how the ESG disclosures apply to your business and products, update your firm’s ESG framework so you are compliant to the regimes, guide you through the governance around the investment process and more.
We continuously stay up to date on all the latest government and FCA’s discussions around the EU’s sustainable investment package and are currently assisting several regulated firms throughout the UK and the EU to future proof themselves as best as possible against the complexity of the regimes. Get in touch with us today.