ESG: Looking Back to Move Forward

Lauren Anderson (Irish Funds) looks back at the introduction and expansion of Environmental, Social, and Governance (ESG) in corporate governance and business to identify the key challenges and subsequent lessons learned. Exploring the themes such as disparate ratings and harmonisation, the article outlines the insight gained from the nascent years of ESG to highlight the essential modifications and transformations required for ESG to be successful for the consumers, the environment, society, financial market, and regulators.

The Foundations of ESG

At the turn of the century, the world experienced boundless newness, some fleeting and some unpredictably lasting. The early 2000s saw the first global index, the popularisation of reality television, the development of Facebook, the creation of online day trading, the invasion of Iraq, and much more. Amongst the change, few would have anticipated the trend of Environmental, Social, and Governance (ESG) in corporate governance and business would define the decades to come.

Soon after the introduction of the term in the ESG lexicon, there was a clear demand by major institutional investors for companies to develop environmentally sustainable and socially responsible products. As a result, in the interest of the investor and in progressing the ESG objectives, both domestic and European regulators entered the emerging regulatory space. While the 2006 United Nations Principles for Responsible Investment (PRI) first required ESG criteria be incorporated into the financial evaluation of companies, the formative European regulation emerged from the Paris Agreement (2015). A roadmap to achieving the Agreement was set out in the 2030 United Nations agenda, which outlined 17 Sustainable Development Goals (SDGs). Specific to the finance industry, the European Commission outlined the Sustainable Finance Action Plan (SFAP, 2018) which aims to influence European and global finance to better and protect both the environment and society. The action plan resulted in three new European Union (EU) regulations:

• 2019/2088 on sustainability‐related disclosures in the financial services sector, referred to as the SFDR;

• 2019/2089 amending Regulation EU 2016/1011 regards EU Climate Transition Benchmarks, EU Paris-aligned Benchmarks and sustainability-related disclosures for benchmarks, referred to as the Benchmark Regulation; and

• 2020/852 on defining a common language and a clear definition of what ‘sustainable’ is, referred to as the Taxonomy Regulation.

Irish Funds: in the thick of it

The regulatory outcomes of the action plan have not been without their challenges. The Irish Funds Industry Association (Irish Funds) has been actively involved in the development, refinement, and implementation of the European Union regulation in Ireland by responding to consultations such as the European Securities Authority (ESA) consultation on Taxonomy disclosures under SFDR and the European Securities and Markets Authority (ESMA) consultation on fund names. Irish Funds, in collaboration with the working groups, has maintained steady, open, and honest dialogue with the Central Bank of Ireland (CBI) to enhance the regulatory clarity for the Irish fund industry. Looking back at the growth of ESG and the corresponding regulatory developments, it is clear there are lessons to be learned.

Lessons Learned

Firstly, consistency and harmonization are essential. The rapid demand for ESG related investments resulted in a barrage of products defined by inconsistent measurements and ratings. In 2006, the value of assets allocated to Exchange Traded Funds (ETF) that included ESG goals in their strategy was $5 billion, rising to $391 billion in 20211. In total, looking at the reporting on sustainable investment in 2020, approximately $35.3trn or more than a third of assets under management in big economies, were deemed sustainable. However, diverse definitions of sustainable and divergent measurement practices have complicated sustainable investment reporting. A recent study of six ESG rating agencies that found the agencies applied 709 different metrics across 64 categories; across the agencies, there were only 10 common categories and many of which do not include the basics such as greenhouse-gas emissions2. The subjectivity and thus, inconsistency across ESG rating agencies has resulted in misleading products which have been deemed harmful to consumer transparency and raises the apprehensions of the regulator. The lack of transparency and comparability of measurement has diminished ESG ratings and resulted in concern of knowing and unknowing greenwashing. Recognizing this issue, some have tried to make corrections. Recently, the Financial Times reported that the MSCI is overhauling its ESG rating amid increased regulatory scrutiny, which will result in the number of ETFs without an MSCI ESG rating to dramatically rise from 24 to 4623. Still, looking forward, it is important to harmonize measurements, ensuring common measurement practices and key areas of focus that will result in relevant data. Harmonization is essential across the ESG space.

Recent European regulatory developments have, in part, targeted the issue of inconsistency in ESG regulation, classification, and reporting. The sustainability‐related disclosures imposed on Financial Market Participants (FMPs) under SFDR was designed to ensure a harmonised ESG disclosure regime across Europe. However, the regulation was developed in haste, in a moment where regulation was needed but understanding on the specific requirements were unclear. As a result, the regulation is lacking in specific clarity (i.e., the definition of “sustainable finance”) and has, in the absence of a labelling regime, been applied in unintended manners. The disclosure regime is flawed with creating opportunities for false categorisation again, raising concerns over greenwashing. Recognizing the weaknesses, ESMA and other regulatory bodies are investigating gaps in the regulation to identify failings allowing for confusion or misuse. Recently, there has been a focused examination into whether, to attract the wealth of young savers who are more likely to express environmental and social preferences in investment choices, funds are using marketing and naming to suggest the ESG fund claims outsized sustainability investments and/or outperform mainstream funds. The concern is these claims are not buttressed by sustainability requirements or consistent performance indicators. Furthermore, there additional concernment over the use of “sustainability” or ESG related terms to charge premiums or “greeniums” to mitigate concern over declining fees. Currently, the use of sustainability terms in fund names and the potential for ESG premiums sit at the center of the ESG debate and will likely dictate forthcoming regulatory developments.

Looking Forward

The European Commission, recognising the issues with SFDR, have begun a review of the disclosure regime and a consultation is anticipated towards the end of 2023. Learning from the initial years of ESG regulation, to improve ESG strategies there must be an increase in clarity of guidance for compliance. The lack of clarity has created frustration and apathy across the ESG space; greater clarity will motivate FMPs to strengthen ESG disclosure compliance which will, in turn, better serve the investors. Furthermore, as new regulation is developed, such as with the ESMA guidelines on ESG terms in fund names (May 2023), ESMA’s analysis on greenwashing (May 2023), and the Social Taxonomy (as part of the SFDR review in 2024), or previous regulation clarified like with the forthcoming ESAs SFDR Q&A (May 2023), exhaustive and rigid clarity must be applied. Still, it is important investors are provided with options.

The ineffectiveness of ESG as it stands detracts from the goals of addressing real life, deeply important environmental and social concerns. Financial market participants and regulators are exhausted, consumers are both concerned and confused, and yet the fact is, ESG is here to stay. If ESG is to be successful for consumers, the environment, society, and the markets, everyone must be on board. ESG must continue to progress, learning from the lessons of the past. The challenges so far should not stop advancements but inform change, and the hope of perfection cannot be the inhibitor of progress.

1Published by Statista Research Department, and Aug 17. “ESG ETF Assets 2022.” Statista, 17 Aug. 2022, https://www.statista.com/statistics/1297487/assets-of-esg-etfs-worldwide.

2 “The Saviour Complex.” The Economist, The Economist Newspaper, 21 July 2022, https://www.economist.com/special-report/2022/07/21/the-saviour-complex.

3Heistruvers, Sandra. “Hundreds of European Etfs to Lose ESG Ratings in MSCI Overhaul.” Ignites Europe, 24 Mar. 2023.