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Regulating the Growth of ESG Investing

A look at the landscape of ESG regulation around the world, across three main areas

Andy Pettit and Aron Szapiro

 

The growth of environmental, social, and governance investing has been astronomical over the past few years. Our latest report, “The Evolving Approaches to Regulating ESG Investing,” shows that investments in European and U.S. ESG-oriented funds increased 44% between the end of 2014 and the end of 2018, reaching a total of EUR 761 billion (further detailed in the Morningstar Sustainability Atlas and U.S. Landscape Report). This growth naturally leads policymakers to examine a spectrum of ESG regulation and policy interventions to facilitate sustainable investing. 

In this report, we explore the scope of these interventions across three broad areas and how regulators’ ambitions vary by location. 

ESG regulation in investment management and advice 

European policymakers have been at the vanguard of this effort with the European Commission’s Sustainable Finance Package of Measures, the multiple elements of which continue to move through the legislative process and are expected to be adopted this summer. This package includes amendments to the Markets in Financial Instruments Directive (known as MiFID II) and the Insurance Distribution Directive that would require advisers to establish their clients’ ESG preferences during suitability assessments. 

Along with the changes to MiFID and IDD, the Undertakings for the Collective Investment in Transferable Securities Directive and the Alternative Investment Fund Managers Directive—Europe’s overarching investment fund rulebooks—are being revised to embed sustainability risk considerations into the investment decision-making process.  

Europe’s efforts to align ESG regulation across the spectrum of investment vehicles is to be commended. However, we are concerned about proposals that would require asset managers to report on the extent to which sustainability risks are expected to impact returns. This question is a subjective matter and may confuse rather than enlighten investors. 

In sharp contrast, the majority of ESG regulation in the U.S. has emerged as a result of the Employee Retirement Income Security Act of 1974, which largely governs retirement advice. This act placed restrictions on economically targeted investments, which has effectively been applied to ESG factors, and therefore blunted the availability of ESG strategies as part of retirement plans.  

In other words, in the U.S., ESG selection must be justified by explaining why it is necessary for an investment, while in Europe it must be explained why ESG factors are not considered. 

ESG regulation in disclosure and governance 

Stakeholders should have access to a gamut of information, including a product’s approach to sustainability in its selection of investments, if and how its managers engage with their investee companies, how managers vote on shareholder resolutions, and how a product performs against its objectives. 

Though these standards of disclosure are currently highly fragmented, it’s a positive step forward that most recent regulatory proposals include a “comply-or-explain” clause. These proposals will increase the likelihood that investors will have access to more-complete information about products’ ESG credentials. 

Examples of ESG regulations around disclosure and governance include: 

  • The European package’s new regulation on disclosures, which should help align standards across investment, insurance, and retirement products. Encouragingly, given both the longer time horizons and that it is the channel through which most people invest, the retirement segment is furthest down the track.  
  • Existing and upcoming rules in Europe and the U.K. require disclosure of how products weigh ESG considerations, as well as their policies in relation to the stewardship of investments.  
  • In the U.S., the SEC has long required disclosure of votes on shareholder resolutions. Steps that shed additional light on these activities and on engagement policies can be valuable for investors. 

Indeed, it’s very likely that raising the bar in one country will lead others to increase the quality of their disclosures. 

ESG regulation toward a sustainability investment language 

Without a level playing field, it can be difficult for investors to compare products and determine what constitutes a sustainable investment. Worse, this lack of standardization heightens the risk of green-washing, where products might exaggerate their ESG credentials. 

The good news is that several groups have been looking for solutions, including nonregulatory bodies. For instance, the Task Force on Climate-related Financial Disclosures and the Sustainability Accounting Standards Board have developed qualitative and quantitative industry-specific disclosure standards. 

International standardization is potentially more important in this area than in any other aspect of sustainable investment regulation. Convergence of these workstreams into a common sustainable investing language can play a vital part in ensuring investors can assess competing products fairly. 

Well-designed ESG regulations can provide a strong platform for continued growth, and it’s reassuring to see activity in this area. With more-consistent standards in place, products are likely to be comparable and understandable to investors, and costs are likely to be lower. 

For the full analysis of the ESG regulatory landscape, download “The Evolving Approaches to Regulating ESG Investing.”

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