Regulatory change on the horizon

Whilst appetite amongst investors for integrating environmental, social and governance (ESG) considerations in their investment portfolios continues to gain momentum, corresponding developments in their fund managers have been somewhat slower in pace. Exclusionary screening is no longer enough to meet investor expectations and there is greater demand for funds with tangible ESG objectives and measurable impacts, with a growing recognition that ESG factors can offer a competitive advantage in the market.

Across Europe the industry is grappling with swathes of new regulations and updates to existing obligations, requiring significant changes across the operating model and increased operational burdens. Rules around disclosures, definitions and new taxonomies are difficult to interpret and confused further by a plethora of ‘soft’ regulation and the decision of the UK to not adopt EU rules.

The imminent implementation of the EU Sustainable Finance Disclosure Regulation (SFDR), the first deadline of which was 10 March 2021, has forced managers to adapt to market developments faster. SFDR requires disclosures at both company and individual fund or portfolio level, whether ESG factors are considered or not. Firms are grappling with many uncertainties and are waiting for the detailed “Level 2” rules to be issued in order to have a better understanding of the requirements. But whilst they wait, several factors are influencing the shape of their eventual implementation; namely:

     1. Many UK asset managers are applying SFDR to their UK companies and funds

Despite no onshoring of the EU SFDR rules by the UK Government, most UK managers will make disclosures about their UK companies and funds in line with the EU rules, until such time as any similar rules are introduced in the UK. In part, this is in order to provide consistent information about their investment process and products, but it is also due to pressure from UK investors requesting ESG strategies and information.

     2. Cautious approach in the UK to categorising funds

SFDR requires fund managers to categorise their funds between Article 6 (not having a specific ESG investment objective), Article 8 (“light green”) and Article 9 (“dark green”). Article 8 can be viewed as a spectrum, ranging from the barest of green products with minimal screening of the underlying investments, to products that perhaps select only the highest ESG-scoring assets. UK fund managers appear to be steering clear of the beginning of the spectrum and are categorising funds as Article 8 only if they fall firmly in the top half. The main reason for this is potential reputational risk. Before the Level 2 rules are finalised and extra guidance is given by regulators, firms are unwilling to put themselves in the position whereby products labelled Article 8 now must be downgraded subsequently to the lesser Article 6.

     3. Data quality and availability challenges are prevalent

Firms are struggling to access ESG credentials of relevant portfolio companies especially at the level of granularity needed to meet the EU requirements. This issue is especially problematic when attempting to disclose the principle adverse impacts (PAIs) of investment decisions on sustainability factors, given the breadth of data needed about the underlying assets. Firms will need to rely upon data from multiple data providers and their own engagement efforts, which will be costly and time consuming. ESG reporting is central to regulatory expectations, stakeholder credibility, client demands and the ability to effectively embed ESG considerations across the business.  However, knowing “what good looks like” from a reporting perspective is often unclear and is made even harder by the absence of quality data and aligned industry standards.

Making your ESG data work harder  

The lack of consistent data quality and the variety of standards means that firms are grappling to understand the ESG credentials of their underlying portfolio companies, often finding that those ESG credentials differ dramatically depending on which data provider is used. ESG at its operational core is, often, a data problem.

As the quality of corporate reporting varies, depending on the industry and region that the portfolio company operates within, multiple sources of ESG data are required in order to form a detailed picture of the investment.  Moreover, ESG risk exists more broadly in terms of supply chains, investments, people, infrastructure and in products. Failure to understand these new risks  can leave firms exposed to material reputational damage.

As a result, managers are increasingly turning to data providers and professional services firms for support to aggregate the multitude of ESG data sources.

Key questions that managers need to ask themselves as part of their ESG data strategy are:

• Is your ESG scoring methodology bespoke to you? There is now a desire for asset managers to be able to control their own definition of “good or green”. Does your ESG scoring methodology align to your investors, their investment philosophy and their ethos?
   
• Can you confidently identify truly “green” investment opportunities? To succeed, Asset Managers must now rely on multiple sources of ESG data to adequately assess ESG credentials. Do you have access to both structured and unstructured data?
   
• Is this data aggregated into a platform that is useable and helpful to your investment analysts?
   
• Do you have data lineage and transparency? Asset Managers should expect an increased importance to be placed on their ability to drill down on exactly what is contributing to the ESG credentials.
   
• Are you just using structured data to inform your analysis? Reliance on self-reported, structured only and often incomplete data sets is not going to provide a rich and current view of the ESG characteristics of a particular investment. Managers need to be able to consume unstructured data, real time news, social media, sentiment analysis, document language, web content and much more in order to provide a true view of a company’s ESG credentials.
   
• Can you adapt consumption of unstructured data? Read unstructured data and make sense of new data formats to accurately paint a reflective ESG picture of your portfolio’s?  KPMG’s own ESG Analytics tool uses a robust transparent and consistent methodology to create a bespoke score that is explainable to investors and regulators leveraging both structured data as well as unstructured data sets, allowing for example, greater transparency over more esoteric investments and private assets.         
   
• New regulatory requirements include the need to demonstrate effective ESG integration, enhanced disclosures and alignment to EU taxonomies. Does your data and reporting capability meet your increasing regulatory obligations?

Success criteria in implementing an ESG ‘culture’

Recognising that ESG requires a philosophical mind-shift as well as an operational one is critical. In KPMG’s recent Wealth & Asset Management “C-suite” survey, CEOs identified that their organisation’s growth will depend on their ability to navigate the shift to a low-carbon, clean-technology economy, both in their company and their portfolios. Better insight in how to capitalise on these opportunities will be necessary to promote long-term profitability and those firms not taking ESG seriously will face the risks of losing clients, employees and access to financing. With added pressure from regulators, and more importantly their peers, it is critical that businesses include these criteria into their strategy and business model.

These critical success factors are:

• Top down sponsorship from the CEO and the board is critical: without it any change will be short lived and will lack credibility.
   
• Appointment of a C-Suite sponsor to drive the end to end transformation and to ‘champion’ the ESG agenda.
   
• Investment into developing a comprehensive ESG strategy aligned to your corporate purpose, ethos and goals; it must be authentic.
   
• Engagement with your clients, your people and your external stakeholders to understand what matters to them and crucially “why?”  
   
• Communication, communication, communication. ESG matters. Avoid treating this as another regulatory box to tick.
   
• Engagement with specialists; ESG is far reaching and of critical importance yet it remains poorly defined with limited standards and common frameworks. Ask for help.
   
• Investment in execution of your strategy and ready the business for changes across the organisation; a strategy is only as good as the implementation.
   
• Understanding your regulatory obligations. Whilst meeting regulatory expectations isn’t the benchmark of success, it helps to prioritise what will be an important and long-term change initiative

ESG matters to your clients, your employees, your stakeholders and your shareholders. Regulators are increasing the expectation and will want you to prove you are acting responsibly and investing sustainably. ESG isn’t something you need to do, it’s everything you do and how you do it. It’s your licence to operate and your opportunity to lead.