This piece originally featured in ESG Clarity and is available to view here.

When it comes to responsible investment and the integration of ESG factors, the alternative investment management industry is arguably at an inflection point: the conversation has shifted beyond what it means and whether it deserves serious attention, to how to approach it in practice, particularly in light of new policy and regulatory drivers, which are the focus of this piece.

2021 is set to bring new impetus to firms’ work in this area, as well as shine a light on new and existing challenges in this space.

Immediate compliance challenges in Europe

The European Union’s Sustainable Finance Disclosures Regulation (SFDR) is set to top the list of many firms’ compliance programmes for the early part of 2021 and has left market participants clamouring for answers to a host of implementation questions. Under the new framework, firms will be obliged to publish information about their policies on the integration of sustainability risks in the investment decision-making process, as well as information on how their remuneration policies are consistent with the integration of sustainability risks. Investment managers will also have to provide additional disclosures to clients about the way in which a product approaches sustainability risks, with more demanding requirements for green products and impact-oriented investments.

As it stands, there remains a significant degree of uncertainty about the scope of the new requirements and also how to delineate products for the purposes of the rules – something of fundamental importance to firms keen to avoid any risk of ‘greenwashing’. There are also more fundamental questions about the appropriate approach to derivatives or short selling.

At this point it remains to be seen whether the disclosure regime will lead to more meaningful approaches to sustainability or whether it will lead firms to take more conservative stances that reduce the potential for innovation.

A sharper focus on responsible investment in US policymaking

The new US administration is likely to change tack and move away from the scepticism towards responsible investment that characterised the Trump administration, as seen in the Department of Labor’s recent work on the topic of ESG integration and engagement by ERISA funds. But at the same time, a radical legislative programme is perhaps unlikely, given that Democrats do not possess a Senate supermajority.

Renewed regulatory focus, on the other hand, is pretty much a given, and individual states may seek to advance their own climate-focused rules. A key question will be to what extent developments in the US reflect the logic inherent in Europe’s Sustainable Finance Action Plan – that policy measures should help ensure that investment capital is channelled towards environmentally sustainable economic activities – or whether the overriding focus is on ESG as a risk management tool and limiting the scope for greenwashing. The latter seems far more likely at this stage.

Understanding the interplay of regional regulatory approaches

Sat between the poles of Europe and US, the UK is itself forging its own path on the green agenda, with a stated goal of matching Europe’s ambitions. We know that 2021 will see further work to elaborate this vision, including work to develop a disclosures framework based on the Task Force on Climate-Related Financial Disclosures (TCFD) recommendations. While there will undoubtedly be keen interest in the specifics of the UK approach – and whether it ultimately ends up being more accommodating of the breadth of investment strategies that sit within the alternatives umbrella – this also illustrates a broader point for globally-active investment firms: close alignment of rules across jurisdictions is unlikely, leading to challenges in terms of product design, marketing approaches and also day-to-day compliance complexity. It is likely that we will see firms search for the highest common denominator to be able to maintain a globally consistent approach, but inevitably we are likely to see areas where rules clash.

Squaring regulation and investor demand

While it is important to shine a light on the policy and regulatory drivers that will shape practice in responsible investment, it is equally important not to minimise the role of investor demand, which is likely to remain the factor that carries the most weight for the foreseeable future when it comes to firms’ practices.

As investors become more discerning, they are likely to ask increasingly demanding questions, challenging even managers that do not seek impact to understand and report the externalities (be that related to climate or other factors) associated with their positions. In this regard, we can expect regulation to become a way in which investors frame the conversation, effectively providing an external benchmark against which to assess firms’ practices.

2021 holds many challenges. But for firms that are able to respond with agility to regulatory drivers, it also offers definite opportunities.