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New ESG regulation from Europe redefines investment risk

When US financial regulators sent one signal after another last year that stronger surveillance of environmental, social and governance (ESG) and climate risks was imminent in the near future, the European Union was busy actually setting its sustainability goals. By mandating that financial advisors and managers in the EU view climate and sustainability as a fundamental investment risk, the new ESG rules will change the global standard for risk management.

What is the Sustainable Finance Disclosure Regulation?

the EU Sustainable Finance Disclosure Regulation (SFDR.)), which came into force in March, is intended to drive capital into sustainable investments. It is widely recognized as the most comprehensive regulatory measure to date in the field of sustainable finance. And for US firms trying to keep up with the rapid pace of ESG-related transformations in the financial sector, the SFDR could provide clarity.

The SFDR was initiated by the European Commission as part of a comprehensive EU action plan announced in 2018 to promote sustainable investments across the EU financial system and bring ESG issues on a par with traditional financial risk indicators. It is broad in scope and includes almost all asset managers, investment product providers and financial advisors operating in the EU. The first phase of the reporting standards is already in place and more and more detailed reporting requirements will be introduced in the coming months and years.

What do the regulations require from EU asset managers and financial advisors?

Under the SFDR, all asset managers in the EU (regardless of whether they are sustainable or not) are now being asked to make public: their approach to addressing sustainability issues; their investment decisions; any “negative impact” of investments on environmental or social factors; and all sustainability risks that can affect investment performance.

From January onwards, financial products that are marketed with ESG properties or as a “sustainable investment goal” will be additional Reporting requirements should prevent greenwashing.

Financial advisors must now advise clients on the sustainability impact of their investments – including the potential impact (negative or positive) on the financial performance of their investments.

The SFDR will act as a mandate for financial market participants to “do no harm” to society and the environment while protecting investors from undue risk from poor ESG positioning of their investments. The rules are designed to make sustainability issues a routine addition to existing financial disclosure and risk management requirements.

The regulations follow a “comply or explain” approach, in which managers and consultants who decide against the disclosure requirements must instead clearly explain why sustainability issues are not relevant. This effectively shifts the default assumption to an essential one, thereby integrating the consideration of ESG issues directly into the standard framework of risk management. Under this paradigm, failure to address ESG risks (e.g. risk to a company’s profitability from levying a carbon tax or disrupting the supply chain due to a flood event) could be viewed as a breach of fiduciary duty.

What does this mean for ESG and US companies?

The SFDR affects US companies through a direct channel: managers and consultants from non-EU countries who market financial products in the EU or advise EU companies are also covered. These are usually big players in the industry. BlackRock, for example, has his SFDR instructions publicly through his website. In one memo The company, released in March, reported that nearly $ 400 billion in assets fell within the scope of SFDR.

For most managers and consultants in the US, the SFDR will have a more indirect effect: it will catalyze a new standard for ESG risk accountability. The reputational costs of ignoring the sustainability aspects of risk management and the potential flight of capital in companies operating within this new paradigm now need to be considered.

The idea that sustainability issues could affect investment trustees in the US is not new. Over the past decade, political groups and academics have proposed revising (or reinterpreting) fiduciary investment standards to include sustainability issues. That fight They make that the best long-term interests for the majority of private investors cannot be fulfilled without considering ecological and social well-being – a short-term focus on purely financial goals is no longer sufficient.

The EU regulations will lead to more reporting of ESG risk data

One of the most transformative aspects of the SFDR can be its impact on corporate reporting. Big money managers already hungry for more quantitative ESG data are now vocation for information that is both mandatory and compatible with international reporting frameworks.

In order to meet this demand, external data providers such as MSCI, Refinitiv, Sustainalytics, Moody’s and S&P Global are now adapting their products to the data points required for compliance with the SFDR.

Taken together, the regulatory and cultural trends that drive corporate ESG and climate risk disclosure will ultimately set a new standard for high quality risk reporting at both the corporate and portfolio level. US managers and consultants who do not start integrating this data are unlikely to keep pace with evolving risk management standards.

Photo credit: Porapak Apichodilok / Pexels

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