Investors need clear, comparable information to understand sustainable investing. A range of new EU standards and reporting rules aim to facilitate this, but implementation will be challenging with a tight deadline. This gives the Grand Duchy an opportunity to create a lucrative niche to help bring these regulations to life.
Europe is the global leader for sustainable, environmental, social and governance (ESG) investing. It hosts more than three quarters of total global assets and funds in this sector, according to market analysts Morningstar. The EU wants to use this lead to build assessment and reporting norms to give investors and other stakeholders greater clarity. Luxembourg, Europe’s leading fund servicing hub, could be the place where this strategy is put into action. “Whilst strategic decisions on fund range and distribution might be taken at group level, significant implementation work will be required locally,” says Nathalie Dogniez (pictured), a partner at PwC Luxembourg.
There can be little surprise that a Luxembourg-based service provider thinks Luxembourg should be the place for this problem-solving role. Yet if history is a guide it will probably make sense to again centralise regulatory implementation expertise where the fund management companies are located (i.e. in the Grand Duchy) for tasks such as risk assessment, risk monitoring, prospectus updating and reporting.
Reporting is key
The Commission’s action plan features four key legislative thrusts: a directive to require all large non-finance firms to report their stance on ESG; a directive to make it clear how financial services firms are incorporating ESG into their strategies; a classification system (or taxonomy) to allow assessments to be made about the impact of climate-related activity; and a framework for understanding ESG benchmarks.
The first element of this plan is the non-financial reporting directive (NFRD). Since 2018 it requires firms with more than 500 staff to disclosure information about their operations in the light of ESG challenges. This features reporting on carbon emissions, biodiversity impact assessments, action on the gender pay gap, the approach to human rights, anti-corruption practices, and more. It is hoped that this information will guide the choices of investors, asset managers, consumers and policy makers.
An analogous approach is to be implemented for asset managers and pension funds from 10 March 2021 with the sustainable finance disclosure regulation (SFDR). These companies will have to make entity-level ESG disclosures in the same way as their non-financial counterparts. This will be required even if they don’t have an explicit sustainability-oriented investment strategy. Additionally, they will need to make product level disclosure of each fund’s ESG characteristics. This will apply to all funds, be they UCITS aimed at the retail market, or alternative funds destined for institutional investors and HNWIs. The distribution network and financial advisors will have to respond to these changes.
Quantifying ESG impact
Then from 2022 reporting will have to be in the light of the green investing taxonomy. Asset managers with an explicit environmental investment strategy will be required to calculate the percentage of their investments which conform to this classification. Alternatively they can issue a disclaimer to say that their fund does not have green investment goals. Also in 2022, there will be the advent of low-carbon benchmark regulation, which will provide a framework under which environmental investment ranking and rating systems work.
It is an ambitious set of proposals, which seeks to provide a universally accepted framework that previous private and public sector efforts have failed to achieve. The fundamental challenge is that notions of sustainability are highly subjective. These policies seek to go with the grain of this by giving stakeholders greater clarity. “Reporting is linked to disclosure and this gives taxonomy a raison d’être in terms of reflecting what sustainable finance means for different players,” notes Flavia Micilotta, sustainability leader at Deloitte Luxembourg. “Both areas complement each other: the taxonomy gives the reporting a voice, while without taxonomy, reporting would remain a fragmented exercise devoid of strategy.”
Timing a concern
Nevertheless the ambition of this agenda is causing some to worry. “The industry is concerned that the breadth and depth of the entity-level disclosure is so large that it will be nearly impossible for managers to provide the level of detail required,” said Sean Tuffy, head of market and regulatory intelligence at Citi, Ireland. The global Alternative Investment Management Association is also concerned that that this drive to promote ESG might cloud the image of funds seeking to provide investment to other important projects. “The diversity and heterogeneity of alternative investment strategies should be taken into account,” they said in a communiqué. ALFI has yet to take a position on the package of measures.
Timing is also a concern for the industry. Consultation is currently on-going, with the details of the SFDR being worked out alongside regulatory technical standards and a review of the NFRD. This consultation closes in September, with the rules expected to be published in December 2020 for implementation by 10 March 2021. Meanwhile the work on the taxonomy will continue, with 1 January 2022 targeted as the start-date.
For Julie Becker, Deputy CEO of the Luxembourg Stock Exchange and founder of the Luxembourg Green Exchange bond listing hub, implementation of these new rules “is still unchartered territory and more guidance is needed, especially in terms of harmonising the scope of different reporting frameworks.” This presents a major opportunity for the Luxembourg fund ecosystem. If it could grow to become an ESG investing problem solver for asset managers it would open up new areas in which to add value.