Luxembourg is set to bear a big responsibility for making the green financial revolution happen. But are the rules of game clear enough, with reporting set to begin in just over a year’s time? And what role can Luxembourg’s fund service providers play?
Sustainable investing has quickly become mainstream. Fund industry analysts Morningstar pointed to a 58% increase in assets being invested in sustainable products last year. Larry Fink of BlackRock said last month we are witnessing “a fundamental reshaping of finance” towards sustainability.
Dark green only?
Fine, but commentators have been talking about “The Green Bubble” for over a decade, as too much money can chase too few clearly green projects. There is evidence that yields are tumbling on green investments. Some argue that the above average stock market valuation of electronic vehicle firm Tesla is being driven partly by the hunt for credible green investment options.
Mostly, notions of “sustainability” are in the eye of the beholder. Environmental labelling schemes have not taken off for this and other reasons. For example, Luxembourg’s industry-run LuxFlag label plays it safe, requiring over half of fund investments to be in projects that are whiter-than-white regarding a set of tough environmental, social and governance (ESG) metrics. Yet this bar has proved to be too high, with only just over 150 funds with assets of a mere €50bn receiving these labels.
Reporting first, but reporting what?
Hence the European Commission is trying a more subtle approach, based on defining degrees of risk and reporting on these. However, some asset managers are nervous that the EU is requiring them to report of their ESG stances before giving guidance on what ESG means.
The 27 November 2019 EU regulation on “sustainability‐related disclosures in the financial services sector” will require, from March 2021, each product to disclose the extent to which they are exposed to sustainability risk, how those risks are being monitored and the outcomes. Yet for Nathalie Dogniez (pictured), a partner with PwC Luxembourg “funds could believe they are creating a green fund in good faith, only to find out in a couple of years that their assessments do not match those of the Commission.”
Defining ESG
The work at the Commission to define ESG is likely to take two or three more years to complete. They want to define shades of green for investment, rather than the sharp green vs brown dividing line that predominates at the moment. “The aim is to develop a methodology that encourages sustainability in all sectors—such as heavy manufacturing for example—just as much as for more obviously green activities,” said Dogniez. For example, a traditional car maker that invests above industry norms in electric mobility could be rewarded with a higher ESG-rating.
Every economic sector will be screened in depth and a detailed classification will be made of which types of activities are more or less green. It is a major task and the results are likely to be controversial. Yet it has the potential for allowing asset managers to create investment products that seek to maximise genuine sustainability impact. In an era when active asset managers are losing ground to passive funds, this has potential for stock pickers to genuinely add value by attaching their reputation to their ESG choices.
ESG risk
On top of this, the rules of Mifid II are in the process of being changed. At the moment retail clients undergo a “suitability test” to ensure their personal financial risk preferences match the risk-profile of products suggested by a financial advisor. In the future, investors’s appetite for ESG risk will also be probed. For example, a client might want to focus on financial returns for the vast majority of their portfolio, but they could also wish to help encourage moves towards sustainability for some of their investments.
In other words, asset managers will have to give more information about their product’s green profiles, and investors will be given greater awareness of the shades of green of their portfolios. Both the taxonomy and the reporting will be “equally transformational” says Dogniez.
Luxembourg needs to react
Luxembourg’s investment fund service providers will need to react to this reality, principally in terms of ensuring compliant yet effective reporting. There could also be a role in assessing the ESG risk of different investments, which would give asset managers the data they need to add shades of green to their portfolios in an impactful way.
“At the moment, many listed companies are undervalued or overvalued because markets are not taking account of ESG risks and opportunities, and these are not embedded in share prices,” said Jane Wilkinson, an ESG consultant. Asset managers need to acquire the ability to understand these dynamics. Can Luxembourg supply the tools?