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ESG and Sustainability Insights

ESG in practice: The different strategic and regulatory standards

6 minute read time

We explore the different models that can be used to measure the credibility of ESG investments.

In the space of just a few years, environmental, social and governance (ESG) investing has been transformed from a minority interest into a key focus for investment funds, investors and corporates. During 2020, 253 European funds altered strategies in order to portray themselves as “sustainable”; while 505 new ESG funds were launched, according to data from Morningstar.

In part, this is simply because ESG-labelled funds and investments have performed well in recent years; a 2020 Morningstar study of 745 Europe-based sustainable funds showed that a majority had outperformed non-ESG equivalents over one, three, five and 10 years.

Yet it is still difficult to measure the ESG impacts of investment and business activity. For years, funds, investors and corporates have been forced to improvise ESG strategies, drawing on a sometimes confusing mix of guidelines devised by industry bodies and regulators. So which tools should fund and investment managers use to measure ESG performance of corporates and assets – and to inform the development of ESG strategies?

Defining purpose

Sharyn Jaques, Sustainability Lead for Institutional Banking at RBS International, says funds should start by focusing on their underlying purpose: “Funds need to work out what’s important to them and where they can make a contribution.”

They can then start using the available tools to build a framework for ESG strategies and assessment processes. The foundations underpinning the definition and measurement of ESG can be built on the UN Principles for Responsible Investment (PRI), which were launched in 2006 (“a pretty good starting point”, says Jaques); and the UN’s 17 Sustainable Development Goals (SDGs), adopted in 2015.

The SDGs provide businesses and funds with a choice of long-term goals to which strategies and products can be aligned. They relate to poverty, health, education, equality of opportunity and a range of environmental issues. Again, Jaques suggests funds focus on a small selection of the SDGs, rather than trying to track progress towards all of them.

The meaningful assessment of ESG impacts depends, above all, on the quality of the data disclosed by corporates and/or asset owners. In relation to the potential impact of climate change, one of the key issues of our time, these disclosures should be guided by recommendations made by the Task Force on Climate-related Financial Disclosures (TCFD) in 2017.

“There’s clear direction on TCFD and there is starting to be more clarity around SFDR, so you can piece together the requirements. That will only get easier in the future, as disclosure requirements become more standardised across the industry”

Kate McKeon, Sustainability Manager, InfraRed Capital Partners

“The TCFD is really a global standard, it’s almost a guiding principle: ‘This is what we think good looks like,’” says Phil Lloyd, Head of Market Structure and Regulatory Customer Engagement at NatWest Corporate & Institutions. “It offers a set of recommendations to enhance transparency on what firms from small corporates to large banks are doing.”

The regulatory roadmap

In recent years regulatory activity linked to ESG has also increased. The first phase of the EU’s Sustainable Finance Disclosure Regulation (SFDR) came into force on 10 March 2021. Some of its stipulations are still optional for many firms, but over the next few years the SFDR will impose sustainability and governance disclosure requirements on a broad range of financial products and firms in the EU. Fund managers must disclose how they have integrated assessment of sustainability risks within their processes. If a financial product has sustainable investment as a stated objective the fund or provider must explain how this objective will be achieved.

The SFDR is “the EU interpretation of the TCFD” says Lloyd, “but it is still quite high level. The big question is: What is a good disclosure; what does the data sitting behind it look like?”

The EU also introduced taxonomy regulation in 2020, containing the criteria to be used to determine whether a specific activity is environmentally sustainable. It is based on six objectives: climate change mitigation and adaptation, sustainable use of water, transition to a circular economy, pollution prevention/control and biodiversity protection/restoration. It includes reporting requirements for products labelled as sustainable or promoting environmental objectives.

The European Commission has also established a Platform on Sustainable Finance, comprising representatives from a range of private and public sector bodies, to advise it on the technical screening criteria in the taxonomy. Nadia Humphreys, a sustainable finance solutions product manager at Bloomberg, is a member of the platform.

She expects the call to prove taxonomy compliance to become more important in the future. “You are going to need to do due diligence that an off-the-shelf ESG product is taxonomy-compliant,” she says. “You will need to justify [your judgment].”

Implementing ESG: InfraRed Capital Partners

In November 2020, the UK government announced that the UK would implement mandatory climate-related financial disclosures by 2025; and that metrics used in the EU Taxonomy will inform the creation of a UK Taxonomy. In December 2020, the Financial Conduct Authority stated that from spring 2022 UK premium listed commercial companies will have to include statements in annual reports setting out whether their disclosures comply with TCFD recommendations.

Many funds and corporates have already worked proactively to align ESG strategies with TCFD recommendations and with the PRI. Kate McKeon, Sustainability Manager at the global infrastructure and real estate investment manager InfraRed Capital Partners, believes the acronym alphabet soup of ESG recommendations and regulations is becoming easier to use.

“There’s clear direction on TCFD and there is starting to be more clarity around SFDR, so you can piece together the requirements,” she says. “Assessing funds’ and corporates’ sustainability performance will only get easier in future, as disclosure requirements become more standardised across the industry and embedded into more organisations.”

InfraRed became a signatory to the PRI in 2011 and its infrastructure business has held a PRI score of A+, the highest attainable rating, since 2014. But McKeon explains that there has been an increased focus on ESG within the business during the past two years, driven in part by feedback from its own staff. The company has introduced a new sustainability reporting framework, using a wider range of sustainability key performance indicators. It has refined investment processes with sustainability fully integrated, starting with screening to ensure the business only pursues opportunities aligned with its sustainability policies. In addition, it has been a certified CarbonNeutral® company since 2019.

InfraRed, the specialist fund manager in the infrastructure and real estate sectors, manages several funds, including the two FTSE 250 listed investment trusts HICL Infrastructure, which invests in core infrastructure, and The Renewables Infrastructure Group (TRIG), which invests in solar parks and wind farms. HICL and TRIG have been reporting against the TCFD recommendations voluntarily since 2019.

InfraRed monitors market and regulatory developments closely on behalf of its funds. McKeon recommends that firms and funds look closely at their peers’ actions and strategies around ESG, taking advantage of the fact that firms are being unusually open about sharing work on this aspect of their business.

She also highlights the importance of getting buy-in to the ESG strategy at all levels of the business. “The commitment from the management team in driving this agenda has led to our significant progress, but it’s also about engaging with staff, so they understand your sustainability strategy … and [how] they are contributing to positive environmental, social and economic outcomes.”

Working towards best practice in measuring ESG impacts, developing an effective overall ESG strategy and ensuring regulatory compliance are all challenging problems for funds and other financial services companies, but we are reaching the end of the period when they are only optional extras. “It’s not a ‘nice to have’ any more, it’s a ‘must-have’,” says Jaques. It is clear that ever-increasing numbers of investors and regulators agree with her.

By David Adams