Fund Governance Insights

ESG trends in 2021: momentum, principles, and assurance

3 minute read time

A number of factors have driven the increased regulatory interest in ESG in 2021. Front-and-centre has of course been the COP26 conference in Glasgow, at which financial services have played a key role in the drive towards ‘Net Zero’ and keeping the Paris-aligned target of 1.5 degrees alive. But there has also been a remarkable compounding of support for ESG on the part of end investors.

The IA has found that “responsible funds” grew 66% last year against the wider industry’s 7%, and ESG inflows averaged over £1 billion a month. As ESG continues to grow it is critical that investor protection is at the forefront or the industry risks losing trust with those it exists to serve. ,

Starting with principles

From a UK government perspective the tone was arguably set at the end of last year when the government set out its ‘ten point plan for a green industrial revolution’, and Richard Monks, the strategy director at the FCA provided initial insight into the seven regulatory principles that the FCA would use to base its regulation of ESG upon. A key aspect of this was that in assessing holdings, a firm should assure ESG data quality including understanding the source and derivation.

Throughout 2021 the momentum has continued to build. We have seen the FCA adopt climate change as a part of its overall regulatory remit and it gets a great deal of coverage in the FCA’s 2021 business plan, so there is no doubt that, as Richard Monks said, ‘sustainable investing is here to stay’, and that there is a real focus on building trust in this market.

Disclosures and reporting

Partly that trust comes from disclosure – in 2021 we have seen a consultation on introducing mandatory Taskforce on Climate Related Financial Disclosure (TCFD) reporting for asset managers from 2023. This focuses on things like risk management and governance, but also disclosing on metrics and targets – firms will need to disclose the metrics they use to assess climate-related risks and opportunities. This links back to the FCA’s principle of assuring ESG data quality. In November the FCA issued a discussion paper on sustainability disclosures and fund labelling, and the government’s ‘Greening Finance’ report sets out next steps in terms of, for example, the introduction of a UK Green Taxonomy.

These developments are similar to some of the developments we are seeing in the EU: for example, the Sustainable Finance Disclosures Regulation (SFDR), which sets out in detail how firms should disclose on things like climate-related risk in portfolios, and the Taxonomy Regulation, also known as the EU Green Taxonomy, which also seeks to provide these commonly-agreed terms. SFDR’s Level 1 requirements were implemented in March with a series of requirements on the Taxonomy applying in early 2022.

It is also worth noting that there are now these two different regulatory approaches to ESG between the UK and the EU. The UK has taken a more ‘principles’ and ‘outcomes’ based approach, while the EU has taken a more ‘prescriptive’ approach.

In both instances, however, there is an emphasis on disclosure, on data quality, and on assurance, so that there is transparency and so the end investor can make informed investment decisions and have confidence that the product they have bought does what it says it will do.

Raising the bar

There are a host of additional ways that funds and firms can seek to demonstrate their ESG credentials. One example is the UK Stewardship Code, which applies to asset managers, asset owners and service providers, and which requires signatories to provide annual reports on policies and outcomes in terms of the economy, the environment and society. The Financial Reporting Council published its first list of approved signatories of the code on 06 September, and a third of applicants were unsuccessful, which shows that the bar was significantly raised with this iteration of the code, with a focus on achieving outcomes - not just on having a policy.

Transparency and credibility

Finally, to close where we started, with principles, the FCA issued a letter on 19 July to AFM chairs in the form of a Dear CEO letter, noting the need to improve trust and transparency, in the context of providing feedback on enhancements needed to applications for new fund authorisations. Key to this was that a firm should be confident that it can validate the ESG and sustainability characteristics of its funds, taking into account whether a reasonable investor would consider that the fund’s holdings were actually fulfilling the sustainability aspirations as set out in the prospectus and the marketing material.

We believe that there is a growing need to drill down into the data to provide assurance both to regulators and investors that an ESG fund, and its underlying investments, genuinely are fulfilling their ESG goals. The bar was raised in 2021, but expectations will be set higher still in 2022.

By Peter Flynn

Associate, Funds Regulation & Governance