It may seem that ESG funds have suffered some setbacks recently.
In the first half of 2024, four major US fund titans – Invesco, JP Morgan, Pimco and State Street – left the Climate Action 100+ initiative, potentially a sign that the tide is turning for sustainable funds. In the US, sustainable funds recorded outflows of $8.8 billion (£6.7 billion) in the first quarter of 2024 – a record worst performance in a single quarter.
In Europe, things are very different. Some would say that’s to be expected. Europe is, after all, the world’s largest market for sustainable funds, accounting for 84% of sustainable assets in the first quarter of 2024. In the second quarter of 2024, they attracted $11.8 billion, up from adjusted inflows of $8.4 billion in the previous quarter.
A robust regulatory environment
Europe’s dominance in the ESG space has been strengthened by a series of ESG-related regulations designed to increase transparency around sustainable funds and thus contribute to the overall improvement of ESG data.
By far the most comprehensive measure is the European Union (EU) Action Plan on Sustainable Finance, which aims to change the way investment firms, wealth and asset managers, banks, insurers, pension funds and professional and private investors consider ESG issues.
The plan has three core objectives:
• Directing capital flows to create a more sustainable economy;
• Ensure that sustainability is integrated into risk management;
• Promote transparency and create a long-term positive impact.
The key to the EU Action Plan lies in legislation. Notable examples are the EU Taxonomy Regulation and the Sustainability Disclosures Regulation in the Financial Services Sector (SFDR).
EU Taxonomy Regulation
This classification tool determines whether an economic activity is environmentally sustainable. This framework supports professional and private investors, companies and policy makers in identifying activities that contribute to environmental objectives. This supports the overall goal of using capital flows to create a more sustainable economy.
The regulation provides a common language for sustainability, helping financial market participants to better understand what the terms “green” and “sustainable” mean, which is crucial to prevent greenwashing. In practice, the framework works by requiring certain financial market participants, companies and EU member states to report on their suitability and alignment with six environmental objectives.
What is SFDR?
The SFDR is a central part of the EU Action Plan, which requires managers to disclose the following information:
• How sustainability risks are taken into account throughout the investment process;
• The different metrics used to assess ESG factors;
• How they consider and manage potentially harmful decisions (known as Principle Adverse Impacts or PAIs).
The aim of the SFDR is to improve the quality of investment products, in particular those claiming to meet ESG requirements (so-called Article 8 funds) or those with ESG objectives (Article 9 funds). The result of these strict disclosure standards is increased transparency and the fight against greenwashing.
UK Sustainability Disclosure Requirements (UK SDR)
In addition to the EU Action Plan, other regulations are also impacting the sustainable funds landscape. The UK SDR, which came into force this year, has created four new voluntary product labels that asset managers can apply to investment vehicles, along with product and entity-level disclosures. This new legislation aims to minimise greenwashing through a specific anti-greenwashing rule aimed at companies that make sustainability claims about their products or services in their advertising.
The four new labels are:
• Sustainability focus – assets that focus on sustainability.
• Sustainability improvers – assets that are not currently sustainable but whose sustainability will improve over time;
• Sustainability Impact – Focuses on solutions to sustainability issues to create a positive impact;
• Blended sustainability objectives – assets that focus on one of the three areas above.
TCFD reporting
The final pro-ESG framework comes from the Taskforce on Climate-Related Financial Disclosures (TCFD). By 2023, the TCFD’s recommendations had been publicly endorsed by nearly 5,000 organizations in more than 100 countries, representing a combined market capitalization of $29.5 trillion (£23.5 trillion).
The TCFD recommends that organizations report on four key thematic areas: governance, strategy, risk management, and metrics and objectives. For example, reporting on Scopes 1, 2, and 3 greenhouse gas emissions would fall under metrics and objectives, while reporting on board oversight of climate risks would fall under governance.
What can I expect from future ESG regulation?
Although regulations vary across jurisdictions, they are all linked by a common theme: data. Think of it as a cyclical and iterative process. Regulations and frameworks require data to exist. As they come into force, data quality improves over time. With higher quality data, regulations and frameworks can be refined or new ones created. And so on.
That’s why fund selectors need access to robust, transparent and insightful data. From navigating new regulations to adapting to changing client preferences and requirements, data is the foundation of any successful investment strategy.
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