Disclosure requirement for asset owners, money managers approved by EU

Asset owners in Europe and financial services companies operating in the European Union will be required to disclose the impact of environmental, social and governance effects on their portfolios after the European Parliament and EU members agreed on new disclosure requirements related to sustainable investments and sustainability risks.

A proposed regulation, which is part of the European Union's overall package on sustainable finance in Europe — the European Commission Action Plan, launched in May 2018 — means asset owners, insurance companies and money managers will be disclosing how they are integrating ESG factors and how they adhere to ESG objectives in their investment decisions. Money managers and consultants will be required to show their own processes of ESG integration and the extent to which ESG risks are expected to affect the returns on strategies or funds sold, even if sustainable investment objectives such as renewable energy are not pursued.

This latest version of the disclosure regulation, which was approved by the EU institutions on March 7, added a new requirement to show if and how investments contribute to environmental damage by, for example, polluting water or reducing biodiversity. Strategies and funds sold by money managers, insurers and advisers will use a single disclosure toolbox to meet the required standards. Aimed at stopping money mangers from making unwarranted claims about the funds they sell, or so-called greenwashing, the disclosure requirements will ultimately boost transparency for retirement plan participants.

Pension fund executives and money managers welcomed this newest attempt but warned that the "adverse impact" reporting standards need to be clearly defined. David Russell, head of responsible investment at the £60 billion ($79.2 billion) Universities Superannuation Scheme, London, said: "The difficulty we foresee will be in gathering ESG data on underlying assets where it may or may not exist. We will therefore be interested to see how the 'adverse impact on ESG matters' requirement will be delivered and what such reporting will look like."

Other ESG risks

Helena Vines Fiestas, deputy head of sustainability at BNP Paribas Asset Management in Paris, said the money management industry knows the ESG risk to investments, but the regulation "opened up the concept of what is the ESG risk of investments to society and environment."

Ingrid Holmes, head of policy and advocacy at Hermes Investment Management in London, said, "Some investors, in common with some member state negotiators, only wanted the effect of ESG factors on investments to be in scope. However, the European Parliament and more progressive investors also wanted the regulation to encompass the impact of investments on the environment and society too. This was an important philosophical debate — that the Parliament won."

Asset owners are waiting for the final text of the regulation, which is expected at the end of the month. It has not been determined when the regulations would take effect, but sources expect it to start by the end of the year or beginning of 2020. However, investors will be given a few years to comply.

Disclosure is expected to begin three years after the law is established, sources said. In the first 18 months after the regulation takes effect, investors will have to decide whether they consider adverse impacts of investment decisions on sustainability factors and put into place relevant due diligence. After 18 months, due diligence will become mandatory for large investment firms with more than 500 employees.

"We need the final text," Ms. Viñes Fiestas said. "You can quantify the impact of investments on a carbon footprint, but how would you quantify the impact on human rights? The text (of the regulation) will probably leave room for qualitative expertise."

Some skepticism

Cindy Rose, head of responsible investing-stewardship at Aberdeen Standard Investments in Edinburgh, was more skeptical. "My fear is that it is going to become box-ticking," she said.

"While I support the framework, there needs to be a deep level of analysis to understand the investments holistically," Ms. Rose added. "We need to be looking at the assets more closely. The regulation should not eliminate the deep disclosure."

"It's not a choice between how different assets are exposed to risks and opportunities," she said. "For example, two companies in the same sector may be susceptible to the same ESG risks but they are different companies" with different investment opportunities.

However, sources agreed the regulation needs to clarify the definition of "adverse impact" because, in practice, pension funds tend to rely on managers to obtain the data and pick and choose what they focus on when reporting.

"The problem is really the (current proposed) regulation's neutrality. ... I'm for the regulation as long as it is going to address a financially material issue," Ms. Rose said, but it seems to be looking at ESG risk in general rather than the resulting financial risk.

Hermes' Ms. Holmes added: "Investors will have to report how they consider environmental, social and governance factor at a firm and, we think, fund level. However, it's not yet clear what level of reporting requirements there will be to support any positive impact claims made for products."

"People are quite hungry to know," she noted.

Adam Gillett, director and head of sustainable investment at Willis Towers Watson PLC in London, said: "At the moment, asset owners are quite reliant on external providers and managers so it is really important that asset owners are clear" on what the regulation requires from them. And "disclosure at the moment is quite patchy in terms of how people do it and what they choose to report."

USS' Mr. Russell agreed: "USS does support increased transparency, but the devil is in the detail. Pension funds tend to have well-diversified portfolios investing in thousands of assets through multiple external asset managers."

BNP AM's Ms. Vines Fiestas noted that how managers implement ESG into portfolios will go beyond the regulations and depend on the mandate from asset owners.

Claudia Kruse,one of 20 members in the high-level expert group on sustainable finance at the EC and managing director global responsible investment and governance at APG Asset Management in Amsterdam, said: "APG is very committed to being transparent and accountable on its responsible investment activities. We compliment the European institutions for their resolve in reaching agreement on this very important topic and look forward to studying the definitive text." APG Asset Management is the manager of the €470 billion ($534 billion) Stichting Pensioenfonds ABP, Heerlen, Netherlands.

Further technical work will follow this political agreement so the European Parliament and the European Council can formally adopt a final text of the regulation, a source near the European Commission said.

Sources also said the new European regulatory standards could apply outside of Europe too. Hermes' Ms. Holmes said that "the expectation is that we (Hermes) apply European regulatory standards in third countries," adding, "Most U.K.-domiciled managers will have registered their funds in Europe, so for them European law will continue to apply whatever happens with Brexit."

End to greenwashing

Mr. Gillett said: "I think the greenwashing has to go. And it is on its way out. People are getting better at identifying what is genuine and what is marketing."

Sources said they instantly see the benefits of the disclosure regulation as to how to position portfolios. "Generally, more information will lead to better knowledge about the subject. It will give more information quality to lead to better investment decision-making. It will lead to tilting the portfolio in a different way," he noted.

Still, Aberdeen's Ms. Rose said "the market needs a variety of approaches to be able to function," adding "hopefully the EU regulation will help to define the criteria for funds that are impact funds vs. (United Nations Sustainable Development Goals) funds."

The agreement on sustainable investment disclosure rules follows a series of legislative measures under the EU Action Plan on Financing Sustainable Growth, which include creation of benchmarks for low-carbon investment strategies and a unified EU classification system, known as taxonomy of sustainable economic activities.