ESG rules for private markets begin to sprout up

Between regulators and industry-led initiatives, asset owners have a growing number of tools to help assess how their ESG goals for private market investments are being met.

European regulators have led the charge. The European Commission's Sustainable Finance Disclosure Regulation requires asset managers, financial advisers and other financial market participants to disclose how they address sustainability and ESG factors in their investment decisions.

While the SFDR applies to companies within Europe, it is expected to have a ripple effect on fund managers in the U.S., particularly those operating in Europe or with EU-based investors.

The next move could come in the U.S., where the Securities and Exchange Commission continues to focus on ESG investing and more transparency for investors to address potential greenwashing, through rules proposed May 25 for public markets that could also wind up influencing investors in private markets.

In the U.K., retirement plan trustees have new climate-related governance and reporting rules based on a framework developed by the Task Force on Climate-related Financial Disclosures.

The standards apply to defined benefit and defined contribution plans. Larger plans with assets of at least £5 billion ($6.3 billion) have been following them since October, and funds with £1 billion or more will start this October.

With the standards requiring pension funds to consider, assess and report on the financial risks of climate change within their portfolios, a commensurate boost in pension fund commitments to net-zero goals is also expected.

Regulation plays "a big part" in ESG investing, said Maximilian Kufer, London-based head of ESG in private markets at Invesco Ltd., with $1.82 trillion under management. "Regulation in a lot of ways really guides us in the right way. I tend to see a lot of convergence in what the regulations require. Disclosure is key," he said.

The SFDR and U.K. rules are making it easier for asset owners to tell managers what they want, said Edward Dixon, head of ESG for Aviva Investors' real assets program in London. Combined with asset owners' own net-zero commitments, "the power of what that will be able to deliver over the next five years will be transformative," Mr. Dixon said.

Other organizations like the International Sustainability Standards Board are also developing standards for a comprehensive global baseline of sustainability disclosure in financial markets.

In the U.K., a joint effort among the Pensions and Lifetime Savings Association, the Association of British Insurers and the Investment Association has developed a carbon emissions template to help pension funds meet their TCFD requirements.

Several other industry organizations are working to give investors more ESG measuring and reporting tools.

One initiative, the Partnership for Carbon Accounting Financials, now has a global reach, helping financial institutions, including private market asset managers, assess and disclose the emissions from their loans and investments through greenhouse gas emission-specific accounting.

On the social side, to address investors' goals to increase diversity in the private companies they hold, the CFA Institute developed a diversity, equity and inclusion code and reporting framework for the investment profession, beginning in the U.S. and Canada.

The Pension Fund Coalition for Inclusive Capitalism also offers open-source ESG investing tools aimed at helping pension funds create more legal responsibility for asset managers to demonstrate that they are investing in line with the pension funds' ESG priorities. The tools include recommended language for investment contracts covering model mandates, voting rights, reporting requirements and ESG criteria.

For private equity investors, the Institutional Limited Partners Association offers an ESG assessment framework to help them evaluate the various stages of ESG integration by general partners. Created with input from both general and limited partners, "the response has been terrific. I think the industry has been looking for tools that drive ESG to the top of their list," said Matt Schey, senior director of sustainable investing and strategic projects for ILPA in Washington.

"For GPs, it provides clarity on what LPs are looking for and expecting. For LPs, it details other approaches that are being taken," Mr. Schey said.

The ILPA framework categorizes GP activities and processes as present, developing, intermediate and advanced. When it comes to the investment process, for example, managers are assessed on due diligence, post-investment management, exit and after sale.

Those in the advanced category might feature ESG metrics on an ongoing basis, assess all portfolio companies annually, and hold board members accountable for material ESG considerations. At exit, advanced GPs might analyze ESG impact on investment performance, and support buyers in continuing sustainable investment initiatives.

The framework also "helps position LPs and GPs to get together for a more robust conversation," Mr. Schey said. The framework was developed with mid- to large-cap managers in mind, "but we have definitely heard the demand for other asset classes" including private debt, real estate and venture capital.

Officials at Washington State Investment Board, Olympia, overseeing $192.3 billion in state defined benefit plan, defined contribution plan and other assets, also use ILPA's diversity data template to have new private equity partners provide diversity information, as well as eVestment's private fund diversity data on more than 200 GPs.

"The push for consistent, comparable ESG information from private equity partners and private companies is still in its infancy, but we are encouraged by the work of ILPA and eVestment to streamline this," said Chris Phillips, director of institutional relations and public affairs at the WSIB.

Arleen Jacobius contributed to this story.