Sustainability heats up

In some jurisdictions, legal debates continue on whether asset managers' "fiduciary duty" must be narrowly interpreted as maximizing investment returns and is therefore not compatible with sustainable investing (unless that is the investor's express wish). As issuers increasingly analyze and disclose their own sustainability risks, and capital markets price securities accordingly, this debate is likely to evolve. Of more immediate concern for some is that investment in emerging markets and small cap companies, for which reliable sustainability data are difficult to obtain, may become less attractive for institutional investors that are subject to ESG requirements.

ESG is increasingly an integral part of asset managers' business strategy. A KPMG in Luxembourg survey found that almost half of all funds managed by participating Luxembourg management companies were described as promoting environmental or social characteristics, or having sustainable investment objectives. A large majority of firms expressed the ambition to increase their percentage of such funds significantly over the coming months and years.

At the global level, IOSCO¹ published its first work plan specific to sustainable finance. IOSCO will review the new International Sustainability Standard Board's (ISSB's) proposed standards, develop assurance standards and review carbon markets. It is also urging regulators and industry to implement its 2021 recommendations addressed to asset managers and ESG ratings and data providers (see below). The recommendations for asset management focused on investor protection issues and aimed to improve sustainability-related practices, policies, procedures and disclosures.

In October 2021, a BIS² report on taxonomies found a lack of use of relevant and measurable sustainability performance indicators, insufficient granularity and a lack of verification of achieved sustainability benefits. It proposed key principles for the design of effective taxonomies. Work is progressing on global definitions for corporate reporting purposes (see below). The EU was the first to impose detailed definitions of "E" within financial services regulation, via the EU Taxonomy Regulation. Other jurisdictions are rising to the challenge of developing their own taxonomies, with an eye to ongoing implementation issues with the EU Taxonomy.

From January 2022, the EU's detailed descriptions of activities relating to climate change adaptation and mitigation objectives became effective. Industry continues to experience difficulties around operationalizing the definitions, lack of data and lack of consistency with other regulations. Work on the remaining four environmental objectives has been delayed due to extended political debate regarding nuclear and gas energy sources. In March 2022, the Commission adopted amendments that, under strict conditions, would include nuclear and gas in the list of "green" activities covered by the Taxonomy. Given the invasion of Ukraine, there were calls for these highly-politized amendments to be revisited, with strongly-held and opposing views, but the amendments were finally agreed.

The UK has adopted the EU environmental objectives in its own taxonomy, but continues to consider the detailed criteria that will underpin these objectives. Criteria for climate change adaptation and mitigation are expected by end-2022. Switzerland is preparing climate scores for sustainable investments, which initially will be voluntary.

Taxonomies are being developed in other regions too. For example, the Association of Southeast Asian Nations (ASEAN), which covers ten jurisdictions, has published a classification for sustainable activities. The Green Finance Industry Taskforce of the Monetary Authority of Singapore (MAS) has published detailed thresholds and criteria for economic activities in the energy, transport and real estate sectors. And the Australian industry, via the Australian Sustainable Finance Institute, has committed to the development of a sustainable finance taxonomy as a priority, but recognizes that legislation may be needed for clarity and to manage greenwashing risks in retail funds.

Initial policy work within the EU on defining "socially sustainable" activities suggests that an "S" Taxonomy will present even more challenges than the "E" taxonomy. Social objectives may prove more difficult to draft and agree, quantitative measures will need to be formulated from scratch in many areas, and the availability and reliability of the data needed to calculate those measures are largely absent at present. It is recognized that S factors can be the most difficult to analyze and embed in investment strategies. The EU Platform on Sustainable Finance (an independent advisory body to the European Commission) explored in detail the merits and challenges of developing a social taxonomy. It subsequently consulted on "minimum safeguards" that require companies to implement procedures in compliance with OECD³ guidelines and the UN guiding principles on business and human rights.

Given the difficulties encountered with the E taxonomy, publication of a draft S taxonomy is not expected in the short term. And it remains to be seen whether regulators will in future grapple with detailed descriptions of “G” factors, or leave industry and investors to refer to long-standing global principles of good governance (see Chapter 5 in our report).

New regulatory requirements around the consideration of ESG risks in investment decision-making and risk management processes will be critical to advancing the sustainable finance agenda. An FSB⁴ report in April 2022 noted that the incorporation of climate-related risks in risk management practices across asset managers and pension funds is at an early stage. It also found that regulatory and supervisory tools for asset managers are limited to micro-prudential measures. Stress tests and scenario analysis have been applied mainly for banks and insurers, and only a few jurisdictions have put these in place for asset managers.

New EU requirements came into force in August 2022 and integrate ESG factors into the existing requirements for fund managers, portfolio managers and financial advisers around decision-making procedures, organizational structures, risk management, due diligence, resources and conflicts of interest. The concept of "sustainability preferences" was also introduced into the investment advice and suitability process, which requires advisers to consider sustainability preferences (in addition to risk tolerance) in their clients' investment objectives. Some EU national regulators may accommodate a best-efforts approach by firms in the first stage. Industry has developed the European ESG Template ("EET") to facilitate the exchange of information between product providers and distributors. From November 2022, further amendments will require product manufacturers and distributors to consider sustainability risks in the target market for products. To assist implementation, ESMA⁵ is updating its guidance in these areas.

An MAS paper on environmental risk management highlights emerging and good practices by asset managers in Singapore, and identifies areas where further work is needed to strengthen resilience to environmental risk. In Hong Kong (SAR), China, the SFC has issued new rules that will require more than 1,800 fund managers to consider climate-related risks in their investment and risk management processes. There is a two-tier approach: a baseline set of requirements for all fund managers managing collective investment schemes; and "enhanced requirements" that will apply to fund managers with AUM⁶ greater than HKD 8 billion. The Japanese Financial Services Authority (JFSA) expects firms to have established governance systems for climate-related risk, developed appropriate business models and strategies to respond, and put in place processes to assess and manage climate-related risks.

The Australian Prudential Regulation Authority (APRA) has published prudential guidance for managing the financial risks of climate change, which applies to superannuation (pension) trustees, as well as to banks and insurers. The guidance does not introduce new requirements but is intended to help entities manage climate-related risks and opportunities within their existing practices, in beneficiaries' best interests. Similarly, the Australian Securities & Investments Commission (ASIC) has identified climate risk as a material financial risk that should be managed in accordance with existing risk management practices and regulatory guidelines.

A "Dear CEO" letter from the Central bank of Ireland (CBI) to regulated firms, including asset managers, set out the CBI's supervisory expectations in five key areas — governance, risk management frameworks, scenario analysis, strategy and business model risk, and disclosures. The CBI noted that sector-specific guidance may be needed in due course. Meanwhile, CNMV plans to analyze the level of climate risk to which Spanish investment funds are exposed, considering different transition and physical risk scenarios and their impact on the net asset value of each fund, as well as the potential contribution to systemic risk.

In response to regulatory concerns about greenwashing, guidance and rules have been enhanced or introduced, requiring asset managers to make disclosures at both entity (management company) and product (fund or portfolio) level. Nevertheless, concerns are growing that requirements are being implemented inconsistently, terminology is confusing for investors, and the plethora of definitions and methodologies is preventing reliable comparisons between products. There is also the risk of overloading investors with disclosures.

The EU led on mandatory and detailed ESG-related disclosures for asset managers and funds. Having introduced baseline requirements in the Sustainable Finance Disclosure Regulation (SFDR) in March 2021, the EU's long-awaited "level two" disclosure standards become effective in January 2023. They provide more detail on the content, methodologies and presentation of the information that asset managers and funds will need to disclose. At entity level, firms with less than 500 employees can choose to report on "principal adverse impact" (PAI) indicators, while at product level there will be new templates for funds to complete for pre-contractual and periodic disclosures.

SFDR implementation continues to give rise to questions around the meaning of and how to operationalize the rules, which continue to evolve. The European Commission and ESMA have also published certain clarifications, which comment on the impact of SFDR on non-EU companies marketing funds into the EU and seek to address the uneven implementation of SFDR across regulators and the industry. In May 2022, the European Commission asked the European Supervisory Authorities (ESAs) to align the detailed SFDR requirements with changes to the EU Taxonomy on nuclear energy and gas, and to consider extending the universe of PAI indicators. And in August 2022, the Commission asked the ESAs to advise on greenwashing risks and the supervision of sustainable finance policies.

National EU regulators have been undertaking reviews. For example:

• The Belgian regulator found that asset managers had “rapidly adapted” to SFDR and investors are more interested in investments with sustainability characteristics. It subsequently stressed the importance of compliance with the regulations.
• The Dutch regulator found that the integration of sustainability risks in investment policies could be more clearly stated, disclosures could be clearer, and funds' objectives were frequently too vaguely defined. A further study showed that funds have a wide interpretation of sustainability, a large share of holdings in sustainable funds are in technology stocks, and that investors struggle to assess fund managers' engagement and to rely on fund names. 
• The Italian regulator has investigated funds classified as having sustainable investment objectives and has asked some fund managers to revise down their classifications to “promoting sustainable characteristics”.
• The Luxembourg regulator encouraged fund managers to follow the draft regulatory technical standards before the final version becomes effective in January 2023. 
• In 2021, the Swedish regulator found a significant portion of funds were categorized as sustainable products but that not all managers were complying with SFDR. It reiterated the need for disclosures to be consistent with funds' investment strategies. It is undertaking another review into whether funds are presented as being more sustainable than they are. 
• The Maltese regulator continues to monitor firms' compliance with SFDR. 
• The Spanish regulator plans to review funds' prospectuses and holdings, analyze funds' management reports and websites, and review the use of the term “sustainable” in funds.

Some EU member states are implementing additional requirements at the national level. In Germany, for instance, certain information relating to SFDR disclosures is presented in funds' annual reports. Since the introduction of the "Fondsstandortgesetz" (Fund Jurisdiction Act) in 2021, external auditors are required to assess whether fund managers are meeting the requirements of certain aspects of the SFDR (for example, checking that the information is correct and complete). Material errors or omissions could lead to modified audit opinions.

In France, on an annual basis, asset managers will need to make available to their investors and the public a dedicated report to outline how ESG factors are considered in the investment strategy and how they are contributing to environmental transition. The AMF⁷ has also updated its policy on funds that use Total Return Swaps, which can communicate about their consideration of non-financial criteria provided they meet certain conditions. The AMF has called on asset managers to be extremely vigilant in their communications.

On the other hand, to facilitate orderly SFDR implementation, the Central Bank of Ireland is establishing a fast-track filing process for pre-contractual document updates to Irish funds. Managers will be able to attest their compliance with SFDR.

UK asset and fund managers must publish on their websites both entity and product-level disclosures on climate change that are consistent with the TCFD⁸ recommendations — larger firms will need to make their first disclosures from 2023 and smaller firms a year later. Under the FCA's new Sustainability Disclosure Requirements (SDR), these disclosures will be extended to cover a wider range of sustainability factors. A further consultation is expected in autumn 2022.

The US Securities and Exchange Commission (SEC) has set ESG as an examination priority for 2022, focusing on whether ESG activities are commensurate with what is being marketed and communicated to investors and intermediaries, and whether investment advisers' proxy voting is aligned. It has also published rule changes regarding funds and their disclosures. Amendments to the fund names rule would extend the requirements to any fund name with terms relating to specific characteristics (including ESG factors). The rule requires funds whose names focus on certain investments to invest at least 80 percent of the value of their assets in those investments. A second set of amendments would require funds and advisers to provide more specific disclosures based on the ESG strategies they pursue. For example, funds focusing on environmental factors would need to disclose greenhouse gas emissions associated with their portfolio investments. Thirdly, the SEC proposes to require funds to tie the description of each voting matter to the issuer's form of proxy and to categorize each matter by type. The goal is to help investors identify votes of interest and compare voting records.

Various regulators have provided guidance for funds and their ESG disclosures, to combat greenwashing. In November 2021, the Swiss regulator provided guidance focused on sustainability-related information at the fund level and the organizational structures of firms managing these products — as well as rules of conduct at the point of sale. The UK FCA published "guiding principles" for managers of retail funds, setting out its expectations on the design, delivery and disclosure of ESG funds. And guidance from the Canadian securities regulators on ESG-related investment fund disclosures covers investment objectives, fund names, investment strategies, risk and sales communications.

In July 2022, ASIC published a non-binding "information sheet" which makes certain recommendations for Australian fund managers and trustees of superannuation schemes concerning the naming, promotion and offering of sustainability-related products. It complements a new guide on product disclosure statements. ASIC encouraged voluntary TCFD disclosures and reiterated relevant existing rules and its expectations, specifically regarding prohibitions against misleading and deceptive statements and conduct, as well as disclosure obligations. ASIC is also undertaking surveillance and enforcement action against any misleading claims relating to sustainability. In Hong Kong (SAR), China, the SFC has provided additional guidance on disclosures and reporting for authorized funds that incorporate ESG factors and for funds with a climate-related focus.

In July 2022, the Singapore regulator set expectations on how requirements apply to retail ESG funds. The circular included new guidelines regarding fund names (for example on the use of ESG-related terms) and expectations on disclosures in fund prospectuses across a fund's investment focus and strategy, reference benchmark and risks. Enhanced reporting and disclosures will also be needed in ESG funds' annual reports and on websites (for example around how an ESG focus is measured and monitored).

The Guernsey Financial Services Commission has consulted on introducing measures to mitigate the potential risk of greenwashing. Its proposed guidance would reinforce expectations relating to disclosure requirements and would apply where explicit sustainability claims are made. It noted its consultation would keep the jurisdiction in step with other jurisdictions' investor protection measures.

In India, SEBI has created a new advisory committee on ESG matters and set out its long-term intention to prescribe ESG disclosures for all mutual fund schemes. And in Japan, the JFSA plans to conduct a wide range of research and analysis on the state of ESG in the asset management industry, including specific indicators, and to promote the monitoring of asset managers.

Labels and standards for products can increase investors' understanding of what is on offer. Over time, industry-led frameworks are set to be superseded by regulation. Regulators are opting for either "kitemarks" that certify whether a product has met certain minimum criteria, or prescriptive labelling schemes that seek to describe the nature of products and their investment strategies.

In the EU, local labels and standards (which generally take the form of kitemarks) have been in use for several years, including the Nordic Swan, the Luxflag and the Belgian Febelfin. The French AMF's "Doctrine" is not a labelling scheme as such but requires consistency between what is said in marketing material and the actual investment management of the fund (by imposing minimum standards on products that hold themselves out as having ESG characteristics) and contains rules on fund names.

First out of the blocks with proposals on mandatory product labels were Germany and the UK, which would require all funds (or at least all funds claiming to be sustainable) to be assigned one from a suite of labels depending on the extent of their sustainable investment. However, BaFin (the German Federal Financial Supervisory Authority) announced in May 2022 that the introduction of the new guidelines was postponed due to the developing regulatory environment and challenging geopolitical situation. It is not yet certain whether the guidelines will be implemented ahead of the EU ecolabel being introduced (see below). Meanwhile, feedback to the FCA's initial proposals for labels such as "transitioning", "aligned" and "impact" was critical, saying the labels will not be meaningful for retail investors. The FCA has delayed its consultation to take account of other international policy initiatives and to ensure stakeholders have time to consider the issues.

Other regulators favor kitemarks. In Guernsey, for example, the regulator has consulted on rules that will allow voluntary designation of funds as "Natural Capital Funds". The kitemark will be available to funds committed to making nature-positive investments, setting and monitoring against appropriate targets, and making relevant disclosures.

A draft EU ecolabel regulation has been delayed due to protracted discussions on the Taxonomy Regulation (see above) but is expected by end-2022. It will apply to all types of funds (as well as insurance-based investment products and bank structured products) and will be additional to SFDR disclosures. The criteria will be based on minimum investment thresholds in EU Taxonomy-aligned activities. For example, bond funds wishing to use the kitemark might need to be at least 70 percent invested in green bonds, and equity funds might have to meet a series of thresholds.

Regulators are turning their attention to the functioning of the capital markets, which will impact asset managers in their role as market participants. Frameworks for green or social bonds are being developed, and ESG ratings and data product providers are under scrutiny.

In Japan, the JFSA intends to establish a framework for objectively confirming the eligibility of green bonds. Meanwhile, the proposed EU Green Bond Standard is being debated by the co-legislators.⁹ It will apply to any type of issuer — listed or non-listed, European or international — and will require initial and periodic reporting, and external verification by an approved entity. It will help asset managers and investors to identify green bonds, but it will also require them to reclassify their existing bond holdings. The European Commission is expected to issue a similar proposal for EU social bonds. And to assist the development of UK social bonds, the FCA is considering providing indicators on the social benefits of projects, working with government ministries and agencies.

IOSCO's final report on ESG ratings and data providers calls for greater regulatory oversight. It found unclear definitions, a lack of transparency regarding methodologies, uneven coverage of products offered, potential concerns about conflicts of interest, and that better communication between providers and rated companies is needed. IOSCO set out recommendations for regulators, ESG ratings and data products providers, users of ratings (including asset managers) and rated companies. Regional and national regulators are beginning to respond.

The JFSA plans to develop a code of conduct for Japanese rating agencies and data providers regarding issues such as the transparency and comparability of evaluation methodologies and governance. ESMA gathered feedback on the market structure of ESG ratings providers in the EU and provided its findings to the European Commission in June 2022. It noted that there are many non-EU providers and the "investor pays" model is the most common. Entities covered by ESG ratings dedicate some resources to their interactions with ESG ratings providers, but ESMA identified certain shortcomings, such as a lack of transparency around the basis for a rating.

Separately, the European Commission consulted to gain a better understanding of the dynamics of the EU ratings market, and to identify possible shortcomings in relation to the consideration of sustainability risks in credit ratings and the disclosures made by credit ratings agencies. The UK FCA has said it can see a clear rationale for regulatory oversight of certain ESG data and rating providers, and for a globally consistent approach.

Increased reporting by corporates within annual financial reports will provide much-needed data for asset managers' investment decisions, enable improved disclosures to investors and inform company ratings.

The ISSB was created in November 2021 to improve the quality, transparency, reliability and comparability of sustainability reporting, with an initial focus on climate risk. To date, it has published two exposure drafts that set out the overall requirements for an entity to disclose sustainability-related financial information on risks and opportunities. Countries are already preparing for the new standards. For example, Japan has established a new Sustainability Standards Board.

Meanwhile, the FSB welcomed the October 2021 TCFD status report, which noted the acceleration of climate-related financial disclosures, and published documents to support decision-useful disclosure. Jurisdictions are seeking to broaden the information disclosed by public companies in accordance with the TCFD recommendations and, as described above, some jurisdictions propose to extend these requirements to all financial services firms and to larger private entities.

The European Financial Reporting Advisory Group has consulted on draft European Sustainability Reporting Standards, which will interface with the disclosure requirements under the incoming Corporate Sustainability Reporting Directive (CSRD). CSRD will require listed companies and "public interest entities" subject to existing EU reporting requirements, to report from January 2024 on their impacts on the environment and risks to the company from the environment ("double materiality"). CSRD will subsequently be extended to large private entities.

Authorities around the globe are introducing TCFD-related reporting requirements and guidance. The UK FCA requires companies with a premium or standard listing to disclose on a "comply or explain" basis against the TCFD recommendations. The US SEC has proposed that public companies should disclose climate-related risks that could impact aspects of their business and include climate-related financial metrics in a note to their audited financial statements. It has also proposed attestation requirements related to emissions data. From 2024, Swiss public companies, banks and insurance companies that exceed certain size thresholds will be required to make TCFD disclosures. The Canadian regulators have proposed new requirements for issuers to publish TCFD-type disclosures. And Australia is encouraging companies to provide meaningful and useful voluntary disclosures about climate impacts, in line with the TCFD, ahead of any mandatory requirements.

 Some jurisdictions have introduced or are considering mandatory TCFD-aligned disclosures for financial institutions (including asset managers). Malaysia's central bank and Securities Commission have published a TCFD application guide to assist Malaysian financial institutions with preparing for climate-related disclosures. The current intention is for all Malaysian financial institutions to adopt a set of basic recommendations from 2024.

Other jurisdictions are requiring broader ESG reporting. From April 2022, Japanese companies listed on the newly-opened prime segment of the Tokyo Stock Exchange are encouraged to enhance the quality and quantity of their disclosures based on the TCFD recommendations or an equivalent framework. However, authorities also plan to introduce new disclosure requirements on human capital and guidelines on human rights due diligence. In Saudi Arabia, the stock exchange has published reporting guidelines intended to be a resource for listed companies to encourage transparency across all ESG factors. Under the UK SDR, existing requirements for TCFD-aligned reporting will be extended to cover wider sustainability factors.