Research Affiliates: Clearer skies ahead
By Ari Polychronopoulos, Partner and Head of ESG at Research Affiliates
The demand for low-carbon and climate-focused investment strategies is rising rapidly as investors seek to positively impact climate change. Accurate data are key to investors’ success and mandatory reporting is critical for data accuracy.
According to Morningstar, nearly € 240 billion, or 45% of all European ETF and mutual fund flows in 2020, went towards sustainable strategies. The past year set a record for low-carbon and climate-focused investment strategies, which attracted approximately € 26 billion in fund flows, up from roughly € 1.7 billion in 2016.
Although these flows represented only about 5% of all European fund flows in 2020, the sector’s rapid growth over the last five years suggests sustainable strategies will soon become mainstream. A driving factor in the rapidly increasing demand for sustainable investing products in Europe is the region’s leadership role in sustainable finance regulation.
Progress is being made
Research by my colleague Vitali Kalesnik and his coauthors, which focuses on carbon emissions data, finds much room for improvement in these data. Investors have a large role to play in seeking to mitigate climate change, but they must have accurate data to be effective in identifying green companies. The path to accuracy lies in mandatory reporting, adhering to a global standard, and auditing of the reported data.
Progress is being made. On 21 April, the European Commission published the Corporate Sustainability Reporting Directive (CSRD), which extends the scope of the 2014 Nonfinancial Reporting Directive that currently applies in the EU.
The CSRD proposes mandatory reporting according to EU sustainability standards and mandatory audits of reported information. The proposed reporting requirements apply to all large EU companies and all companies listed on EU-regulated exchanges.
Current EU climate transition regulation
The two principal European bodies making recommendations for climate transition regulation are the Task Force on Climate-Related Financial Disclosures (TCFD) and the Technical Expert Group on Sustainable Finance (TEG). The TCFD framework requires companies to disclose risks related to the transition to a low-carbon economy and risks related to the physical impact of climate change.
The purpose of the TEG, as described on its website, is to provide ‘an EU classification system—the so-called EU taxonomy — to determine whether an economic activity is environmentally sustainable; an EU Green Bond Standard; methodologies for EU climate benchmarks and disclosures for benchmarks; and guidance to improve corporate disclosure of climate-related information’.
The EU taxonomy sets reporting standards and performance thresholds. Starting in January 2022, all fund providers, insurance product providers, and pension plans who market their strategies in the EU as being sustainable must report using the taxonomy framework.
Financial market participants will be required to disclose how the taxonomy was used in determining an investment’s sustainability and the proportion of taxonomy-aligned investments, expressed as a percentage of the investment, fund, or portfolio.
Transparency and comparability
The EU Green Bond Standard (GBS) is intended to improve the ‘transparency and comparability of the green bond market, as well as to provide clarity to issuers on the steps to follow for an issuance, in order to scale up sustainable finance'.
The purpose of the GBS framework and reporting requirements for proceeds of green bond issues is to increase the availability of financing, and to lower the cost of that financing, for projects aimed at reducing climate change.
The EU Regulation for Low Carbon Benchmarks provides the ‘definition of minimum standards for the methodology of the ‘EU Climate Transition’ and ‘EU Paris-aligned’ benchmarks, that are aligned with the objectives of the Paris Agreement and addressing the risk of greenwashing’.
The TEG ‘has also worked on disclosure requirements in relation to Environmental, Social, and Governance (ESG) factors in the benchmark statement and the benchmark methodology for all types of benchmarks (except interest rate and foreign exchange benchmarks) including the standard format to be used to report such elements'.
Clearer skies on the horizon
Europe is setting the pace on sustainable finance regulation. In order for investor actions designed to mitigate climate change to be successful, investors need accurate data.
The European Commission’s recent proposal for mandatory reporting is a tremendous step in the right direction.