The U.S. and countries around the world have made pledges to halve greenhouse gas emissions by 2030. 1 2 Companies are also making a pledge for net-zero carbon emissions by 2040. For the finance and insurance industry, these pledges translate to a demand in the sustainability and societal impact of businesses and investments across the entire swath of related environmental, social, and corporate governance (ESG) factors.
The E.U. has taken the lead in reigning in loose ESG and sustainability claims through the Sustainable Finance Disclosures Regulation (SFDR), which took effect on March 10 of this year. These Level 1 SFDR regulations call for pre-contractual disclosures of sustainability risks by financial advisors, specifically on their websites. Additional Level 2 SFDR regulations that take effect on January 1, 2022 are detailed in the Final Report on draft Regulatory Technical Standards. These standards aim to reduce "information asymmetries" and combat the problem of false claims about sustainability (greenwashing). Similar to evolving standards and certifications for organic items in the food industry, SFDR sets standards for sustainability and ESG claims for financial products. Previously loose terms such as "carbon footprint," "GHG intensity," "green products," and even "do not significantly harm (DNSH)" are defined, calculations and equations stated, and mandates set for financial market participants to detail sustainability claims, disclose input data, and explain rebalancing methodologies.
Many of the details are still being worked out, but the underlying themes in these regulations are transparency, due diligence, and consistency. While these regulations apply to all E.U. regulated funds, they foreshadow the inevitable expansion of sustainability and ESG risk disclosure regulation in domestic markets across the globe as governments and investors demand a consistency and quality of ESG disclosure in financial products. With firms outside of the E.U. scrambling with compliance teams to weigh the immediate impact of SFDR requirements on their own products and services, and the possibility of similar regulatory efforts brewing in a Biden-Harris administration committed to addressing the climate crisis, prudent firms should be preparing for a 2022 where ESG product marketing messages are more consistent, specific, and data-driven.
Read on for three ways to get ready.
Recent examples of ESG position statements: J.P. Morgan, Brown Brothers Harriman, UBS, Goldman Sachs, Credit Suisse.
Most firms are already posting ESG position statements on their websites. It's time to increase the specificity of ESG and sustainability marketing claims through categorization. SFDR categories define three classes of products: Article 6 products that don't promote ESG factors, and Article 8 and 9 products that hold varying degrees of sustainability. A three-tier categorization of products would serve a valuable first step in SFDR compliance, as well as force the development of underlying website workflows to integrate ESG marketing messages with regulatory compliance review. Composite products such as funds that are an aggregation of underlying investments will require a methodology for category score weighting and normalization. Websites will need to be tooled to consume external data sources and evaluate rules for categorization on an automated basis. An audit trail of website updates, particularly changes to categorization which necessitate an "explanation" based on SFDR rules, would also prepare the firm for regulatory compliance. Traditionally a digital marketing instrument, the content management systems powering websites, would need development updates to accommodate these requirements. An automated and systematic approach ensures the accuracy of disclosures, supports a methodical approach to disclosure that can be explained, and naturally insulates the organization from the risk of greenwashing.
The due diligence to pore through annual sustainability reports and compute the normalized impacts of underlying companies toward an ESG product can be an overwhelming challenge. Integrating with a third-party ESG data provider to supplement internal research seems a natural solution. However, these integrations take time. Now is the time to be researching and subscribing to an ESG data provider. PiSrc spoke with several ESG data providers and each have their own proprietary methods of data acquisition, scoring, and updates. S&P Global's Trucost provides extended environmental data such as greenhouse gas emissions, even considering Scope 1, Scope 2, and Scope 3 "upstream" and "downstream" sustainability impacts, accounting for the contributions of business travel, supply chain, commuting, etc. MSCI dimensionalizes the exposure and management factors of environmental impact to arrive at a composite score. Refinitiv relies heavily on corporate sustainability reports and covers major index equities, some stretching back to 2003. Depending on the firm's ESG approach and position statement, one data provider may prove better suited than another. As regulations develop and evolve, selecting an ESG data provider that is flexible and in tune with regulatory developments will be a key differentiator. Once a data provider is selected, the data feeds will have to be consumed, transformed, and integrated with internal operational workflows. This can also take considerable time, and organizations should be planning for these activities in the near term.
Screenshot of fund-level exposures to ESG metrics.
Once ESG data is obtained and integrated with internal operations, a flexible framework for propagating this data across investments will need to be created. An internal tool that provides real-time reporting into ESG risk exposures and sustainability categorizations will be essential to enabling fund and asset managers to hedge product exposures on a daily basis. These snapshot reports can be used in conjunction with rebalancing scenario calculators, similar to foreign currency exposure rebalancing, to ensure consistency with product ESG risk and sustainability disclosures, as well as compliance with regulatory standards. Advanced organizations will automate these processes with alerts and automated internal/external transactional policies to optimize competitive flexibility while minimizing perturbations to regulatory disclosures.
Daily ESG and sustainability computation, alert, and rebalancing workflow.
With governmental pledges, regulations will follow. As we near mid-2021, the time is quickly running out for financial market participants subject to SFDR regulations. Whether or not a firm is bound under EU's SFDR, all firms should prepare for ESG and sustainability disclosures that are more regulated and can stand up to scrutiny. As impacts from climate change continue to grow, a focus on sustainability will drive regulatory as well as consumer interest in carbon footprint and the entire suite of ESG criteria for investments. Product marketing on websites will require review and development to support the automation, data integration, and updated workflows that keep up with standardized rules on accurate disclosure. It's time to start thinking about ESG risks and sustainability disclosures in a new light - one that is quickly becoming more regulated, increasing in demand, and urgent as pledges toward a sustainable future turn real.
Interested in learning more about how to get ready? Talk to PiSrc. We provide solutions in integrating with ESG data providers, automating website ESG disclosures, and implementing ESG and portfolio rebalancing strategies. Ask for a demo of ESGflow, our enterprise portfolio ESG management and rebalancing tool.
Based in New York City, we are technology and data experts with experience in the finance sector and have helped organizations managing assets in the trillions to automate operational inefficiencies, comply with regulations, enable digital capabilities, and better serve their clients.
