New regulations around environmental, social, and governance (ESG) investing could have major ramifications on the European financial sector.

As it unveiled the rules in early March 2019, the European Commission (EC) emphasized that the measures, which target ESG disclosure, are linked to its wider push to implement the 2015 Paris Agreement and fight global climate change.

“The new rules on disclosures will enable investors and citizens to make more informed choices so that their money is used more responsibly and supports sustainability,” said EC vice president Valdis Dombrovskis.

Outlining ESG Integration and Disclosure

While underlining that firms must act in the best interests of their clients, the regulation stipulates how asset managers, insurers, pension funds, and investment advisers must integrate ESG risks and opportunities into their processes. It also requires that they provide investors with consistent information showing their compliance with ESG integration, as well as on any “adverse impact on ESG matters” their assets might have.

The EC stresses that its target is to address “information asymmetries” on sustainability issues between the providers of investment products and other participants in the financial market. “The availability of information is crucial to the integration of risks related to the impact of ESG events on the value of investments, for example in assets located in flood-prone areas,” explains the EC.

The regulation is divided into three main pillars. Its goals include:

  1. Avoid greenwashing. Along with preventing firms from perpetuating unsubstantiated or misleading claims about sustainability and the benefits of their products, this pillar also seeks to increase market awareness of sustainability.
  2. Achieve regulatory neutrality. This refers to the EC’s drive to harmonize the new disclosure rules across the respective EU member states.
  3. Level the playing field. This pillar specifies the products and services managed by the new rules: investment funds, insurance-based investment products, private and occupational pensions, individual portfolio management, and insurance or investment advice.

Viewing the Rules in Context

The European Commission’s new regulations form part of the EU’s action plan on sustainable finance, first presented in May 2018 under the EU’s sustainable development and carbon neutrality agenda. The action plan outlines various reforms with three broad objectives: achieving sustainable and inclusive growth by reorienting capital flows toward sustainable investment, mainstreaming sustainability into risk management, and fostering a new focus on transparency and long-termism in finance and economics.

The impact of the new rules will likely depend on the extent of firms’ existing ESG capabilities.

More recently, in February 2019, the EU agreed on two new categories of low-carbon benchmarks—a climate-transition benchmark and a specialized benchmark—both of which align with the Paris Agreement’s goal of limiting the global temperature increase to 1.5 degrees Celsius above preindustrial levels. The EC describes them as “voluntary labels designed to orient the choice of investors who wish to adopt a climate-conscious investment strategy.” Technical experts are working on how to best determine which companies are eligible for inclusion in the benchmarks.

Meanwhile, the EC hopes collaboration with legislators will help them reach an agreement on the outstanding area of the action plan—taxonomy. This refers to the proposal for a unified EU classification system of sustainable economic activities that aims to encourage investment in these areas.

Weighing Possible Outcomes

A report from ratings agency Moody’s opines that investment firms that already have ESG products in place could see a net win from the rules. It also comments that the changes could boost confidence in the ESG investment market, given the associated improvement in transparency.

Nevertheless, Moody’s estimates that costs for asset managers could rise by 0.25% to 2%, warning that margins might suffer as a result. It stresses that the impact will likely depend on the extent of firms’ existing ESG capabilities. Moody’s points to potentially large one-off costs, since implementing the rules may necessitate system overhauls, increased staffing, and additional training for employees. Bigger firms, especially those that have been pioneers within the ESG space, would likely be less impacted on the cost front.

Smaller active managers, by contrast, could find the new rules especially burdensome—particularly those that have taken relatively little action on the ESG front. This also comes at a sensitive time for active managers, who have recently faced increased competition from lower-cost, passive rivals offering exchange-traded funds (ETFs), the products that mimic benchmarks.

If these rule changes spur investment into the ESG segment as expected, then by the same token money may be moved away from those companies with a demonstrated negative environmental impact—particularly as the regulation requires disclosure about adverse effects. At the least, the ESG disclosure rule changes mean that investors should be able to look forward to more transparency and better-quality information.

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