Raising the bar for ESG investing

Carl Balslev Clausen
Product Manager, Director of ESG Investing, SimCorp

Connect with Carl on LinkedIn

Theodor Christensen
Head of Sustainable Finance at the Danish Financial Supervisory Authority

Connect with Theodor on LinkedIn

Explore the drivers for the SFDR and how it can shape the future of sustainable finance and our planet.

Read the article and learn about:

• The drivers for the SFDR and its impact on capital markets 
• The role of regulation in shaping the future of sustainable finance  
• The need for transparency and standardization in ESG investments  
• Best practice approaches to implementing the SFDR  

Foreword by Carl Balslev Clausen, Product Manager, Director of ESG Investing at SimCorp

Over the last few years, ESG investing and sustainable finance have firmly made their way on the capital markets agenda. As I see it, there are two interesting dynamics evolving in the industry.  

First, there is significant R&D activity in established companies, as well as a large pool of innovative startups using new and disruptive technologies, to create enriched perspectives on ESG and impact. This includes details on companies’ operations and activities, from their supply chains and internal operations, to the systemic impact of their products and services. But with the growth of sophisticated and granular data, the challenge for the investor becomes standardizing it in a way that is more easily comparable, on a like for like basis, to get a true picture of what they are investing in.  

Meanwhile, the difficulty for asset managers lies in fully integrating non-standardized ESG data into their investment operations. Key to overcoming this, is the consolidation of ESG data into the core investment data set and across the front-to-back investment lifecycle. This consistent approach across research, portfolio simulations, risk monitoring, performance attribution and reporting, creates an optimal data overview and supports the growing client demand for ESG data.  

Secondly, in parallel with the success of ESG funds inflows, there is some skepticism about the quality and level of commitment to sustainability and societal impact, across the ESG funds offered. It is fair to say that many of the ESG funds recently launched are difficult to distinguish from traditional tech funds. Asset owners already engage in careful due diligence processes when placing an ESG mandate with asset managers, but they also need more support with transparency when it comes to classification of ESG funds. 

Industry associations and regulators can play a pivotal role, to drive standardization and ultimately the credibility and legitimacy of the ESG market. There are ESG initiatives in jurisdictions across the globe, but the most comprehensive and ambitious is probably the European Commission’s 2018 action plan for financing sustainable growth, including the Sustainable Finance Disclosure Regulation (SFDR).

As part of SimCorp’s client support and ESG market engagement, we spoke to Theodor Christensen, Head of a newly-formed Sustainable Finance unit within the Danish Financial Supervisory Authority, to explore the drivers for this far-reaching regulation and just how it can shape the future of sustainable finance, and perhaps our planet too.  

Carl Balslev Clausen: The Danish Financial Supervisory Authority has formed a new group for sustainable finance, including the monitoring of the incoming EU SFDR regulation. What is the group’s mission and what priorities are you focused on in the coming 12 months?  

Theodor Christensen: The unit was established towards the end of last year with a focus on the supervision and the regulation around sustainable finance. This includes the SFDR but we will also be looking at the taxonomy regulation, once that kicks in, and a number of new developments in the sustainable finance area.  

Sustainable finance is a relatively new area for us and a megatrend that affects more or less the whole financial sector and also supervisory entities like us. While many of the tools or processes that will be used to supervise this area are the same as those that we use for other areas, this is still a fundamentally different and sometimes unique investment area to work in. It requires having an in-depth understanding on topics like climate change, social issues and what is considered sustainable.  

With the SFDR having an impact across capital markets firms in the EU, we decided it would make more sense to centralize the work and build the specific set of competencies needed, to really understand the regulation and the market forces at work and ultimately provide the best foundation to support capital markets firms.  

Carl Balslev Clausen: The SFDR is the core focus at present, what is the purpose and intended impact of the regulation on capital markets ESG practices?  

Theodor Christensen: Together with the taxonomy regulation, the main purpose of the SFDR is to standardize and harmonize sustainable finance. It will lift the bar significantly with a minimum threshold for what can be called sustainable investment. Before the SFDR, we had no common definitions and no joined-up regulatory framework to distinguish or to categorize what could be called sustainable financial products.  

The SFDR provides this framework and together with the taxonomy that will be introduced, it will create a coherent set of rules for sustainable finance, defining what firms need to live up to, to be sustainable and what they need to tell their investors. Ultimately, it is designed to provide the retail investor with clear communication and for financial advisors or asset managers to convey just how sustainable a given financial product is, or make clear when a product is not considered a sustainable investment and why.  

What is important to underline is that the disclosure regulation is not a conduct requirement. It's perfectly legitimate to not take sustainability into account, but if you do claim to offer a sustainable financial product, then the bar has now been raised significantly, as to what will actually constitute such a financial product. In our view, it will prevent mis-selling and enhance investor protection and transparency and that will be a game changer for the ESG investing space.  

Carl Balslev Clausen: While increased investor transparency could deliver a competitive opportunity, do you think regulation will deter firms from introducing ESG investment products, given the additional reporting burden?  

Theodor Christensen: What we may see is a bifurcation in the market. Today it is relatively easy to call something an ESG product. After the SFDR and the taxonomy regulation comes in, some products will no longer fit the bill. While the new regime will require increased reporting for the sector, especially in the beginning, to date there has been limited incentive for the industry as a whole to go the extra mile. Firms haven’t had to – or really been able to - distinguish themselves above their peers, when it comes to the quality of their sustainable products.  

So I believe we will see greater differentiation in the financial sector. I expect that the net effect will be an increase in the amount and accessibility of sustainable finance products, thus creating more choice and transparency for investors.  

Carl Balslev Clausen: Talking of standardization in the capital markets, why is it important to have a global standard for ESG investments? And what role will the impending taxonomy rule play in achieving this?  

Theodor Christensen: With the disclosure regulation and the taxonomy, we will have a relatively coherent and common EU framework, pretty much in place from 2022 when it really kicks in. Of course, that only covers European capital markets. Since we have globally integrated financial markets, many see the end goal being a set of global standards.  

Today we have an alphabet soup of different ESG ratings providers, data providers, certifications, mechanisms, reporting standards and templates. While most of the work itself is solid, the methodology varies from provider to provider. This makes reporting an administrative burden, both for the financial sector and for firms in the real economy. Broad global standards could help lower administrative burdens and facilitate a wider uptake of ESG and sustainable finance.  

At the accounting level, for example, there is work underway to establish a common standard for the non-financial information, which would be similar in nature to IFRS. Achieving this in the ESG space would make it simpler for firms, with one set of requirements that they need to live up to, to access green capital.  

Achieving global standards is also about connecting the emerging world with mature capital markets. It can be difficult for investors in mature markets to tap into potential ESG investment opportunities in less developed markets, as the disclosure and reporting rules are quite strict and specific. This in turn implies a risk of concentrating ESG investments in the established markets, while sucking capital out of other parts of the world. This is not necessarily the most efficient way to combat climate change.  

Carl Balslev Clausen: Has there been any feedback from financial market participants about the most challenging parts of the regulation for them to embrace?  

Theodor Christensen: Some financial market participants have been surprised as to the level of detail and rigor that is being applied. For example, the requirement to ensure that you do no significant harm, a key part of the SFDR, can be challenging. This is because you really have to do quite a thorough assessment of the companies invested in.  

I mention this because it’s important to remember that while firms need to show reporting on more common indicators such as CO2 emissions, the SFDR takes a broader sustainability perspective, which also includes social and governance issues, or what it sometimes called the triple bottom line. Demanding this data will inevitably see it being more readily produced. I would very much expect that within a few years’ time we will see more granular reporting not just on the climate-related issues, but also the social and human rights aspects of the regulation.  

Furthermore, a fair number of companies have been struggling with the ambitious timeline for implementing the SFDR, which started applying from 10 March 2021. While the detailed regulation is still not finally approved, the EU Commission has been very clear that firms have to live up to the SFDR as far as the level one text goes from this date.

We expect that the detailed regulation will apply fully from 1 January 2022, subject to confirmation from the EU Commission. From a supervisory point of view, we understand there may initially be a chicken and egg situation when it comes to methodology and data. We therefore see 2021 as a transition year, where firms should really try to do as much as is possible, on a best effort basis. From 2022 onwards however, once both the detailed regulation for the SFDR and the taxonomy has come into force, we expect firms to have much more data and report more rigorously.

Carl Balslev Clausen: Given these challenges, is there a best practice approach for firms, when implementing the SFDR, from an operations and data management perspective?  

Theodor Christensen: While we don't have specific advice as a supervisory body, I believe that it will be important for financial companies in general to integrate ESG and sustainability into their core processes. At the moment, we are witnessing the mainstreaming of sustainability across the financial regulation, so this is definitely an area with significant political momentum. A lot also depends on where firms are on their sustainability journey. Those firms that have worked ambitiously with the agenda for some years will already have many of the tools and processes to implement the SFDR efficiently.  

Carl Balslev Clausen: Finally, looking beyond 2022, what are your aspirations for capital markets with respect to ESG investing and what opportunities do you see unfolding?  

Theodor Christensen: As a regulator, we don't have any views on the political aspects of this area. But this is a huge regulatory push with many different pieces of legislation, and while there may be some fuzziness around the precise interplay between the various rules now, I believe that in a three-five year horizon we will have a coherent set of rules governing the sustainable finance area.