ESG – challenge and opportunity for Scotland's asset managers
Jan Gruter is Legal Director in Addleshaw Goddard's Investment Management group and a member of the firm's cross-departmental wealth & asset management sector team, based in Glasgow.
There has never been greater interest in environmental, social and governance (ESG) orientated investing, and particularly so in Scotland.
According to data from the Investment Association's Asset Management Survey 2018-2019 Scotland is responsible for 11% of the UK's responsible investing market, outpacing its 7% share of the conventional market. A recent report from the Ethical Finance Hub found sector growth in Scotland of more than 27% per year since 2004, mostly in ESG related funds.
Yet there are clear challenges facing both asset managers and investors when it comes to ESG investing. The understandings that underpin ESG concepts are often nebulous and ill defined, making it hard to measure the merits of individual financial products and ultimately to hold asset managers and portfolio companies accountable.
At a European level, significant progress is being made to develop a comprehensive ESG legal framework. From next year, the EU Disclosure Regulation will bring in transparency obligations. This will include, for example, whether investment processes feature sustainability considerations. Specific pre-disclosure and reporting obligations applying to financial products (such as funds) will vary in scope and complexity, with the most comprehensive applying to products holding themselves out as pursuing ESG objectives.
Nevertheless, we are only at the beginning of regulatory development.
In particular, the new EU rules do not currently extend to creating a pan-European ESG label for investment products. The long-negotiated Taxonomy Regulation makes steps towards this, aiming to create a binding framework for defining activities that can be deemed "sustainable". However, it will be for regulators at the national level to establish suitable marketing frameworks for such products.
Furthermore, the Taxonomy Regulation only really covers the "E" in ESG with the "S" part being the most likely candidate for further definition in years to come.
Scrutinising performance of investment products depends on reliable information. Some of the new rules aim to improve availability of ESG-related data – for example by extending non-financial reporting requirements to large listed investee companies.
There will be gaps, especially around unlisted companies. Asset managers themselves will be subject to detailed reporting requirements and will have a pressing need to obtain ESG data points on their portfolio. There will be significant reliance on third-party data providers. These are often unregulated and employ range of methodologies and metrics so challenges around comparability of data will continue and will continue.
The scope for either accidental or wilful data misuse and misrepresentation will increasingly come into focus as ESG products are made more accessible to retail investors. The regulators will be watching closely. It's not far-fetched to predict that regulation of ESG data providers will be on their agenda in years to come.
Will COVID-19 lead to a slowdown in the focus on ESG investing?
After all, some might argue that the focus of asset managers and investors will now be shorter term performance considerations and regulators will be preoccupied with putting the economy back on track rather than regulating ESG.
It's unlikely to pan out that way. With many ESG focussed funds having outperformed conventional funds during the pandemic and the increased focus on the "S" part of ESG during the pandemic, we likely see even more appetite for ESG financial solutions and corresponding attention from the regulators.
Those who can navigate the coming regulatory changes and scrutiny will be best positioned to make a success of the many opportunities that ESG investing presents. For Scotland's asset management industry with its strong commitment to responsible investing, this is great news.
Published 26 August 2020