The regulatory landscape for asset managers has changed significantly over the past year, especially when it comes to ESG and sustainable investment practices. In this piece, we review some of these changes in more detail and share recommendations on how managers can prepare for 2022 and beyond, including:
- How regulators are trying to stamp out greenwashing and what managers can do in response to better substantiate their sustainability claims and practices
- How recent efforts to standardize sustainability disclosures for companies and investors will transform how managers are expected to collect, analyze and report data
- Why the launch of new industry standards, membership groups and initiatives (like the Net Zero Asset Managers Initiative) are creating a higher bar for managers, and what steps managers can take to keep up with the competition
Regulators focused on stamping out greenwashing via ESG disclosure
The prevalence of greenwashing in the asset management industry has caught the attention of regulators, with several regulatory bodies taking steps to clarify the labels and practices that should be used to articulate a manager’s approach to ESG.
The Securities and Exchange Commission (SEC) was active in addressing ESG throughout 2021, paying particular attention to evolving practices among registered investment advisers (RIAs) and forming the infrastructure needed to carry out the Commission’s regulatory priorities related to ESG. In April 2021, the SEC issued its first-ever ‘Risk Alert’ related to its review of ESG investing. This alert offered more transparency into what the SEC views as acceptable behavior for managers in the ESG space and identified those ESG practices the Commission deems to be risky or likely to create a conflict of interest. A few weeks earlier, the SEC had announced the creation of the Climate and ESG Task Force within the Division of Enforcement. This taskforce is mandated to identify instances of “ESG wrongdoing,” such as the misrepresentation of ESG capabilities.
SEC officials continue to signal that rulemaking related to ESG is on the horizon. In a July 2021 conversation with the now former CEO of the Principles for Responsible Investment (PRI), Fiona Reynolds, SEC Chair Gary Gensler indicated that there is an urgent need for climate disclosures and signaled rulemaking related to these disclosures would occur in the near term; in a December 2021 speech, Commissioner Caroline Crenshaw suggested that this rulemaking remains on the SEC’s agenda and is anticipated in 2022.
Meanwhile in Europe, the EU continued to move forward with its regulatory agenda related to sustainability in 2021. In March, the Level One rules of the Sustainable Finance Disclosure Regulation (SFDR) went into effect, requiring all EU managers to review the methods by which their investment approach does or does not take sustainability into account. Based on this assessment, managers were required to label their funds as they correspond to the articles of SDFR (e.g., Article 6, Article 8 or Article 9) and to make corresponding disclosures based on the article type. The Level Two rules of SFDR have been repeatedly delayed and are not set to go into effect until January 2023, at the earliest. U.S. domiciled managers that have a nexus to the EU, or who pursue an active marketing effort in the EU (except those who rely on the provisions of reverse solicitation), are in scope of SFDR and are required to comply with SFDR in the same form and fashion as EU domiciled managers.
Also in Europe, managers with products designated as Article 8 or Article 9 under SFDR have had to undertake a review of investment activities based on the technical screening criteria associated with the EU Sustainable Finance Taxonomy (Taxonomy Regulation). The main feature of the Taxonomy Regulation is to provide a classification system that helps companies and investors determine which activities should qualify as “sustainable” (e.g., nuclear energy, natural gas, etc.), and requires increased disclosure by those entities that claim to provide a sustainable product or service.
While there is much debate about which economic activities should be included or excluded under the taxonomy (currently, the six sustainability objectives of the regulation are each related to environmental topics, with more objectives related to social factors expected in 2022), the existence of an EU-wide framework has had significant knock-on effects for investment managers with exposure to European businesses. In the U.S., managers who are not in scope of the Taxonomy Regulation are increasingly fielding requests for disclosure information related to the regulation’s sustainability objectives, and this trend is expected to continue into 2022.
Finally, in the UK, the Financial Conduct authority (FCA) published a discussion paper in November 2021 focused on the asset management industry and the labeling of sustainable investment products. The comment period for this discussion paper closes in mid-2022, at which point market prognosticators expect the FCA to propose rules in the manner of SFDR. The UK has also made significant commitments to expand reporting related to climate risk in the public markets, and in December 2021, the FCA released final rules and guidance for asset managers and asset owners requiring them to make disclosures consistent with the Task Force on Climate-related Financial Disclosure (TCFD) framework.
Silver’s key takeaways: While rulemaking in many jurisdictions is still in progress, asset managers are under increasing pressure to support and substantiate their claims related to ESG, climate and impact. Firms that vaguely point to ESG strategies or do not have processes to document and evidence their ESG investment activities should be wary of the regulatory shift and mounting investor expectations related to frequency and quality of ESG disclosures, which themselves stem from regulatory actions. Firms with strong existing processes should ensure they are on track to comply with both current and future regulations, and audit their activities to ensure their ESG efforts match their ESG commitments and communications.
Standardizing sustainability disclosures for companies and investors
We have also seen significant progress towards standardizing the reporting and disclosure of a range of sustainability issues from diversity, equity and inclusion (DEI) to climate change and biodiversity.
The biggest recent move towards disclosure standardization was the creation of the International Sustainability Standards Board (ISSB) by the IFRS Foundation which sets and oversees financial reporting standards for financial markets around the world. Formally announced in November 2021 at the UN climate conference in Glasgow (COP26), the ISSB intends to consolidate the work of both the Value Reporting Foundation–itself created by the merger between the Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council (IIRC)–and the Climate Disclosure Standards Board (CDSB). The ISSB also introduced draft technical standards for climate disclosures, which will be updated and published in 2022.
Similarly, the SEC is soon expected to come out with two sets of proposed corporate disclosure rules: (i) related to climate risk disclosure; and (ii) related to human capital management. These rules will likely build on the efforts of industry standard-setters like those mentioned above.
Amidst announcements from regulators and standard setters, there have also been several industry-led efforts to standardize ESG data, especially among private fund managers.
- ESG Data Convergence Project – In September 2021, a group of LPs and GPs in private equity launched the ESG Data Convergence Project, in cooperation with ILPA and the Boston Consulting Group, to streamline data collection and comparison within the private equity industry. The convergence project has an initial focus on six key ESG metrics including GHG emissions and board diversity.
- Novata – In October 2021, a consortium of philanthropy and business leaders launched Novata, a public benefit corporation that is building an ESG database for private markets investors and firms. Novata’s ESG framework features ten specific metrics, such as water management and employee safety.
- ILPA – In November 2021, ILPA released its revised due diligence questionnaire (DDQ) and Diversity Metrics Template to meet growing LP demand for standardized metrics about private fund managers. ILPA specifically updated both the ESG section of the DDQ, drawing on the revised UN PRI Limited Partners Private Equity Responsible Investment DDQ, and the DEI section to reflect a broader definition of how DEI should be integrated into the organization.
- Nasdaq – In December 2021, Nasdaq agreed to align with ILPA’s Diversity Metrics Template by committing to collect DEI data from private fund managers and make it available to investors free of charge via the Nasdaq eVestment platform as early as February 16, 2022. The database will include diversity metrics for investment firms as well as aggregated diversity metrics for the board and senior management of private funds’ portfolio companies.
The combination of these developments signals that asset managers will no longer be able to point to the lack of consistency around ESG data as an excuse for why ESG and other sustainability factors are not considered as part of the investment decision-making process. While managers will still be expected to interpret and use the data that is most relevant to their particular investment strategy, the exponential increase in the quality and universality of ESG data addresses one of the biggest concerns among both LPs and GPs about the lack of decision-useful data.
Silver’s key takeaways: The sprawling patchwork of sustainability disclosure frameworks and standards is finally beginning to tighten around a universal standard. While the difficult work of harmonizing these frameworks will continue for some time, there is a clear expectation from both regulators and LPs that managers be transparent when it comes to communicating their ESG and impact methodology and performance.
In addition, while climate change continues to be top-of-mind for regulators and standard-setters, asset managers should treat any rulemaking on climate disclosure as a preview of things to come on other sustainability issues as regulators and standard-setters work to harmonize disclosure requirements, standards and frameworks.
Managers face a higher bar to keep up with the competition
Not too long ago, a fund manager that wanted to raise its profile as a sustainable investor could apply TO become a PRI signatory and glow in the recognition of being aligned with a set of industry best practices. But as the sustainable investment industry has matured, so too has the bar of what is considered best practice.
The big buzzword of 2021 was ‘net zero’, with several different groups of investors and financial institutions joining forces to announce their intentions to align their portfolios with a net zero world. These net zero groups include the Net Zero Asset Owner Alliance (with 56 members and $9+ trillion in combined assets under management), the Net Zero Asset Managers Initiative (with 220 signatories and $57+ trillion in AUM), and the Net Zero Investment Consultants Initiative (with 12 initial members and $10+ trillion in assets under advisement). In April 2021, these organizations and other net zero groups for banking, insurance and other financial services came together to form the Glasgow Financial Alliance for Net Zero (GFANZ), which by the time of COP26 included 450 financial institutions representing more than $130 trillion in private capital committed to net zero targets.
The sheer size and reach of these groups makes them important bellwethers for tracking trends in the asset management industry, especially when it comes to ESG, impact and sustainability. However, investment firms should be careful about committing to a net zero group or net zero target unless they are prepared to meet what are likely to be increasingly stringent requirements.
As an example of net zero requirements, members of the manager-specific group, NZAMI, make a commitment to, among other goals, set interim GHG targets for 2030 in line with a 50% global reduction in CO2, take account of portfolio Scope 1 & 2 emissions, implement a stewardship and engagement strategy consistent with net zero targets, and disclose to investors information on net zero investing and climate risk and opportunity.
Fulfilling these long-term climate commitments can require years of planning and the buy-in of the entire firm, not to mention deep climate expertise via an in-house team, external consultants or a combination of the two. And as outlined above, regulatory considerations should also be a component of a manager’s decision to make net-zero commitments. In a sign that regulators are paying attention to net zero momentum, SEC Commissioner Caroline Crenshaw shared her view in a December 2021 speech that it is not clear how companies will achieve their net zero goals or provide the requisite information investors need to understand such goals.
A good starting point for managers, regardless of whether they aspire to join a net zero group or set a net zero target, is to familiarize themselves with the intricacies of TCFD reporting. The UK recently became the first G20 country to mandate TCFD-aligned reporting for the country’s largest companies and financial institutions, a requirement that goes into effect in April 2022. Similar requirements for fund managers in the UK are on the way as the result of the FCA’s open consultation on sustainability disclosure requirements and a new potential classification and labeling system for sustainable investment products.
Other standards and frameworks that have emerged in recent years and represent what a higher bar in 2022 could look like include:
- Operating Principles for Impact Management – Introduced in April 2019, the Operating Principles for Impact Management (or Impact Principles) provide a framework for designing and implementing an impact management system that integrates impact considerations throughout the investment life cycle. The Impact Principles are relevant to all types of impact investors and sizes of investment portfolios, asset types, sectors and geographies. Already, some 150 impact investors with a combined $425+ billion in impact AUM have signed onto the Impact Principles.
- SDG Impact Standards – Currently in development, the SDG Impact Standards are focused on catalyzing investment to achieve the Sustainable Development Goals (SDGs) by 2030. To date, SDG Impact has proposed Standards for Private Equity Funds, Bond Issuers, and Enterprises. SDG Impact has also collaborated with the Organization for Economic Cooperation and Development (OECD) on developing the Impact Standards for Financing Sustainable Development, which are designed to support donors in the deployment of public resources through development finance institutions and private asset managers in a way that maximizes the positive contribution toward the SDGs.
- CFA Institute standards – In November 2021, the CFA Institute introduced their Global ESG Disclosure Standards for Investment Products, which are designed as a voluntary standard for how managers consider ESG issues in an investment product’s objectives, investment processes and stewardship activities. While it is unknown at this stage whether the standards will get broadly adopted by the market, it is worth noting that the CFA Institute has made efforts to roughly align their standards with SFDR requirements in the EU.
Interestingly, each of these three standards either already requires external verification of alignment (Impact Principles) or is in the process of developing an assurance framework (SDG Impact, CFA Institute). This echoes what we have seen from many regulators and LPs, who are united in their desire for an accountability mechanism to hold managers accountable and reduce greenwashing.
Silver’s key takeaways: As with the net zero groups, managers should make sure they understand which standards are relevant to them and whether they will be able to meet the requirements. A good approach to evaluating the applicability of these standards is by first recognizing where an investment strategy fits on the broad spectrum of sustainable investing approaches, with negative screening generally on one end and impact investing on the other end.
We do not feel that managers should join these groups or align with these standards solely in response to LP pressure. Requirements are constantly evolving and we believe managers should make their decisions based on current fit, their ESG strategy and capabilities and what is reasonable and practical for their team, rather than future aspirations.
The Silver team continues to monitor each of these developments. We look forward to your comments and questions.