Despite the market upheaval, environmental, social, governance (ESG) investing is gathering momentum, and this shows no sign of decelerating anytime soon.
As ESG funds continue to accumulate ever larger sums of money, regulators are having to step in. Our latest insight on sustainability looks at how ESG regulation is impacting the funds industry, sharing insights on the potential direction of travel in the months ahead.
An asset class that keeps growing and growing
While many asset managers have suffered outflows amid the volatility, ESG funds remain an outlier, and continue to enjoy healthy growth.
According to PwC, asset managers are expected to see their ESG related assets under management (AUM) jump from $18.4 trillion in 2021 to $33.9 trillion by 2026.[1] Meanwhile, PwC adds that the AUM controlled by ESG UCITS funds could top EUR 7.9 trillion by 2025.[2]
So, what is driving this?
Investors – both retail and institutional – fully recognise the importance of ESG.
For instance, a 2023 study commissioned by BNP Paribas found 41% of asset owners and asset managers said that committing to net zero is a priority for their organisations – a substantial increase from 2021, when only 18% of respondents had a net zero commitment in place. [3]
“Sustainability has become an increasingly prominent feature of investing. This is because a new generation of investors is putting a special emphasis on sustainability, equality and a number of other non-financial performance-related factors when allocating capital and making investment decisions. Trustees of pension funds and investment fund managers are being put under pressure to invest responsibly,” said Kobus Cronje, Managing Director for Guernsey at JTC Group.
This focus on ESG is being reflected in the manager selection process.
Analysis from PwC in Luxembourg seems to back this up, with 66% of European institutions saying that they plan to stop investing in non-ESG funds, while 71.9% added they would happily pay a premium for accessing ESG products. [4]
In addition to helping investors meet sustainability targets, ESG funds have a relatively decent track record of delivering superior returns, at least when benchmarked against non-ESG funds. Although ESG equity funds fared badly in 2022, they outperformed non-ESG equity funds in the first quarter of 2023, partly due to their heavy exposure to technology stocks.
“The overarching principles of ESG is ultimately to ensure long-term sustainability, which in turn will drive better returns for all. ESG related investments, especially those that combine with technology and innovation, can provide superior returns and offer an element of future proofing which may be absent in a number of traditional investments,” commented Cronje.
Risk management is also a major consideration for investors when making ESG allocations, noted Gregory Yianni, Senior Manager – Sustainability Services. For example, several high-profile institutions have divested from fossil fuel heavy companies amid concerns that they pose long term financial risks to their portfolios. This comes following warnings from regulators that some assets could become stranded – or difficult to sell – as the world transitions to net zero.
ESG funds find themselves under pressure
Although ESG funds are managing records amount of money, the industry does face some challenges.
One of the biggest problems is that ESG investing is still a new discipline, meaning there is often uncertainty about what assets qualify as being ESG. This is partly subjective, as different investors will have their own opinions on ESG and sustainability.
Even across different geographies, there are often conflicting opinions among investors about ESG. “For example, in developed markets, environmental and climate change related investments are considered relatively more important versus in the developing world, where socio-economic investments tend to carry more weight,” said Cronje.
The lack of quality data does not help the ESG cause either. This comes as the BNP Paribas study noted that 71% of asset owners and asset managers said incomplete and inconsistent data is the biggest barrier to ESG investing a 17-percentage point increase since 2021. [5]
Similarly, different ESG ratings agencies – which have recently come under the regulatory spotlight in the EU –also adopt their own methodologies when determining ESG scores, and not all of these will be aligned. This simply adds to the confusion.
Without decent data, it becomes harder for managers to accurately report on ESG to investors. It also increases the risk of greenwashing, whereby a manager might imply, even inadvertently, that their fund is ESG, when it is nothing of the kind. This is a problem which risks eroding confidence in the entire ESG market, a point made by Orla Philippon, CEO of JTC Global AIFM Solutions in Ireland.
“The challenge is that the terms and measurements of ESG have not been fully agreed, nor are they easily determinable. As such, the risk of greenwashing remains a major challenge for ESG investors,” she added.
Again, this is something which regulators globally are looking to stamp out.
A market ripe for regulatory intervention
Regulators and industry bodies across major markets – including the EU, US and UK want asset managers to be more transparent about how they factor ESG into their investment and risk management processes, amid concerns that greenwashing has become entrenched within the industry, according to Cronje.
By doing so, it will become easier for investors to compare different managers on ESG criteria.
The question is, what are regulators and industry bodies doing exactly?
Firstly, efforts are underway to bring about standardisation of ESG data and reporting frameworks, noted David Vieira, Group Head of Sustainability Services. “Work by industry bodies – such as the International Sustainability Standards Board, as well as regulators in the EU (i.e., through the Taxonomy), UK and US are helping to create a smaller, more uniform sets of standards, which will aid clarity on data collection and reporting for all parties,” he continued.
The EU is demanding funds become more transparent on ESG as well.
For example, the Sustainable Finance Disclosure Regulation (SFDR) introduces mandatory disclosure obligations for AIFMs and UCITS – irrespective of whether they run ESG mandates – and requires them to publish information on how they integrate ESG into their operations at both an entity level and a fund level. This could be in the form of website disclosures or prospectus updates.
SFDR’s Level 1 provisions – which came into force in 2021 – have been supplemented by more comprehensive Level 2 requirements. Under the Level 2 rules, managers must comply with detailed pre-contractual and annual reporting disclosures, and these disclosures must be submitted in a mandatory reporting template.
“The regulators are looking to stamp out greenwashing, by ensuring that products labelled as sustainable are genuinely sustainable. The SFDR requires information about sustainability to be clearly disclosed in the documents provided to clients,” said Louis Lamotte, Managing Director of JTC Global AIFM Solutions in Luxembourg.
Looking ahead, the UK and US is expected to follow the EU’s lead by introducing their own ESG reporting requirements for asset managers.
“Regulators around the world are implementing a wide variety of legislation which imposes a high degree of transparency on investment funds. The reporting requirements have been a real challenge, as they are complex and costly. JTC has a specialist Sustainability Services team and our Global AIFM solutions business has extensive experience in guiding and supporting investment advisers, fund promoters and client boards on how to develop and implement effective ESG strategies, together with ensuring compliance with regulations,” commented Cronje.
David Vieira concluded:
“It is clear that ESG and sustainable investing is on the rise, but at the same time the standards and reporting requirements remain a complex and moving target for many.
JTC’s Sustainability Services are based on a comprehensive understanding of the latest reporting requirements and best practices, both as a FTSE 250-listed public company, and also having over 36 years of governance experience across asset classes and geographies.”
“Our team can help support companies and investment managers to develop and implement their own ESG/sustainability goals which are tailored to their specific needs. Specifically for alternative investments, we now offer AIFM solutions from three key jurisdictions, alongside our Sustainability Services.”
He continued, “I believe that the increased scrutiny on ESG and sustainability reporting requirements is a positive development. It will help to ensure that organisations are held accountable for their claims and help provide the transparency needed to make informed investment decisions.”
With regulation set to increase and with regulatory bodies looking to issue and impose further guidance and obligations for asset managers, further expertise and navigation support will be needed, in order to develop and implement (cost) effective ESG strategies over the months and years ahead.
To find out more about JTC Global AIFM Solutions, please visit the dedicated website: JTC Global AIFM Solutions
For more information on ESG and Sustainability Services provided by JTC, please visit the following page: Sustainability Service.
[1] PwC – October 10, 2022 – ESG focused institutional investment soaring 84% to $33.9 trillion in 2026 making up 21.5% of assets under management: PwC
[2] ESG Clarity – July 23, 2023 – PwC reveals the top 20asset managers with Article 8 and 9 funds by AUM
[3] BNP Paribas– September 6, 2023 – Institutional investors accelerate their low carbon transition strategies
[4] Wealth Briefing – June 28, 2022 – The ESG phenomenon: PwC Luxembourg
[5] BNP Paribas– September 6, 2023 – Institutional investors accelerate their low carbon transition strategies
