Fund companies including Vanguard Group, BlackRock Inc. and State Street Corp. that sell investment products in the European Union come under the new rules that took effect this month, though details are still being finalized.
“There are many issues to be resolved, it is causing anxiety,” said Rick Lacaille, global lead for environmental, social and governance investing at State Street, whose SPDR exchange-traded funds are some of the most popular.
Surging investor appetite for green investments means that rules on disclosure, both for traditional funds and those that call themselves sustainable, will become increasingly important.
In the U.S., the Biden administration is taking the first tentative steps toward imposing similar rules. The Securities and Exchange Commission already is focusing on climate-related disclosures by companies. While any big changes will take years, they could change the way companies disclose information about diversity, carbon emissions and worker pay.
These environmental, social and governance, or ESG, disclosures have historically been governed mostly by a hodgepodge of voluntary frameworks and private data firms. Europe’s new Sustainable Finance Disclosure Regulation requires banks, private-equity firms, pension funds, hedge funds, and other asset managers to meet a slew of ESG requirements. It applies to all funds, even if they don’t sell themselves as sustainable.
The disclosure affects trillions of dollars in assets for fund companies that actively market funds in the EU. That includes around 55 U.S. firms that manage Ireland- and Luxembourg-based funds from the U.S., two common places for overseas funds due to favorable tax environments, according to data provider Morningstar Inc.
One-third of the 100 largest cross-border investment managers that distribute their funds into Europe have a U.S. parent company, according to a report last year by the accounting firm PricewaterhouseCoopers.
One concern of some fund managers is that the rules may have gotten ahead of reality. Many funds will be required to disclose information on companies, including data that the companies may not disclose themselves.
For example, U.S. fund manager Barings’s Ireland-based Global High Yield Credit Strategies Fund has a stake in Inspire Brands Inc., the U.S.-based owner of Arby’s, Dunkin’ and other restaurant chains. Inspire Brands is privately owned and doesn’t disclose many of the metrics that Barings might have to report on for its fund, such as any gender pay gap.
A Barings spokesman said “ESG topics are a key focus area” for the firm, which doesn’t comment on specific investments within its portfolio. Inspire Brands didn’t respond to a request for comment.
In many countries, including the U.S., companies aren’t required to report ESG data. For example, only about one-third of S&P 500 companies disclosed diversity information, such as any gender gap among employees, in their annual reports for 2020 according to a recent Wall Street Journal review of more than 160 reports.
Fund manager BlackRock, which has made a big bet on ESG, predicts the European initiative will reinforce the global trend toward the greening of financial products. “Our ambition is to move more money into sustainable products than any other asset manager in Europe,” a spokesman said. “We view [the new regulation] as a catalyst to accelerate that transition.”
Europe’s prescriptive approach to ESG disclosure could have big knock-on effects outside the Continent. JPMorgan Chase & Co. estimates that nearly $7.2 trillion is invested along ESG guidelines, up from an estimated $3 trillion last year, with 80% of that money in Europe.
“The big unknown is…how established these standards become beyond Europe,” said Andy Pettit, European policy research director at Morningstar.
The SEC, which stymied calls for tighter ESG rules under the Trump administration, has in recent weeks shown a renewed enthusiasm for the topic. The regulator has made ESG an “enhanced focus” of its inspections of firms; set up an enforcement task force to pursue misleading ESG disclosures; and requested public comment on climate disclosure.
“It’s time to move from the question of ‘if’ to the more difficult question of ‘how’ we obtain disclosure on climate,” acting SEC Chair Allison Lee said in a speech last week. Gary Gensler, President Biden’s nominee to head the SEC, in a recent Senate hearing backed increased SEC guidance on such disclosures.
Several questions remain unresolved: Should there be a new standard-setting body in the U.S. to write ESG rules? Does every company need to disclose the same metrics, regardless of its industry or whether it is privately owned? And should the data be audited? Any effort will likely run into opposition from investment firms and industries that fear the new disclosures will hurt their appeal to investors, leave them open to litigation or prove costly to implement.
Better ESG disclosure, along the lines of standard accounting rules, is a hot topic among investors now. “If some companies reported their sales whenever they shipped from a warehouse and some when cash was received, it would be completely impossible for an investor to say which is a good company,” said Jeff McDermott, head of Nomura Greentech, a New York-based investment bank owned by Nomura Holdings Inc. “We don’t have this today for ESG.”
Many money managers generally welcome industrywide standards as a way of countering “greenwashing”—unjustified claims by products to be more climate-friendly or socially conscious than they really are. But the industry has concerns about the European approach.
The new rules will require firms to disclose the negative effect of their investments on the climate or social and governance issues, by quantifying more than a dozen mandatory “principal adverse impacts.” These range from board gender diversity to greenhouse-gas emissions and exposure to controversial weapons, but the data often isn’t available.
Europe is “going much further than [firms’ current reporting], because we don’t have the data,” said Marie-Adelaide de Nicolay, head of the Brussels office of the Alternative Investment Management Association. Fund managers will have to comply with the rules on a best-efforts basis, she added.
Those best efforts will likely involve some guesswork. Data companies that sell ESG information to investment managers often use modeling and estimates to help fill in gaps in the information that is publicly disclosed by companies.