On 10 March 2021, the EU Commission put into effect new Sustainability-Related Disclosure Regulation (SRDR) in the financial services sector. It stipulates 'sustainability disclosure obligations for manufacturers of financial products and financial advisers toward end-investors’. It also lays down new obligations to report ‘adverse impacts on sustainability matters at entity and financial products levels’.
This regulation aims to remedy the complicated melee of different methodologies and standards for reporting. As ESG finance is a reasonably new and increasingly dominant reality for financial services, this is a vital piece of regulation that will, in an ideal world, ensure the quality of financial products in the EU by filling in the previous Swiss cheese-like reporting standards. Another potential by-product of the regulation will be an increased level of confidence in the ESG market and a concomitant increase in investment in ESG funds, which will also stimulate further growth.
The Sustainability-Related Disclosure Regulation also specifies criteria for unregulated businesses to be categorised as ‘sustainable’ if they are to receive investment. However, whilst this makes substantial headway into standardising reporting standards, there is still a long way to go if ESG finance is to continue growing at its current rate. Furthermore, there are concerns over the varying definitions and categorisations of ESG. This haziness undermines the label ‘ESG’; as Merryn Somerset Webb points out, ‘one man’s green dream is very often another’s sin stock’.
This article will assess the current trajectory of ESG-related corporate finance including its challenges and opposition. It will also evaluate the impacts of this movement on law firms and their clients.
Some of the main ESG debt finance products include green bonds, green loans and Sustainability-Linked Loans (SLLs). Green bonds are a fixed-income security (meaning it pays fixed periodic interest payments) which are intended to support environmental projects and initiatives. SLLs also aim to facilitate the borrower’s environmentally sustainable growth and investment. Brokerage firms and mutual fund companies also now offer exchange-traded funds (ETFs) that follow ESG criteria.
Catalysed by a high density of social and environmental movements in the past few years, ESG finance and impact investment (a strategy that aims to derive financial gains whilst achieving positive environmental or social change by investing in ESG-related companies and financial products) is more prominent than ever. According to the Financial Times, last year $152bn of new money was invested in ESG products with total global assets in these products reaching over $1.6 trillion.
There has also been a proliferation of private equity and venture capital firms dedicated to impact investment strategies. These firms and the green finance instruments aim to stimulate lasting innovation in sustainability by funding every step of the global supply chain. This strategy has proven to be effective with many examples of ESG-driven companies receiving financing from these firms and green instruments. One example of this is the immunotherapy and vaccine company Vaccitech, backed by the Oxford Sciences Innovation venture capital firm, which helped develop the ChAdOx vaccine. However there is a strong opposition to such strategies and sustainable debt securities.
One of the main issues with ESG funds and 'sustainable investing’ is greenwashing. The pressure on asset managers and equity funds is so high that almost every active fund is labeled as ESG or marketed as such. Marcus Björksten, manager of the high-performance sustainable fund Fondita Sustainable Europe, explained that, ‘Nowadays, every second fund is claiming it is in some way sustainable’. However, in reality there is a high chance that these funds are either tech-heavy or are covertly invested in fossil fuel companies.
The aforementioned Sustainability-Related Disclosure Regulation put into force on 10th March 2021 is the most potent regulatory attempt yet to appease such issues and restore faith in the market. The regulation makes greenwashing very difficult by instituting requirements for companies to disclose any ‘investment decisions and advice [that] might cause, contribute to or be directly linked to effects on sustainability factors that are negative, material or likely to be material’. Only then will they be able to receive categorisation as either sustainable or non-sustainable, the latter of which is politically extremely undesirable.
Attracta Mooney from the Financial Times writes, ‘The new rules could have far-reaching consequences for asset managers — not just in Europe but around the world as investment firms are forced to demonstrate they are serious about sustainability. They will also influence the decisions of listed companies which will find themselves under pressure to focus more on ESG issues or risk losing investor capital’.
It remains to be seen whether such disclosure requirements will have a palpable effect on greenwashing, however the regulations appear stringent enough to require a significant level of input from firms for reporting. To begin, Articles 3 and 4 require that, ‘Financial market participants shall publish on their websites information about their policies on the integration of sustainability risks in their investment decision‐making process’. Under the second stage of the SRDR (forecast to be implemented in 2022), companies and funds will be required to report ‘on issues such as carbon footprint, investments in companies active in fossil fuel sectors and exposure to controversial weapons such as cluster bombs’.
The effect on these strict rules on public disclosure will result in enhanced competition between both investors and companies as funds will compare their sustainability commitment products and policies with competitors, and investors will select which ones provide the most promising ESG statistics, and therefore arguably the most potential for returns.
Maria van der Heide, head of EU policy at ShareAction, a charity dedicated to responsible investment, states, ‘It is a groundbreaking law. For the first time, investors will be forced to account for their negative externalities (“adverse impacts”) on people and planet’. According to PwC, assets in sustainable investment products in Europe alone are expected to reach €7.6tn by 2025, which will increase its proportion of the European share market to 57% from 15%.
And whilst the EU is leading the charge, the International Financial Reporting Standards (IFRS) Foundation is expected to launch a global Sustainability Standards Board at the UN’s COP26 climate summit, which is due to be held in Glasgow in November 2021. The IFRS is backed by the International Organization of Securities Commissions (Iosco), which regulates the world’s securities and futures markets.
The impacts of this on law firms presents a similar challenge. Lawyers will see an increased proportion of billable hours coming from sustainability reporting. They will be left to fill in the inevitable holes in the regulation, such as which ESG data to report. Lawyers will have to work closely with their clients in order to establish both which environmental and social factors their business affects and which factors affect them. This will allow them to accurately assess their sustainability performance, and therefore comply with the SRDR. Establishing and quantifying this is a difficult and time-consuming task, and will be a significant focus of law firms in most practice areas, especially while the regulation is new.
Furthermore, there is a growing body of opponents to the regulation who argue that ‘the unique nature of their operations will make comparisons difficult’. This will result in an abundance of compliance work, and possibly some disputes arising which will create more work for litigation and dispute resolution lawyers.
Evidently, there has been a huge global drive to implement sustainability and ESG reporting standards for financial institutions. The regulation is not watertight, and not enough time has elapsed to observe their efficacy and endurance. However, the fact that these regulations exist at all, and that they have provoked worldwide self-reflection and investigation into companies’ and financial institutions’ responsibilities beyond their shareholders is a seminal moment in itself. Perhaps its biggest impact will be in beginning the worldwide push for more impactful and specific regulation. The avalanche has begun.