Outsourced investment compliance solutions can help firms to ensure that they have an ESG compliance process that is up to date, can grow with their monitoring needs and help them to take their first steps towards adapting successfully to the new requirements.
The exponential growth of ESG investing shows no sign of slowing down. Since 2015, sustainable debt issuance has risen nine times, while Europe has seen a tenfold increase in flows to ESG funds, according to the 2021 Sustainability Trends Report by Al Gore’s Generation Investment Management. Almost half the world’s assets under management ($43tn) are now committed to a net zero emissions target.
Incorporating ESG criteria into decision-making processes is increasingly seen as a function of responsible investing. BNP Paribas Securities Services’ latest Global ESG Survey reveals that ESG incorporation is increasingly driven by a real belief in improved long-term returns.
It is, however, not easy for firms to accurately assess the true ESG credentials of different funds – a process made harder by the inconsistency of ESG labelling practices.
Across Europe, individual member states offer their own flavours, with EU funds able to choose from at least nine ESG style labels. The criteria underlying the labels combine objective standards (usually in the form of sector exclusions or limitations) with subjective criteria including ESG practices, internal controls and guidance on exercising voting rights. The use of these subjective criteria, which relies on individual managers’ interpretations, has led to some concern in the industry about consistency of labelling and the potential for managers to make misleading claims.
To reduce this risk of greenwashing and create a more level playing field, legislators and regulators across the world are introducing tough disclosure, screening and reporting measures. In the US, the world’s largest fund market, the Securities and Exchange Commission issued an ESG-focused Risk Alert on 9 April 2021 detailing the deficiencies it observed during examinations. This alert could be the precursor to a US version of the European Union’s Sustainable Finance Disclosure Regulation (SFDR).
Across the pacific in Asia, jurisdictions are also taking steps to combat greenwashing. Hong Kong’s Securities and Futures Commission has enhanced the disclosure standard and compiled a list of verified ESG funds. Japan’s Financial Services Agency is also planning rules and standardised criteria for ESG or sustainability-labeled investment funds. Meanwhile, the New Zealand government introduced the Financial Sector (Climate-related Disclosures and Other Matters) Amendment Bill in April to make climate-related disclosures mandatory for certain organisations, including investment managers, banks and large insurers.
SFDR: Hanging the greenwashers out to dry
The EU has taken a particularly tough line on greenwashing. The SFDR, introduced in March 2021, aims to bring consistency and comparability to the EU fund industry’s sustainability-related labelling, and provide greater transparency on financial products’ sustainability. Under the new regulation’s “Level 1” requirements, asset managers are already subject to entity-level disclosures regarding the integration of sustainability risks into investment decisions. More detailed “Level 2” requirements are scheduled to be rolled out in 2022.
Under the SFDR, asset managers will need to classify their funds into three groups:
- “Dark green” (Article 9) funds have sustainable investment as their objective.
- “Light green” (Article 8) promote environmental and/or social characteristics.
- “Grey” funds (Article 6) have no sustainability commitments in the investment process and no exclusions in the portfolio.
The enhanced disclosure requirements for light green and dark green funds significantly raise the bar for investment firms’ ESG scoring. Our survey shows that almost half (48%) of respondents in Europe say that they understand SFDR and what it means for their organisation. This likely reflects the phased rollout of SFDR. It also indicates that there is some room for improvement in understanding as the regulation continues to be implemented in 2022.
The evolving role of outsourced investment compliance
Increasingly, both asset owners and managers will have to screen their portfolios to confirm they adhere to the relevant sustainability or ESG criteria. But while negative screening has been an established ESG methodology for many years, ESG scoring for disclosure purposes is in its infancy. In our Global ESG Survey, more than 70% of firms said they had only introduced ESG scoring in the past two years. Investment compliance monitoring solutions can provide firms with the critical support they need, in the following ways:
Fund classification and credentials
How can managers prove that a product should be classified under article 8 or 9 of the SFDR? An outsourced investment compliance solution can provide independent confirmation of the fund’s classification and credentials to the asset owner, regulator and investors.
Whether a fund seeks to confirm adherence to SFDR or the ESG-related fund labels already issued by some EU member states, the investment compliance monitoring process can be enriched with new rules to monitor the additional ESG criteria. For instance, carbon footprint metrics can be monitored at asset and portfolio level to validate the fund meets its objectives. Rule cards can be developed to monitor the unique criteria applicable to labels and confirm a fund’s adherence to its benchmark.
It is vital that the investment compliance rules which underpin ESG labels are appropriate and regularly monitored. Institutional investors need independent assurance to confirm that the criteria that support the labels are met, for example, sector exclusions and exclusion of companies involved in prohibited activities.
Most asset managers are developing their own ESG scoring based on huge amounts of raw data. Asset owners want to make sure the manager will do what it says, and may require much stricter controls in their ESG portfolios. By relying on third-party independent checks and data sources, they can make sure their ESG-related investment guidelines are strictly adhered to and mitigate the risk of greenwashing.
Independent third-party validation of non-financial processes, controls and data outputs can also help managers to build trust with investors and differentiate their products from other managers whose products use in-house, or limited, screening processes.
Scalability and expertise
Although the EU has delayed the SFDR implementation by six months, institutional investors still have less than a year to prepare. Firms must put in place appropriate screening methodologies, provide the relevant disclosures, and ensure adherence to the correct categorisation and labels.
However, many firms may not have in-house teams with the necessary, specialist expertise required to incorporate sophisticated ESG criteria into their compliance monitoring processes. Screening and monitoring ESG criteria requires look-through capabilities, data and the technical expertise to conduct portfolio, fund and company level assessments to examine the underlying assets’ exposure. An outsourced investment compliance provider can offer large teams of compliance specialists and other ESG experts, as well as the technological capabilities and systems to integrate complex ESG factors into monitoring workflows.
Beyond compliance: from reactive to proactive
Investment compliance has traditionally been a reactive service, informing managers of breaches once portfolio criteria has been contravened and recommending corrective actions. Responding to the increasing demands of the SFDR and investors, investment compliance is now evolving to play a more proactive role. BNP Paribas Securities Services partners with firms to reduce the rate of breaches through an ‘early warning’ system. For example, if a firm has a 5% limit of assets with carbon exposure, BNP Paribas Securities Services’ solution can put in a warning at 4% to give clients time to change their investment choices and avoid triggering a breach.
Building the ESG compliance capabilities of the future
Investor interest in ESG funds is only set to grow, and with it, the accompanying regulatory measures to ensure a level playing field and to protect investors from potential mis-selling. Increasingly, investment compliance providers are vital partners in helping the investment industry to build trust with investors and ensure ESG funds are constructed in accordance with regulations.
About BNP Paribas’ ESG and investment compliance solutions
- BNP Paribas Securities Services performs investment compliance in 17 locations for over EUR 2.5 trillion of client assets, using a specialist proprietary system that supports monitoring processes across a wide variety of fund types including UCITS, AIFs, ‘40 Act funds and mandates.
- As the first global custodian signatory of the Principles for Responsible Investment (PRI), BNP Paribas Securities Services is committed to having a positive impact on society and the environment by taking actions that are essential for the future – economic development, environmental protection and energy transition, social inclusion – with clients, the communities with which we interact and employees.
 Internal figures as at 31 May 2021