By Lisa Iagatta, Chair, International Securities Association for Institutional Trade Communication (ISITC)
Interest and demand for Environmental, Social, and Governance (ESG) priorities in the financial market has been growing rapidly. In fact, research by PwC found that almost 60% of mutual fund assets will apply an ESG lens by 2025. The rapid ascension of ESG – which went from niche strategy to mainstream consideration almost overnight – is regarded by some as “the most significant development in money management since the creation of exchange-traded funds two decades ago,” according to Bloomberg. However, what may be even more striking than the rapid growth of ESG is that, for the first time in recent memory, U.S. markets lag other geographies and jurisdictions as it relates to innovation and traction on this front.
Consider, for instance, that across ESG mutual funds, European assets account for 70% of the total assets, globally (P&I). Moreover, turning to fixed income, U.S. issuers of green bonds raised just $60.8 billion last year vs. $160 billion raised by their European counterparts (Bloomberg). While the European Commission recently enacted SFDR (Sustainable Finance Disclosure Regulation), which went into effect March 10, 2021 (PwC), U.S. regulators have dragged their feet in creating guardrails that would provide clarity to both fund managers and investors alike.
Considering this lag, sitting idly by is a losing strategy. Once U.S. regulators catch up with investor demand, those without an ESG game plan will be at a distinct disadvantage. Without concrete guidance, it can be difficult for corporations, fund managers, asset owners and other stakeholders to balance standardization with flexibility and overcome reporting fatigue. However, even in the face of significant challenges, forward-thinking firms implementing strategies today to prepare for what will surely await them in the future will be much better-positioned in the long run.
Below are three of the most pronounced challenges and strategies for stakeholders to consider now to prepare them for what lies ahead.
Challenge 1: Lack of SEC guidance
The biggest challenge arguably facing U.S. financial firms at the moment is a lack of guidance from the SEC. Executives are hesitant to run too fast in any direction, only to be issued new disclosure requirements against which their latest initiatives conflict. Firms taking this approach will fall into the trap of sitting idly by, too afraid to make a move in any direction for fear that their work will be negated once new guidelines are issued. The lack of motion among regulators and absence of a hard deadline also removes any urgency to act. The challenge is that there is no deadline, because ESG infrastructure is still a moving target.
Prospective Strategy: Start within your firm
In the absence of formally-issued SEC guidelines, firms must switch from a place of passive reactivity to proactive planning. This creates an opportunity to play an active role in shaping the conversation, sharing and exploring common challenges, and beginning to develop a common language. The best place to start is within your own organization. For example, firms need to hold themselves to a higher standard and explore opportunities for self-reporting.
Regulatory and reporting practices, like anything else, require practice, and firms will not magically awake one day with a robust ESG reporting system. They must begin building the infrastructure internally – no matter how imperfectly – so that through trial and error, they are prepared for the day when regulatory mandates are in place. The biggest benefit right now is time. Forward-thinkers will use this time to experiment and explore, knowing that any action is better than paralysis.
Challenge 2: Lack of common standard language
Currently, lack of a common language makes it difficult to conceptualize, categorize, and evaluate ESG goals and initiatives. The strongest example is greenwashing: with no clearly-defined benchmarks, firms can invent their own language to describe sustainability frameworks and metrics. As a result, it becomes easier to manipulate the parameters and choose to disclose favorable factors that make them appear outstanding, while concealing those which paint them in a negative light.
Materiality, as a result, is critical. Think of this example: a bank that reports low carbon emissions will certainly appear better on paper than a vehicle manufacturing plant, but those aren’t the material issues relevant to stakeholders, nor the needle-moving initiatives around which a bank should focus their efforts anyway.
Prospective Strategy: Interoperability
While these factors make it difficult to evaluate ESG traction objectively, there are some clear starting points. One that investors are demanding is increased data transparency. Though we still don’t have a clearly defined standard system, the best way to begin working toward a shared understanding of ESG principles is to expand the network of shared data. Interoperability will play a key role in making this a reality.
While the impact reporting ecosystem remains fragmented, certain organizations are already take steps toward interoperability and more collaborative data systems. One such example is the Impact Management Project, an initiative among a group of highly-regarded organizations that have worked to create sustainability frameworks and corporate reporting guidelines. The IMP serves as a strong example of a collaborative effort and shared vision set in motion around integrated reporting.
Challenge 3: “Reporting Fatigue”
Companies and fund managers already absorb significant costs related to traditional financial reporting requirements. In fact, internal compliance costs can range anywhere from $600K to $1.6 million annually, according to some estimates by Meketa. CSR and ESG reporting, which often requires a specialized skillset and external data demands, will only add to the cost of compliance, while creating a new set of metrics IR professionals and executives will need to understand and measure.
Prospective Strategy: Efficiency-based Innovation / Technology
Alongside the growing importance of data transparency, technology will also play a key role in advancing firms’ ESG agendas. Using new tools such as AI and machine learning not only alleviates the current burden of self-reporting, but also allows ESG protocol to scale with firms as they continue to grow. Decentralized systems such as blockchain could also come into play in creating a common source of ESG data that is reliable, verifiable, and more widely accessible. Embracing technology in asset management will translate to increased meeting investor demands, exceeding the bottom line.
A look ahead
Tomorrow’s markets, economy, and values will not look the same as they do today. Those who sit and wait will ultimately lose out, while those who proactively adapt and advance their business models will prove resilient. There is no easy road nor shortcut to a fool-proof system, but these challenges are best solved collaboratively. The growing focus on ESG around the industry reinforces our mission at ISITC to partner with other industry organizations, serve as a platform for conversation and discussion, and learn from our shared challenges and successes in order to continue our collective growth toward a more sustainable and conscientious financial services future.