Green and other sustainable investment continues to attract significant inflows of assets throughout Europe. Across the entire investment universe, L3A is witnessing a greater proportion of funds domiciled in Luxembourg and other European Union member states that are to some extent sustainable or green than anywhere else in the world. This places a responsibility on our members to ensure both investors and regulators remain happy.
Planning, launching and running ESG funds that invest in public markets has been made easier by gradual improvements to sustainability data and to ratings and assessments of securities issuers. However, significant data gaps still exist, while asset managers and other industry participants remain exasperated by the vagueness of definitions of ESG, sustainable and related terms.
Although disclosure requirements have been codified by the EU's Sustainable Finance Disclosure Regulation, as well as being complemented by voluntary net zero emission-reduction initiatives, fund groups and their service providers struggle to meet the data demands of different stakeholders, from investment managers themselves to fund selectors, investors and regulatory authorities, including verifying the validity of the data that is available.
SFDR fund downgrades
The most visible impact of the ongoing confusion surrounding sustainable investment has been the wholesale shift in classification of funds under the SFDR from article 9 – funds with a sustainable purpose – to article 8, which are merely required to meet the test of demonstrating sustainability characteristics.
According to Morningstar, article 9 funds holding around 40% of the category's assets were downgraded in the final quarter of 2022, ahead of the entry into force of detailed SFDR regulatory technical standards. The European Commission is under pressure from asset managers to consider changes that would get rid of the article 9 classification altogether, given that industry members are having such difficulty complying with it, an approach that L3A would support.
A specific challenge for L3A members concerns private markets and alternative investment strategies, which we believe will prove an even harder nut to crack. In particular, private companies will only gradually come within the scope of the EU's yet-to-take-effect Corporate Sustainability Reporting Directive (CSRD). In the future, L3A members can expect to work closely with private equity firm clients to leverage their greater ability to obtain sustainability data from their portfolio companies – in contrast to real estate and infrastructure investments, on which data is already more widely accessible.
Even Norges Bank Investment Management, which oversees the world's largest sovereign wealth fund, has complainedthat it struggles to obtain relevant data on emissions and energy use within its real estate portfolio. Overall, dealing with incomplete ESG data represents an additional burden for fund sponsors and their service providers, requiring significant resources, expertise, time and money.
More rules, more data
Meanwhile, the legislative process in Europe grinds on. Aside from any possible revision of the SFDR, some member states are continuing to wrangle over the inclusion of gas and nuclear energy in the EU's taxonomy that classifies sustainable sectors and activities. The CSRD is set to be followed by a proposed Corporate Sustainability Due Diligence Directive, which would introduce requirements for companies to conduct detailed due diligence to identify and prevent adverse human rights and environmental impact relating to their own operations and along their value chains.
L3A members, and indeed all administrators of AIFs with clients whose investments touch on deforestation or the energy market, or whose products or services ‘import’ carbon emissions from outside the EU, will be affected. 'Comply or explain' rules on minimum wages, board diversity and other social and governance issues will affect fund groups themselves and their administration providers as well as their underlying investments.
Meanwhile, investment management groups have also signed up to a multitude of initiatives, ranging from the Principles for Responsible Investment to commitments to protect the Amazon rainforest and marine biodiversity, and covering emissions from the production of goods to their use and disposal, as well as their own operational emissions. All this information needs to be measured, audited and disclosed to stakeholders.
Act now, adjust later
Greenwashing is hard to define, and there are questions about the extent to which it is the product of deliberate misrepresentation, negligence, confusion over standards or sheer lack of data. But accusations carry a heavy reputational threat, as DWS can testify after having been accused of exaggerating its ESG credentials, resulting in legal action in the United States and raids by investigators in Germany.
Regulators are becoming tougher about holding companies to account for their green claims, and activist shareholders - some of whom have launched their own funds - and NGOs are using their rights as shareholders to press companies to address sustainability issues more seriously and urgently.
Court cases against Shell board members for backtracking on emissions targets and failing to prepare the company for the net zero transition, or for ongoing lending to fossil fuel projects against banks that are subject to a legally binding duty in France to ensure companies' activities do not harm the environment, will have serious ramifications for the investment industry.
L3A members therefore occupy a critical point in the process of ensuring that data is being collected to meet not only today’s ESG requirements, but also those that are set to arise in the future – and for which detailed regulatory guidance often lags significantly behind imposition of the legal requirements, as was the case with the SFDR.
New jurisdictions, new standards
Additionally, L3A members, as specialist alternative fund service providers that in their capacity as administrators have direct access to the portfolio companies of their clients’ funds, are in a strong position to assist in the collection, sorting and management of the data.
Most providers today offer solutions linked to the regulatory reporting requirements such as the SFDR as well as additional services including asset scoring and review, meaning they can access data directly and provide support for clients in this process.
Meanwhile benchmark providers, rating agencies and global standards bodies are simultaneously working to clarify harmonised measurement and reporting rules, with further changes to be expected over time.
And the industry faces the prospect of having to accommodate legal developments in other jurisdictions, such as new rules being drawn up by the Securities and Exchange Commission for the US. L3A members can expect to play an increasingly critical role in ensuring that funds and their promoters are able to meet the requirements of the sustainability transition, in all its many facets, in the years to come.