The lack of common standards has long been a major issue when it comes to the development of environmental, social and governance (ESG) investing. But recent proposals by the European Parliament for a sustainable finance taxonomy that would pave the way for common ESG investment standards are raising concerns among investors.
The proposed sustainability taxonomy, drawn up in Brussels last month, is basically a regulatory framework for establishing which economic activities substantially contribute to ESG objectives. To be fair to the EU, the rationale for the establishment of a sustainable finance taxonomy is commendable since it will set certain standards that have to be met before a financial product can qualify as a sustainable investment.
But there are concerns that its implementation at this time, when ESG investing is still evolving, particularly in Asia, may not be compatible with the fast-evolving nature of sustainable investments. Fears also exist that the sustainable finance taxonomy may result in over-regulation, eventually stymying the highly-innovative and creative aspects of ESG investing.
At present, there are a proliferation of ESG scoring/rating systems drawn up by various asset managers, index providers, and specialist entities, including MSCI, FTSE, Sustainalytics, RobecoSAM, and UBS.
The rating/scoring systems help investors identify the level of ESG compliance by specific corporates (whose securities they invest in). MSCI's methodology, for example, examines 37 ESG-linked issues and ranks them from 0 to 10.
But while these scores provide a basis for building an ESG-focused portfolio, they fail to answer the bigger picture. In particular, what characteristics should make up a portfolio that follows an ESG rating system.
This unanswered question, plus the proliferation of ESG scoring/rating systems, has, in some cases, resulted in confusion among investors, especially those who are new to ESG investing.
In addition, institutional investors have different needs and requirements for ESG investing. In the case of a large pension fund with US$300 million in assets, its requirement may be to align its ESG investments with its corporate culture.
Whereas in the case of a regional asset manager, its requirement may be to provide its clients with ESG-linked products that can generate sufficient returns while also providing some social impact.
Then there’s the case of an insurance global company, whose ESG investing requirements may take the form of identifying which sectors have to be excluded from its portfolio to make it consistent with the requirements of its policyholders.
Because of the wide difference in investor and client requirements, there is a growing consensus among industry practitioners that having a set of common standards for ESG investing may not give investors the flexibility that is needed to build their own ESG investment frameworks.
“Investors and clients are all different. They have different needs and the business is extremely fast evolving and extremely innovative. I really hope that the regulators are not over-regulating by already putting taxonomies into place at a stage when we’re really still evolving,” says Michael Baldinger, managing director, and head of sustainable & impact investing at UBS Asset Management.
While some confusion may remain with the absence of a set of common ESG investment standards, it is possible for institutional investors to overcome the lack of standards by building their own ESG framework that fits their own requirements.
“The market and the clients are smart and they will tell us somehow which direction ESG investing will go. And obviously, we guide our clients, but we need the flexibility right now,” Baldinger says.