How can Asset Managers adapt to the flow of sustainable finance regulatory changes and use them to create a competitive advantage?
In our previous article, we tackled the first of four dimensions that real Environmental, Societal & Governance (ESG) players need to build a platform of trust with their clients and investors: anchoring sustainability at the heart of corporate strategy.
In this article we explore the second dimension – gearing up for unprecedented transparency – and reveal important challenges and opportunities that Asset Managers can seize in the sustainable finance regulatory journey.
European investors fueling the growth in ESG funds
In the previous two years, institutional investors have consistently increased allocations to sustainable investments. In 2020 alone, 49% of institutional investors surveyed by Schroders said that their allocations to sustainable investments had risen over the last five years. This increased demand from institutional investors is reflected across the ESG funds which, according to Blackrock’s first sustainable investing survey, saw an inflow of 203 billion USD between January and September 2020. Investors from the European region are identified as very strong contributors to this growth. Looking ahead, this growth is expected to continue with 50% of investors surveyed by Blackrock planning to double their sustainable assets under management (AUM) by 2025.
A new fleet of sustainability driven regulations emerging
While future growth looks promising, both institutional and retail investors are experiencing hurdles to transitioning their portfolio towards having a more positive impact across ESG factors. With 61% of European institutional investors claiming a lack of agreed upon definitions for sustainable investments and 75% of Belgian retail investors being doubtful of their impact through ESG investments, the concern over greenwashing still haunts the sustainable investment landscape.
To safeguard the growth in sustainable assets and further reduce the investment gap, which is estimated at 260 billion euro per annum for Europe to reach its 2030 climate and energy targets, regulators are working on a whole new fleet of sustainability driven regulations and on retrofitting previous regulations to the ESG context. Central to this regulatory roadmap is the quest for greater transparency on non-financial impact and the search for improved financial stability through revised risk management practices that take the effects of climate change into account. Regulations focusing on transparency and a common language around sustainability are expected to be particularly popular amongst investors given that 45% of institutional investors indicated greater transparency on non-financial performance as a key driver for increased investments in sustainable assets.
While European regulators are leading the pack, other regulators around the world are also working towards a more robust regulatory environment centered on sustainability. In the United States, we are seeing a more bottom-up approach where financial services providers are leading the thrust by actively collaborating with issuers to harvest additional relevant ESG information. More in accordance with the European regulatory roadmap, the UK is moving beyond the “comply or explain” approach and is set to become the first country which makes the Task Force on Climate-related Financial Disclosures (TCFD) -aligned disclosures mandatory across its entire economy. Outside of Europe, the Australian government has set out its own “Australian sustainable finance roadmap”, which indicates different milestones and projects such as taxonomy development and guidance on TCFD reporting.
One thing is certain: the market is set to become more regulated in the near future and additional regulations are bound to arrive or change as the market matures. Future market leaders will be those that can Understand evolving global sustainable finance trends that drive the regulatory roadmap and the challenges they represent, Anticipate these challenges by harnessing a flexible yet robust organization, and Leverage these regulations to develop a more compelling product offering and competitive market position.
1. Understand sustainable finance trends
Financial institutions are often found to be heavily focusing on the EU Green Taxonomy. While the EU Green Taxonomy is a key cornerstone of the regulatory roadmap, a significant amount of other regulators, ranging from the European Banking Authority to the European Central Bank & the Financial Conduct Authority, are bringing forth a wide range of regulations which include overarching initiatives, such as the Sustainable Finance Action Plan by the European Banking Authority, and regulations dedicated to specific purposes. Successfully navigating these regulations requires Asset Managers to breakdown their complexity, identify interlinkages and continue to monitor their evolutions.
Our analysis highlights two major trends that encompass the full scope of the roadmap and serve as foundational elements for the impact assessment. First and foremost, the regulatory roadmap drives a shift to mandatory disclosure by introducing a common language on several non-financial indicators across the ESG spectrum. Secondly, regulators are focusing their effort on the product governance to ensure investment decisions across sustainable marketed products are in line with customer expectations.
More investments required to be compliant
While Asset Managers have been at the forefront of the drive towards a common language for sustainability, as shown by Blackrock’s continued push for TCFD & Sustainability Accounting Standards Board (SASB) aligned reporting while waiting on a global standard, they face a daunting task because of regulatory change. They are already shouldering significant costs related to compliancy with EU Financial Regulations, from both a run and change perspective. Nevertheless, 64% of European Asset Managers participating in the 2019 Global ESG Global Survey of BNPP, which focused on the practical implications of ESG integration, indicated they will need to invest even more to remain compliant with the sustainability driven regulatory roadmap. In addition to the financial consequences, the ability of Asset Managers to comply with the regulatory roadmap on time is increasingly being questioned.
These investments and scrutiny on the regulatory roadmap originate from a set of challenges relating to the implementation of regulatory requirements. These include but are not limited to the below:
- Taxonomy for Sustainable Activities – Complex definitions requiring equally complex technical solutions and an implementation process that spans the entire institution and its business model.
- EU Labels for Green Financial Products – Re-aligning existing and developing new products to qualify for the ecolabel may lead to a wide range of products having to go through complex product development and approval processes
- Green Benchmark Indices – Developing new and realigning existing investment products utilizing the new benchmarks carries significant scale, data and methodology challenges
Asset Managers preparing to gear up for this unprecedented transparency, taking into account the interdependencies and synergies throughout the regulatory roadmap, will need to take a robust approach to analyzing the impact on their organization. Building on this robust analysis, Asset Managers should then focus on flexibility and scalability in the implementation of regulatory requirements. This will ensure they are ready to address future evolutions in the roadmap.
2. Anticipate by establishing a flexible organization
Given the high regulatory pressure Asset Managers have faced in the past, they can consider themselves as veterans of the quest for compliancy. These past experiences will provide valuable lessons for the implementation of sustainability driven requirements. However, Asset Managers will need to adopt a tailored approach towards the multitude of stakeholders requesting transparency, the array of interdependencies across the regulations, the dynamic nature of the regulatory landscape and the nature of the data required.
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These challenges will require Asset Managers to map the current state of their operating models.
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This mapping can then be used as the foundation on which several impact assessments can be built. In parallel to mapping the current state, Asset Managers should acquire intimate knowledge of the regulatory landscape through a holistic interpretation of supervisory expectations.
The combined insights from these two activities will enable Asset Managers to structure a more detailed impact analysis. Pragmatic tools, such as the sustainable finance regulatory quick scan, can accelerate the identification of future impacted areas compared to the current state and prioritize them accordingly.
A detailed gap-analysis across all aspects of the workstream’s operating model can then be performed, covering processes, architecture, and governance. Such an exercise can be supercharged by leveraging the sustainable finance regulatory toolbox.
- Processes – An in-depth gap analysis of the current and desired processes will reveal the need for updates of some or the creation of new ones. Central to the analysis of these processes will be the assessment of the data required to ensure compliant decisions and consumption by both internal and external users. With more than six out of 10 respondents to the BNPP ESG survey identifying data as the biggest hurdles for ESG implementation, this is no easy task. Given the vibrant ESG FinTech environment, Asset Managers could look towards these players for support.
- Architecture – Most if not all regulations across the regulatory roadmap have a significant focus on the collection, analysis and reporting of ESG specific data points. Ensuring data is collected, ingested, transformed and disseminated internally and externally has a significant impact across the front to back system landscape. Based on experience, we see that successfully expanding the data model to include ESG data requires a dedicated revision of the data governance model and a flexible data architecture. The implications of this will be addressed in our next article.
- Governance – The introduction of the MiFID & solvency II amendments for ESG considerations are designed to have implications across the organization, ranging from organizational changes, risk management practices and produce governance processes. The European Securities and Markets Authority’s (ESMA) proposition requires manufacturers and distributors of funds to consider the client’s ESG preferences within the target market of investment products and within the mandatory product review process. An in-depth review of the governance processes should identify areas of improvement to accommodate to the periodic reviews and correct assessment of the ESG risks related to the product.
Following the in-depth gap analysis, Asset Managers should consolidate all the initiatives proposed by the workstreams into executable projects in line with the multitude of regulatory deadlines.
The roll-out and implementation of these projects should not be seen as independent of other initiatives surrounding the impact of sustainable finance. All these initiatives should be closely coordinated to ensure they take maximum advantage of emerging synergies and are centered on the same principles of flexibility, integrability and scalability of the IT landscape. This will enable Asset Managers to keep pace with evolutions in both the scientific field (leading to additional impact indicators) and regulatory requirements.
In parallel to the internal gap analysis and implementation of identified projects, Asset Managers should continue to feel the pulse of the ecosystem, comprising traditional players, fintech partners and competitors.
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Many of the challenges faced by Asset Managers are not unique to them but are shared across the industry.
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To deliver transparency in an efficient manner, Asset Managers should look beyond their boundaries and join forces with other ecosystem players to drive value throughout the compliancy process. For example, Asset Servicing organizations are particularly well placed to bridge inconsistencies between disclosure regulations and required data points for compliancy with taxonomy regulations.
Combining robust analysis with flexibility and scalability will allow Asset Managers to complete their quest for compliancy in an efficient way while also improving their market position in a more regulated environment.
3. Leverage sustainable finance regulations to thrive
Despite the healthy growth in sustainable AUM, future growth and a smooth green transition calls for a transparent playing field. The sustainability driven regulatory landscape presents Asset Managers with an opportunity to embed a common language of sustainability within their own organizations and externally. This will ease the understanding and lay the foundation for relationship development with their investors and other stakeholders. By incorporating these efforts into their brand, Asset Managers can lead the charge against greenwashing. This will send a sustainable message to the general public and their clients, positioning the organization as an ESG pioneer and paving the way for competitive advantage in the near future.
Data & Sustainability savvy Asset Managers understand that far from being just an obligation, compliancy is fertile ground for future growth, improved decision-making and a more qualitative method of service. With yet more changes on the horizon, gearing up for unprecedented transparency now will allow Asset Managers to react and adapt more flexibly in the years to come.
In our next article, we will focus on the 3rd dimension of real ESG players: Delivering on the promise of true sustainability.
This article was co-written by Seyha Nop, Jonas Van de Wygaert and Maxim Buyle.