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ESG regulation is advancing – but regulators are out-of-step

Sustainable finance rules for fund managers are evolving quickly, but there is a risk of global divergence as regulators in Europe, US and UK move ahead with new plans.

• New Private Equity Wire research shows 80% of survey respondents expect ESG to receive the most regulatory focus in coming years

• Over a year after the first phase of Europe’s SFDR was brought into force, the next steps of regulators are being watched closely by fund managers

• Risk of delay to SFDR’s second phase could lead to ‘product labelling approach’ by some funds, devaluing the entire ESG proposition

Sustainable finance rules for fund managers are evolving quickly, but there is a risk of global divergence as regulators in Europe, US and UK move ahead with new plans.

In a survey of the industry by Private Equity Wire, around eight out of 10 respondents expected ESG to be an area of greater regulatory focus, within a list of other priorities.
The first phase of Europe’s Sustainable Finance Disclosures Regulation (SFDR), which was brought into force last year, has been generally perceived as a success on a global level, but what follows it in Europe and elsewhere is less clear.

While some fund managers have rebuilt their investment strategy or launched new bespoke fundraising vehicles tied to the SFDR categorisation, others have more simply formalised an existing ESG strategy or continued with a business-as-usual approach, say sources.

With the inevitable delays in new ESG regulations, there is the potential for SFDR to turn into a fund product label and revert to being a marketing tool, said one advisory source. If implemented incorrectly, they run the risk of devaluing the entire ESG proposition, the source added.

The next stage – or Level 2 – of the SFDR (which should introduce more detailed and prescriptive disclosure requirements under Articles 8 and 9 and principal adverse impact of investment decisions) has been repeatedly delayed, most recently into January 2023.

In the US, the SEC wants to increase disclosure requirements for companies on climate-related risk but has extended the period for public comment up to June 2022 amid a wider pushback. The regulator wants firms to disclose how they identify and manage climate risks including scenario analysis and wants updates on progress towards meeting any climate pledges, including the use of carbon offsets or renewable energy certificates.

In the UK, Task Force on Climate Disclosures (TCFD) rules came into effect in April but under a phased approach, with only the largest UK registered companies and financial institutions required to disclose climate-related financial information on a mandatory basis.

Expansion of the rules is expected in 2023.

Although the SEC’s proposals are aligned with TCFD, a proposed classification approach in the UK through the FCA differs slightly from Europe’s SFDR, potentially adding to the cost and complexity already faced by many fund managers in meeting new regulatory requirements.

The UK’s forthcoming taxonomy – due at the end of 2022 – is also uncertain. It may classify North Sea gas extraction as a ‘green investment’, according to a newspaper report in May citing government sources, while the EU labels natural gas power plants as ‘transitional’.

“The fact is that ESG means something totally different wherever you are,” says Andrew Poole, director at risk consultancy ACA Group. “So that spread of focus is causing GPs concern – ‘If I deal with one thing, does that mean I’m missing out something else?’ They may be running a regulatory triage to keep one regulator happy while irritating another.”

Key implication | LPs: Investors are seeking ways to standardise ESG metrics and provide a mechanism for comparative reporting across the industry but regional regulatory divergence could be an obstacle


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