End of Week Notes
The SFDR, so far.
Plus 2 must-reads and a plea for American corporations to support democracy!
As the EU Sustainable Finance Disclosures Regulation (SFDR) takes effect and regulators in the United States consider more ESG-friendly policies, two questions on my mind: Will the EU model work to both clarify the main types of sustainable funds and to encourage more capital flows into them? And will it be a viable model for the US and the rest of the world?
In essence, the SFDR defines two types of sustainable investments that correspond with what I think of as 1) broad ESG funds (per Article 8 of the SFDR) and 2) sustainability impact funds (per Article 9).
Morningstar has been monitoring how fund companies are classifying their funds since the regulation took effect on March 10. My colleagues Hortense Bioy, Elizabeth Stuart, and Andy Petit are out with a progress report today (available here to users of Morningstar Direct) in which they estimated the size of the European ESG and sustainable funds market:
Based on the data collected so far, we estimate that funds currently classified under Article 8 and 9 represent up to 25% of the overall European fund market. This means that the European ESG and sustainable funds market, based on SFDR definitions, could be worth as much as EUR 2.5 trillion. And we expect this number to increase in the coming months as managers enhance strategies, reclassify funds, and launch new ones that meet Article 8 or 9 requirements.
So far, most fund companies have grouped only their most clear-cut ESG and sustainable impact funds into the two categories. But many plan to categorize additional funds in the coming months. Amundi, for example, is aiming for 75% of its AUM to be Article 8 or Article 9 funds by year end.
How they do this will be interesting. Thus far, the list of approaches commonly used by Article 8 funds includes exclusions, various types of security-level ESG assessments, portfolio-level ESG characteristics, and engagement. Many funds use a mix of these approaches, but some, my colleagues found, rely only on exclusions, be they norms-based or based on activities deemed unsustainable or having high ESG risks such as weapons, tobacco, coal and other fossil fuels.
My view is that funds with a limited set of exclusions, say norms-based and sin stocks, and no clear commitment to the systematic use of ESG assessments for security selection and portfolio construction, should not make it into Article 8. Funds that do have a systematic commitment to ESG, to me, should qualify even if they don’t employ any exclusions. While engagement is highly important to me, I don’t think a fund that relies solely on an asset manager’s overall ESG engagement program should qualify for Article 8.
Article 9 funds are supposed to make investments that are deemed to contribute positively to environmental and social challenges, while making sure the companies follow good governance practices and don’t do significant environmental or societal harm. While my colleagues found that a majority of Article 9 funds so far have a thematic and/or impact focus, there may be some reticence on the part of fund companies to place funds in Article 9 out of concern that they ultimately won’t pass muster with regulators. They found a couple of cases where very similar funds from different asset managers were classified differently.
The fact that similar strategies have been classified as either Article 8 or Article 9 suggests that some managers may have taken a too prudent classification approach or others have taken a too generous approach. It could also be the case that the managers who parked more funds into Article 9 are more confident than others in their ability to demonstrate the “sustainable” nature of their investments
While waiting for further guidance from the regulator, my colleagues note, many managers have already identified funds that, with some changes to the investment process, can meet at least the Article 8 requirements.
For many of the asset managers we spoke to, it is essential to have as many funds as possible classified under Article 8 and 9. They see SFDR as an opportunity to demonstrate their commitment to sustainable investing. They also feel pressure from some distributors and fund buyers that have said they would only consider funds in Article 8 and 9 categories going forward.
So basically, we will be in the process of boundary setting for a while, as fund companies and regulators clarify the line between conventional funds and Article 8 ESG funds, and the line between Article 8 ESG funds and Article 9 sustainable impact funds.
But because of the size of the EU market and the fact that most fund companies of any size also invest in the US and other regions, subsequent regulations in those other regions will either be patterned after the SFDR or will have to respond to it in justifying a signficantly different approach.
COVID-19 Made Sustainable Investments Go Viral
Thoughtful piece by Michael Moran in the journal Foreign Policy, in which he argues that the pandemic has reinforced the thesis for sustainable investing by placing the spotlight on the “S” in “ESG.”
Prior to the pandemic, most of the ESG focus was on climate, other environmental, and gender diversity issues. Now, it’s more about the wellness of people and the employer-employee relationship. Says Moran:
This is having a profound effect on the course many industries are charting to emerge from the pandemic. The new focus on air quality that people breath in a building is one example. Efforts to mitigate the risk of infections have also uncovered truths about the threat that poorly managed humidity, temperature, air flow, and carbon dioxide buildup pose even in so-called “normal” times.
The duty-of-care that companies should feel for employees — or customers, tenants, and subcontractors — is also being newly scrutinized. Can a firm that decides against requiring masks on its premises be sued for a COVID-19-related death? Does a return to the office that mixes vaccinated and non-vaccinated workers raise similar liabilities? Viewed through the lens of ESG, strict adherence to what’s legal may not clear the hurdle of what’s ethical. And that has given labor new leverage in its relationship with management everywhere.
Contending with climate change: The next 25 years
Princeton Professor Robert Socolow, writing in the 75th Anniversary edition of the Bulletin of the Atomic Scientists outlines what it’s going to take to control climate change over the next quarter century. This imminently accessible piece is well worth a read. Here’s the Abstract:
Any successful effort to address climate change over the next 25 years will involve a “credible swap” that greatly reduces greenhouse gas emissions from the burning of fossil fuels, provides energy in entirely different ways, and also reduces demand for energy. On the demand side, the next quarter century offers abundant high-leverage opportunities to reduce future emissions via intelligent urban design, building construction (notably in the gigantic apartment complexes), and efficient vehicles and appliances. On the supply side, there are three variants of the swap. In one, the work horse is renewable energy (solar power, wind power, hydropower, and power from biological feedstocks); in a second it is nuclear power; and in a third it is a reshaped fossil fuel economy. The three are by no means mutually exclusive. Each brings disruption and risks, rivaling those of climate change if done inattentively. Well-executed solutions will require threading a needle.
Better late than never?
I appreciate the difficulty large corporations have in taking “political” positions. Yet, of course, they take narrowly self-interested political positions all the time when they seek tax breaks, incentives, or oppose regulatory actions. And that feeds into widespread public distrust of “giant corporations”, with many people seeing them as focused on their own profitability even at the expense of people and the planet. In an era of sustainability, that may be changing. Corporations must now attend to the systemic implications of their decisions.
Unfortunately, huge Atlanta-headquartered companies Coca-Cola and Delta Airlines failed to step up to defend democracy last week when the Republican-dominated Georgia legislature passed a racist bill restricting voting and the governor signed it into law.
After the fact, Coca-Cola and Delta have now condemned the action but only after activists, customers and a coalition of powerful Black executives put pressure on them to do so. And only after it became law.
Where do large American corporations like these really stand on the question of democracy in America? It is past time for them to step up to the plate. They could do that by going to Washington, D.C. and twisting some arms to support the For The People Act and the John R. Lewis Voting Rights Act.
Meanwhile, in Texas today … sigh …
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