The role of ESG regulation in private markets
Environmental, social and governance (ESG) investing has become a prominent theme for asset managers and investors alike. Sana Hameed Baba explains why and describes its behavioral and cultural impact on private markets.
Many asset managers are looking to increase their sustainable private market allocations over the coming years. This increase may involve voluntary commitments in line with the United Nations Principles for Responsible Investment (UNPRI) and the goal of achieving net zero across investment portfolios by 2050. In my view, however, regulations will accelerate the use of sustainable investments as a strategic allocation within private investments the most. Analysis by ESG Book found that ESG regulations have increased by 155% globally in the past decade, with 1,255 ESG regulations introduced since 2011.1 While this increase seems huge (it is!), sustainability regulations are well meaning: they are designed to help investors allocate capital according to their preferences and ensure an efficient flow of capital toward sustainable solutions. Indeed, we believe that such regulations have been successful in driving an increased allocation to sustainable investments over recent years. They are likely to continue to do so, based on investors’ future intentions.
Sustainability-related regulations across the globe have been focused on mitigating the greenwashing risk through enhanced disclosures (to ensure improved information and thus better decision-making), unintentionally creating a hierarchy of marketing labels. For example, the adoption of the Sustainable Finance Disclosure Regulation (SFDR) in the European Union (EU) has introduced classifications such as Article 6, 8 and 9, but many investors and market participants have started to use them as marketing labels (which the European Securities and Markets Authority (ESMA) is seeking to review in its latest consultations).
In an attempt to learn from the SFDR, the Financial Conduct Authority in the UK has now introduced an explicit labelling regime governed by its Sustainable Disclosure Requirements (SDR). As a result of this increasing array of regulatory-driven labels, asset managers are competing to have more and more “superior” labels in their private market fund offering.
Given the disclosures and reporting of ESG metrics enforced by the plethora of global sustainability standards and regulations, such as the International Sustainability Standards Board (ISSB), Task Force on Climate-Related Disclosures (TCFD), Taskforce on Nature-Related Disclosures (TNFD), Sustainable Finance Disclosure Regulation (SFDR), UK Climate Reporting and the Corporate Sustainability Reporting Directive (CSRD), it has become clear to industry participants that ESG is no longer optional if they want to remain commercially viable. Disclosure requirements have also made it easier to understand the environmental, social and governance aspects in the supply chains of private investments. This has led to thought-provoking analyses of the allocation of capital to “sustainable” options.
Regulations have played a significant role in creating a behavioral and cultural shift toward sustainability in private markets. The consistent increase in ESG regulations across the globe has also caused these topics to be considered standard parts of the investment process by portfolio managers. This has been helped by the growing body of research and studies that there is a close relationship between sustainability and financial results, and sustainability is increasingly being taken into account alongside geopolitical and macroeconomic challenges. That said, firms are still transitioning toward ESG becoming truly embedded in the investment process.
Overall, regulations have played a pivotal role in pushing ESG further up the agenda. However, if we want to make a better world for future generations through a repositioning in financial markets and investments, we must adopt not only a professional but also a personal change in attitude to ESG topics. Whilst financial markets can support change,: modifications have to take place in the real economy and in the minds of individuals too, prompted by governments and public policy.
