July 22, 2021—For decades, the European Union (EU) has led the world in pursuing sustainable finance policies, particularly in carbon reduction. Within Europe, sustainability objectives enjoy broad support across the left, right, and center. Last year, the European Commission ratcheted up these efforts by incorporating its “European Green Deal” into its massive multi-year budget program, alongside efforts to boost European competitiveness in the digital space. In December 2020, we described this ambitious program in a Wilmington Wire entitled “EU’s Green & Digital Transition: Which Industries will Benefit?”. The surprisingly large multi-year budget, as well as its focus on green and digital technology coupled with the European Central Bank’s (ECB) COVID-related monetary support has underpinned our positive view of European equity markets.
In this Wilmington Wire, we explore a parallel effort by the European Commission to formally integrate sustainability objectives into the EU’s capital markets directives. This regulatory initiative is top of mind for many European asset managers and institutional investors but is less well-known among U.S. counterparts. Of course, many listed European companies are responsive to their European stakeholders and have already started pursuing sustainability objectives. Likewise, many European investment managers have encountered strong demand for sustainable strategies from European institutional investors and have already integrated sustainability into their investment processes, regardless of how their products are branded. We anticipate that as economic actors in Europe become progressively more responsive to sustainability objectives, reallocating capital from value-destroying legacy industries to value-creating emergent ones, the better the likely outcomes will be for the EU’s long-term economic growth.
EU’s capital markets union: work-in-progress
Over the last 15 years, the EU has been building its capital markets regulatory system, crediting a capital markets union (CMU) to facilitate free flow of capital across national borders, much like the single market encourages free flow of goods and services. The EU wants stock and bond financing to be more widely accessible to European firms, which have traditionally relied on commercial banks for their corporate financing needs. The EU has been making steady progress in developing regulations, particularly regarding disclosures and conflicts of interest, significantly strengthening the authority of the European Securities Markets Agency (ESMA), the EU’s equivalent of the SEC in the U.S.
The EU is advancing its “EU Green Deal” by integrating sustainability-related disclosure requirements into its regulatory framework. These requirements aim to encourage private investment capital to flow toward firms with demonstrably sustainable characteristics. They also seek to make “greenwashing” (overstating sustainability credentials in order to attract more investment capital) an illegal practice.
The heart of the European Commission’s work is EU Taxonomy, which provides disclosure requirements for large public firms doing business within the EU. Per the taxonomy, a firm can describe itself in its corporate reporting as pursuing one or more sustainable activities provided it pursues any one of the six objectives noted in Figure 1, does no significant harm (DNSH) to any of the other six, and adheres to both the Organisation for Economic Co-operation and Development (OECD) Guidelines for Multinational Enterprises and U.N. Guiding Principles for Business and Human Rights.
Source: European Commission
EU Sustainable Finance Disclosure Regulations
These corporate disclosure requirements also form a foundation for the Sustainable Finance Disclosure Regulations, or SFDR, which cover investment managers marketing products within the EU. While these regulations came into legal effect on March 10, 2021, ESMA has not yet translated these regulations into actionable technical standards. This work may take until mid-2022, so it is still a work in progress.
As of March 10, 2021, investment managers marketing products in Europe (e.g., through Dublin-registered UCITS or Luxembourg-registered SICAVs) were required to self-declare their investment products under one of three SFDR categories (Articles 6, 8, or 9). These categorizations involve progressive degrees of sustainability and accompanying disclosure. The sustainability-focused EU asset manager Robeco has prepared concise summaries of the three categories (Figure 2).
The fundamental principle of the SFDR is that an investment manager seeking to characterize an investment product as sustainable must provide detailed supporting information in prospectuses. Any strategy that cannot provide such information must represent in its prospectus that it is not pursuing a sustainability objective.
Understandably, there is growing interest among European institutional and retail investors in self-declared Article 8 or Article 9 strategies. Investors will likely take some comfort in these designations, since they are made under an official regulatory regime in which inaccurate or incomplete representations by investment managers can invite regulatory sanction. It’s not unlikely that investors would perceive an Article 8 categorization as a minimum sustainability threshold, subject, of course, to the pursuit of their own due diligence.
As work has not yet been finished on actionable technical standards, there remains considerable uncertainty and even speculation among investment managers regarding the exact nature and intensity of the disclosures that ESMA might ultimately require under each category. Consequently, one shouldn’t infer too much from the self-declared categorizations that were made in March 2021. Some of these categorizations may have either been placeholders or premature. They may change as more clarity becomes available on the technical standards.
We will be carefully monitoring the work of the ESMA and the reactions of market participants to further developments in the integration of the EU Green Deal into the capital markets union.
We are currently overweight equities, including developed markets. Our overweight in developed markets is influenced by our positive views toward Europe. As mentioned above, we take some comfort from the EU’s aggressive multi-year spending plans, especially with respect to targeted potentially highly productive areas, as well as green and digital technologies. Likewise, we believe the EU’s complementary work in integrating the green deal into capital markets, while still a work in progress, will support reallocation of capital investment from legacy industries to emergent ones.
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