ESG – Verena Ross sets out ESMA’s views

Two recent speeches by Verena Ross, Chair of ESMA, (to the AGM of the International Credit Markets Association on 9 June 2022 and to the Irish Funds Annual Global Funds Conference on 31 May 2022) have given market participants an insight into ESMA’s stance on a number of ESG related matters.

While ESMA has no formal role in the development of policy or legislation (beyond preparing advice to the Commission on Level 2 measures), it can, even so, be useful to see where its thinking stands on some of the key issues.

In the speech to the ICMA AGM, Verena Ross made the following points:

General remarks

• as at the end of March 2022, assets managed by EU domiciled ESG funds grew by 20% over the past twelve months to €2.1 trillion while the EU market for green, social and sustainability bonds stood at €1.2 trillion, up 50% over the same period
• the current economic environment, though, is one of sharply rising prices and inflationary pressures, with short-term risks in commodity related financial markets
• investor preferences are shifting and issuers are looking at ways to finance their transition into more sustainable activities
• the current geopolitical situation amplifies the significance of sustainable finance as a way to speed up the transition away from environmentally harmful and problematic energy sources.

ESMA and sustainable finance

• ESMA’s approach follows its 2022-2024 Sustainable Finance Roadmap (the ESMA Roadmap) and is focused on
  • promoting transparency
  • tackling greenwashing
  • building regulatory capacities at EU and national level; and
  • monitoring, assessing and analysing ESG markets and risks.
• its work for 2022, which covers both cross-sectoral and sector-specific actions, includes
  • development of a disclosure framework under the SFDR and the Taxonomy Regulation, to clarify disclosure obligations for sustainability products
  • further deepening the understanding of the greenwashing phenomenon and working with national supervisors to fight it and
  • supporting the Commission as it develops its views in relation to ESG ratings and ESG factors in credit ratings.

Greenwashing and disclosures

• between May 2005 and May 2018, ‘ESG’ was mentioned in less than 1 per cent of earnings calls of global companies. By May 2021, this had increased to nearly 20%
• transparency is essential to ensure that associated investments actually account for the purpose for which they are marketed
• tackling greenwashing is one of the three priorities of the ESMA Roadmap, and ESMA will be looking to define its fundamental features and take coordinated action in multiple sectors to find common solutions to combat the detrimental effects that greenwashing may pose to investors
• ESMA has been working hard to increase transparency and comparability of the sustainability characteristics of financial products
• ESMA is working closely with the EU’s NCAs to ensure convergence in supervisory outcomes as they start supervising the various financial market players and their conduct in this area
• market uptake and the bedding down of the framework will significantly improve transparency and comparability over the next few years
• there is, though, a steep learning curve and market feedback is essential so ESMA is about to establish a Consultative Working Group (CWG) of the Coordination Network on Sustainability (CNS) to enhance exchanges with the private sector
• while corporate sustainability disclosure and reporting should ideally have preceded product disclosure, in reality, it has taken longer to come to fruition but there is now significant progress, both at EU level (with agreement on the Corporate Sustainability Disclosure Regulation) and through the European Financial Reporting Advisory Group’s work on the draft European Sustainability Reporting Standards
• internationally, sustainability initiatives have been launched, by IOSCO and by the International Sustainability Standards Board (ISSB), whose first exposure drafts on sustainability related reporting standards have now been published for consultation
• ESMA sees it as essential for the EU and global reporting standards to be interoperable, both to ensure helpful disclosure to investors internationally and to limit unnecessary burdens on companies who operate both within and outside the EU
• ESMA actively supports the work of IOSCO’s Sustainable Finance Task Force and may eventually endorse the ISSB standards if they meet certain pre-defined criteria.

ESG ratings

• the IOSCO work on ESG ratings and data providers was co-chaired by ESMA, with its recommendations on ESG ratings and data providers being published in November 2021
• these promote measures to improve the independence, transparency and reliability of ESG ratings and data products and push for comparability of, rather than consistency between, ESG ratings
• different ESG ratings can have different measurement objectives – the important thing is that whatever the objective, this is clear to the user, and the methodology followed is transparent
• ESMA’s view is that the currently unregulated nature of ESG ratings and data assessments could pose potential risks to investor protection - see its recent call for evidence on the topic
• ESMA regards the mismatch between (a) the demand for ESG investments and (b) the transparency and comparability on the real sustainability impact of financial products available in the market as being an “important challenge”, which could lead to misrepresentation and wrongful disclosure and mis-selling of what appear to be ESG products to final investors
• ESG factors will remain one of ESMA’s focus areas in its work on Credit Rating Agencies for 2022
  • it has recently assessed the implementation of ESMA’s Guidelines on Disclosures and
  • recently finalised a workstream looking into the extent to which the consideration of ESG factors have been integrated in CRA’s credit rating methodologies.

Carbon markets

• a IOSCO workstream dedicated to assessing the functioning, and potential risks, of global carbon markets has commenced under the IOSCO Sustainability Task Force, being co-chaired by the CFTC and ESMA
• this will work to establish a set of good practices and essential features that support the sound, safe and transparent functioning of these markets
• ESMA published an in-depth analysis of the functioning and surveillance of the EU carbon market in March 2021. This
  • unveiled important findings and policy recommendations, to further improve transparency and monitoring of the EU carbon market and
  • identified certain challenges, such as developing a comprehensive view and in-depth understanding of the market when fragmented data sources make a clear picture difficult to establish.

In an earlier speech to the Irish Funds Annual Global Funds Conference on 31 May, Verena Ross also devoted a section of her address to the issue of Sustainability and greenwashing, making the following points:

The EU’s sustainable finance framework

• Demand for sustainable financial products remains strong - the net asset value of ESG funds increased by 17% in the year to March 2022 and net inflows into ESG equity funds have amounted to EUR 218 billion over the last 3 years (as against EUR 55 billion for their non-ESG peers)
• the sustainability disclosure regulatory framework, though, is incomplete and imperfect at this time –the detailed technical rules under SFDR are still awaiting publication in the Official Journal while clarity on corporate disclosures from legislation such as CSRD is ‘urgently’ awaited
• in time, the CSRD, its accompanying reporting standards, and the global standards being promulgated by the ISSB will together help to complete the picture and significantly improve the underlying sustainability information

Clarification of Level 2 RTS under the SFDR

• ESMA accepts that the comprehensive nature of the investor disclosures under the SFDR are complex for investors to understand and the technically challenging rules are difficult for the market to digest
• the ESAs expect the product templates “to significantly enhance comparability of disclosures” when they become mandatory from 2023, but the underlying complexity of the information is, and will continue to be, a persisting challenge. To assist, the ESAs:
  • have published a document to assist the interpretation of various aspects of the Level 2 RTS under the SFDR – see our summary here
  • plan to issue a comprehensive set of formal Q&As after the RTS are published in the Official Journal. These will cover the practical application of the rules, covering the SFDR disclosures and the additional taxonomy-related product disclosures.
  • will continue to consider how to simplify the disclosures for investors and streamline the rules for the financial market participants
  • will address their new mandates to develop Level 2 measures on nuclear and gas disclosures under the taxonomy Regulation and their review of the PAI indicators – see our summary here
• in addition, ESMA has published a supervisory briefing (see our summary here) intended to clarify several areas of our RTS that have been unclear to market participants, which should promote convergence with regard to how the NCAs supervise investment funds with sustainability features

Article 8 and Article 9 funds

• on the application of the rules and the dangers of greenwashing, disclosures under the SFDR are often being used as product classification – the description of a fund as being an “Article 8” or an “Article 9” fund is being used in fund managers’ marketing material as a quality labels for sustainability – this is a particularly concern for ESMA in respect of investors investing in products disclosing under Article 8 of the SFDR
• the purpose of Article 8 disclosures is “to highlight any kind of environmental or social characteristics promoted by such products – however small it might be”
• it is very important that investors do not take the mere presence of an Article 8 disclosure as an indication of sustainability per se but, instead, review the disclosures to determine the actual sustainability characteristics and the extent to which the product actually applies them in its investment strategy
• the ESAs and NCAs will work together to reduce “over-disclosure” by investment funds under Article 8, to avoid misleading disclosures to investors about the greenness of a product
• they also support efforts to create clear criteria for financial products making sustainability disclosures, such as the possible introduction of sustainability labels for financial products, to help generate much needed clarity for retail investors.