#sfdr – BOS

ESG investing in a changing regulatory environment: investing in active or passive ESG financial products?

By Marco Morazzoni and Dr. Kristjan Jespersen

◦ 8 min read ◦

The impending climate crisis emphasizes the need to mobilize large-scale investments to finance the transition towards a more sustainable and inclusive economy. The financial sector plays a pivotal role in this context, as it allocates capital from investors who wish to pursue financial and non-financial objectives to corporations and stakeholders who need these resources to empower the sustainability transition.

Over the past decades, individual investors have become aware of the risks inherent in unsustainable business practices, being increasingly interested in financial products that combine a competitive risk-adjusted return with Environmental, Social and Governance (ESG) criteria. Despite the increase in funds, indices and benchmarks that include ESG dimensions, the universe of ESG financial products remains difficult to navigate for individual investors due to the range of investment strategies that can be used to pursue ESG goals, such as negative and positive screening, best-in-class, ESG integration, impact investing and ESG engagement. In addition to ESG strategic considerations, investors ought to consider the level of active management inherent in their ESG products, since it has considerable implications for financial returns and the ESG objectives pursued.

In fact, while some financial products have an active investment approach, trying to beat a reference benchmark, others merely aim to replicate the ESG impact and financial performance of an index.

‘Active versus passive’ debate

The literature on conventional active and passive investing is almost unanimously in favour of long-term passive investing, due to active managers’ inability to consistently beat the market and to the lower fees charged by passive funds. However, the ‘active versus passive’ debate in the context of ESG investing is more nuanced. This is because ESG investing entails the pursuit of intangible and hardly quantifiable goals that go beyond the achievement of mere financial returns. Furthermore, due to the different definitions and methodologies used in the assessment of ESG performance and the resulting unrealiablity of ESG data, the trade-off between impact and financial returns can be difficult to reconcile.

A study conducted on 78 ESG active mutual funds and 15 ESG exchange-traded funds (ETFs) seeks to contribute to the debate by illuminating the financial and non-financial features that characterize these sustainable financial products. The funds were selected from Morningstar Direct according to specific criteria, such as: availability of an ESG rating, European domicile, invested in equity, active investment approach (for mutual funds) and passive investment approach (for ETFs).

By constructing an equally-weighted portfolio for the selected ESG active mutual funds and ESG ETFs, the study used the CAPM, three-factor, four-factor and five-factor model to compare the portfolios’ risk-adjusted perfromance before and after fees. To increase the robustness of the study, the regression analysis was conducted on various market benchmarks, such as MSCI World, STOXX Europe 600, MSCI World ESG Leaders and MSCI Europe ESG Leaders.

The regression results indicated that the ESG active portfolio outperformed the ESG passive portfolio both before and after accounting for management fees. Controlling for the criteria used in the selection of the funds, the active outperformance could be attributed to the funds’ instrinsic characteristics, such as investment orientation, ESG investment approach and ESG scores. Accordingly, 77% of the ESG active portoflio had a global investment orientation compared to 27% of the ESG ETF portfolio. This entails that the active portolio covered more geographies, exhibiting higher diversification and improved risk-mitigation.

Further, 83% of the active portfolio practiced ESG engagment, a strategy that previous literature associates to superior financial returns and improved ESG impact.

By engaging with companies on ESG issues, ESG active funds may have been able to help ‘lagging’ firms improve their ESG performance, while enabling ‘leading’ firms to address their ESG issues. With respect to ESG scores (Morningstar and MSCI), the active portfolio displayed a lower overall ESG score compared to the ESG ETF portfolio. This finding could suggest that the active portfolio invested in lower rated companies on average, with the objective of helping them transform their ESG strategy and thus pursue higher risk-adjusted returns.

Insights to individual investors in ESG financial products

Recognizing the limitation derived from the small sample size and the fact that the active outperformance might be due to the specific funds selected, the findings were used to provide a set of insights to individual investors who wish to invest in ESG financial products.

Firstly, individual investors were categorised into ESG-unaware, ESG-aware and ESG-motivated, according to the investor labels used by Pedersen et al. (2021) “Responsible investing: The ESG-efficient frontier”. This categorization simplified reality to the extent that it became easier to derive actionable insights. Furthermore, it provided more granularity with respect to investors’ prerogatives regarding the trade-off between the pursuit of an ESG impact versus a risk-adjusted return.

Based on this categorization, investors who disregard ESG information (ESG-unaware) should invest passively in broad conventional ETFs or in a diversified portfolio of more specific conventional ETFs.

Investors who consider ESG information for risk-mitigation purposes (ESG-aware) ought to focus on the level of selectivity displayed by active managers in their stock-picking activity, measured in terms of high/low R-squared. If active managers are highly selective (low R-squared), ESG-aware investors may consider foregoing part of their return, due to the higher active management fees, and thus benefit from managers’ ability to pursue a greater ESG impact and potentially higher risk-adjusted returns.

Conversely, if active managers exhibit low selectivity with respect to a reference benchmark (high R-squared), investors would be better off investing passively in broad ESG ETFs or in a diversified portfolio of more specific ESG ETFs. Lastly, ESG-motivated investors may be better off investing in ESG active funds who practice ESG engagement, as the higher fees charged by these funds would worthwhile, given the superior ESG impact inherent in ESG engagment strategies.

Regulatory considerations

In addition to the empirical findings, the study also included regulatory considerations in the assessment of the suitability of active versus passive ESG financial products for individual investors. This was critical, since the new MiFID for sustainability preferences will come into force on the 2^nd of August 2022.

According to this regulation (2021/1253), investment firms will be obliged to ask their clients about their sustainability preferences and find out whether they are interested in sustainable financial products. If the answer is affirmative, financial advisors will only be allowed to offer MiFID-aligned products to their clients. A MiFID-aligned product will have to include a minimum portion of ‘environmentally sustainable Investments’ (SFDR article 9), EU Taxonomy-aligned investments, or enhanced article 8 investments, consisting of article 8 investments (SFDR article 8) which also include Principal Adverse Impact (PAI) indicators.

Linking the new regulatory requirements to the findings of this empirical research, it is reasonable to expect that ESG-unaware investors will no longer exist, as investment firms will be legally required to inform these clients about the ESG implications inherent in their investments. This will give rise to an increase in supply of sustainable financial products (MiFID-aligned), as investment firms strive to keep up with the increased demand for these products. The rise in supply will most likely be larger than the increase in demand, since a portion of the new ESG-aware investors might continue disregarding ESG information, if ESG financial products are priced unreasonably (excessively high management fees). This will ultimately lead to higher competition among investment firms, with a consequent downward pressure on fees in the long-run. Lower investment costs could subvert individual investors’ incentives, as they decide on whether to invest in ESG active or passive funds. Accordingly, it might become desirable for ESG-aware investors to invest in ESG active funds who practice ESG engagement, as opposed to it being a strategy exclusively suitable for ESG-motivated investors.

The information contained in this blog post is not to be taken as constituting the giving of investment advice or recommendation. The reader is acting for its own account, and they will make their own independent decisions as to whether any investment is appropriate based upon their own judgment.

About the Author

Marco Morazzoni is a recent graduate in MSc Applied Economics and Finance from Copenhagen Business School. Having an interest in finance and ESG, he wrote his master’s thesis on “ESG exchange-traded funds versus ESG active funds: how can individual investors pursue ESG objectives while achieving competitive risk-adjusted returns?”

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo: Khanchit Khirisutchalual on iStock

How the EU Taxonomy Impacts Businesses Beyond Europe

By Andreas Rasche

◦ 4 min read ◦

In 2020, the EU launched its classification system for environmentally sustainable economic activities, the so-called “EU Taxonomy Regulation” (hereafter: the Taxonomy). The Taxonomy is part of an integrated system of new EU-wide sustainability regulations, including new disclosure requirements for investors. While the Taxonomy is based on EU regulation, it can be expected that it will also have effects on businesses beyond Europe.

Basically, there are two ways in which the Taxonomy can affect non-EU companies. First, there are direct regulatory effects on non-EU companies. Because of the global nature of financial markets and the existence of global trade flows, non-EU companies will be directly exposed to the Taxonomy in different ways. Secondly, there will also be more indirect consequences, which I call “ripple effects”. Such effects exist because the Taxonomy raises the bar globally for how sustainability information should be disclosed, by whom it should be disclosed, and it which ways it can be disclosed. I briefly discuss both effects.

Direct Effects

In the short run, some non-EU companies will be exposed to the Taxonomy because of direct regulatory effects. Consider the following two examples:

A non-EU investor or financial advisor that wants to offer products on the European markets will be exposed to the Sustainable Finance Disclosure Regulation (SFDR) which requires an alignment with the EU Taxonomy. To offer financial products on European markets non-EU investors will therefore have to align with SFDR and hence the Taxonomy.

A non-EU company with EU-based investors is very likely to receive questions from these investors about the company’s alignment with the Taxonomy. Investors need this information to meet disclosure requirements under SFDR, for instance to classify their financial products in terms of their sustainability exposure. In other words, at least some non-EU companies will start disclosing more on Taxonomy-related indicators.

I could list more examples here (e.g., non-EU asset managers wanting to raise money in the EU), but the message is clear: the effects of the Taxonomy are not limited to businesses located in Europe. Particularly, the Taxonomy’s interaction effects with SFDR will affected non-European companies as well as investors.

Ripple Effects

Ripple effects are more indirect effects. They occur if an intervention, such as the introduction of a new regulation, creates further effects that reach beyond the system that was supposed to be influenced by the intervention. Such regulatory ripple effects can occur in different ways.

In the context of the Taxonomy, one important ripple effect is related to the practices of European businesses. Many of these businesses are global players, and they will apply the Taxonomy to their global operations regardless of whether these operations occur in a country that is legally covered by the Taxonomy. Sustainability reporting is usually done at the corporate level and therefore also includes firms’ non-European operations. The EU’s new disclosure regulation the Corporate Sustainability Reporting Directive (CSRD) will require that such reporting at the corporate level is taxonomy-aligned. In this way, European global players will “export” the Taxonomy to other parts of the world.

There are also ripple effects at the political level. The system of new EU legislation – including, the Taxonomy, SFDR, CSRD and other regulatory elements – is unique in the world. So far, no other region or country has a comparable system. However, the major economic regions in the world have also realized that future business will be difficult without sustainability-related regulations that enhance transparency and prevent greenwashing.

Consider two recent examples: In June 2021, the UK announced the creation of a Green Technical Advisory Group. This Group is supposed to develop and implement a UK green taxonomy, which is expected to be based in part on the EU Taxonomy system (e.g., in terms of metrics). In the US, President Biden signed Executive Order (EO) 14008 during his first days in The White House. While this EO does not aim at creating a US-based taxonomy, it has created a National Climate Task Force across different federal departments, which at least some see as an important step into the direction of more rigorous ESG-related regulation.

Other countries and regions are likely to look to Europe when thinking about how to design a workable taxonomy regulation, as the challenges that have driven the creation of the EU Taxonomy are the same throughout the world: we need more transparency around sustainable economic activities, we need to better benchmark firms’ sustainable activities, and we we need to prevent greenwashing.

It is too early to say whether there will be convergence among the taxonomies developed by different countries and regions, but one thing is for sure: they are here to stay…

About the Author

Andreas Rasche is Professor of Business in Society and Associate Dean for the Full-Time MBA Program at Copenhagen Business School. More at: www.arasche.com.

Photo by Krzysztof Hepner on Unsplash

SFDR, NFRD and the EU Taxonomy – What is their relationship?

By Andreas Rasche

◦ 5 min read ◦

The new Sustainable Finance Disclosure Regulation (SFDR) is on the minds of many investors these days. While a lot has been written on SFDR itself, I discuss how it relates to the Non-Financial Reporting Directive (NFRD) and the EU Taxonomy on sustainable economic activities. Taken together, these regulations can be overwhelming and maybe even confusing. While this is not the right place to comprehensively discuss all three regulations, I make some clarifications on their interlinked nature.

SFDR, NFRD, and the EU Taxonomy – What are we Talking About?

To start with, let us briefly review the three legal instruments, all of which belong to a series of EU regulations under the EU Action Plan on Sustainable Finance.

NFRD is the EU legal framework for regulating the disclosure of non-financial information by corporations. It was adopted in 2014 and states that corporations have to report on ESG information from 2018 onwards (for the 2017 financial year). NFRD is rather flexible – it applies only to so-called “public interest entities” (basically rather big corporations) and it contains so-called comply-or-explain clauses (allowing for non-disclosure of information if this is made transparent and reasons are given).

SFDR is the new EU regulation that introduces rules for financial market participants (FMPs) and financial advisers (FAs) to report on how they account for sustainability risks. SFDR applies at the “entity level” (i.e. requiring financial firms to report on how the whole organization deals with such risks) and also on the “product level” (i.e. requiring firms to report on how their financial products are affected by such risks). SFDR contains few comply-or-explain clauses (e.g., smaller firms, with less than 500 employees, can opt out of reporting on due diligence processes). The regulation asks all FMPs and FAs to report on sustainability risks even if they do not offer ESG-related products. If an entity offers ESG-related products, SFDR requires additional disclosures depending on how “green” the product is considered to be. SFDR came into force on 10 March 2021.

The EU Taxonomy regulation (hereafter: the Taxonomy), which entered into force 12 July 2020, reflects a common European classification system for environmentally sustainable activities. Basically, the Taxonomy tried to answer the question: What can be considered an environmentally sustainable activity? Answering this question is essential for investors to prevent “greenwashing” – i.e. a situation in which financial products are marketed as being sustainable without meeting sustainability criteria. The taxonomy defines six environmental objectives, and it defines an economic activity as sustainable if this activity contributes at least two one of these objectives without, at the same time, doing significant harm to any of the other objectives.

Differences and Commonalities

To start with, it is important to note the different legal status of SFDR/the Taxonomy as well as NFRD. NFRD is based on an older EU Directive (2014/95/EU). Directives imply that EU member states have to translate the broad requirements into national regulation. By contrast, SFDR (2019/2088) and the Taxonomy (2020/852) are both based on European regulation, which is immediately enforceable and does not require transposition into national law.

To understand how the three legal frameworks relate to each other, look at the Figure below. NFRD applies to corporations of all kinds. Hence, for investors NFRD is mostly relevant because it stipulates how investee companies report ESG data. SFDR, by contrast, most concerns financial market actors and ensures transparency about how these report on sustainability risks to their audiences (e.g., retail investors). The Taxonomy was introduced to have a common reference point when trying to figure out whether an economic activity really is sustainable. The Taxonomy therefore has the power to further specify the regulations set out in SFDR and NFRD.

Emerging Relationships

The linkages between the three frameworks will be further specified throughout the coming years. While SFDR has been in force since 10 March 2021, it is only in the so-called “level 1 stage of development”. As with many EU regulations, level 1 development sets out the basic framework principles for a regulation, however without specifying technical details. SFDR level 2 will come into force once the regulation is complemented with Regulatory Technical Standards (RTS), which are developed right now. The RTS will also specify the linkages to the Taxonomy in more detail (e.g., related to the “do-no-significant-harm” concept inherent in SFDR).

So, what can we say right now? The current versions of SFDR and NFRD do not yet link disclosures to the Taxonomy. This is likely to change, especially with the SFDR RTS being further specified and rolled out (in early February the European Supervisory Authorities released their final draft of the SFDR RTS). Moreover, the NFRD regulation is currently under consultation and will be revised in the near future. However, two important linkages are important to consider right now.

First, the scope of the Taxonomy is defined through NFRD and SFDR. In other words, if an organization is affected by NFRD and/or SFDR, the Taxonomy will also be relevant for its disclosure practices. It is important to note here that the EU Taxonomy defines further mandatory disclosures in addition to what is laid out by NFRD and SFDR.

Second, the Taxonomy asks companies (incl. asset managers) to report the percentage of their turnover and capital as well as operational expenditures that are aligned with the Taxonomy. It also asks asset managers to report the percentage of their portfolio which is invested in economic activities that are aligned with the Taxonomy.

The Future

We will witness a good deal of technical specifications of all three regulations throughout the next years. SFDR level 2 reporting will kick in once the RTS standards are part of the reporting (probably by mid-2023); also by 2024 year-on-year comparisons of data points under SFDR will be likely mandatory. The six environmental objectives of the Taxonomy will be specified through technical screening criteria, some of which will be released very soon.

It is good to see non-financial reporting and sustainable finance being backed by strong European regulations. It allows for more comparison and benchmarking and hence transparency. But, of course, we should also be prepared for a good deal of clarifications that will be necessary until institutionalized reporting cycles can fully kick in and unfold their potential.

About the Author

Andreas Rasche is Professor of Business in Society at the Copenhagen Business School (CBS) Centre for Sustainability. His latest book “Sustainable Investing: A Path to a New Horizon” (with Georg Kell and Herman Bril) was published recently. Email: ar.msc@cbs.dk Homepage: www.arasche.com