Making sense of ESG: HLEG’s Arlene McCarthy on the role of regulators

This article is one in a series of thought leadership pieces written for Responsible Investor by members of the European Commission’s High Level Expert Group on Sustainable Finance. To see other HLEG coverage, see here, or to comment, visit our discussion page.

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One of the key challenges identified in the High Level Expert Group on Sustainable Finance’s Interim Report is to better integrate ESG factors into financial decision-making.
ESG disclosure and reporting is the bedrock of a sustainable financial system and therefore specific and targeted proposals to strengthen reporting requirements are a focus of the group’s work.
The ESG landscape is evolving and expanding not only to meet the demands of investors for responsible and ethical investment opportunities, but increasingly to take account of the materiality of ESG risks and their impact on financial markets. Investors are using ESG data to assist them with investment decisions across a broad spectrum – for portfolio decisions and research notes. ESG indices are regularly used by analysts and research firms for assessments and credit ratings.
Yet investors continue to face a complex system of multiple reporting frameworks, metrics and standards. There is more transparency and visibility around ESG factors than ever before, with over 400 frameworks to choose from. The Task Force for Climate-related Financial Disclosure has led the way in arguing for a more coherent and consistent approach to climate reporting, citing the numerous reporting options, namely:
“GHG Protocol, Global Reporting Initiative, ISO Standards, Sustainability Accounting Standards Board, Climate Disclosure Standards Board, World Resources Institute, World Business Council for Sustainable Development, CDP, and various industry-specific guidance.”
The reporting landscape is further complicated by the existence of national standards and laws. The EU’s Non-financial Reporting Directive, which came into effect in December 2016 is a major step forward. It provides for mandatory ESG reporting by listed companies in 28 member states – but companies again may choose which standard they wish to adopt.
All of this is a major improvement for transparency and visibility of ESG factors. But how are investors to make sense of the information provided if it is disclosed using different methodologies and metrics? More importantly, how do they identify the link between disclosure and reporting of ESG factors and their role in managing financial risk?
Just as Europe moved to introduce harmonised standards for food labelling in a world where consumers were not able to make sense of the numerous listing of ingredients on products and the information overload on packaging and tins, Europe needs to come up with a core set of harmonised reporting standards for ESG disclosure. This is critical where there is a strong link between ESG-related financial risks, poor performance for companies, and wider risk in the markets.No one would deny that the market is already driving forward higher and more effective standards for ESG disclosure in response to investor demand. Market innovation will continue to drive cultural change, and this voluntary, market-based approach may indeed get us to where we want to be – but not in the timespan required to prevent financial risks building up because of a failure to adequately reflect ESG factors in investment and financial decision-making. As regards climate disclosures and financial risks, we are rapidly reaching the tipping point. Regulation can assist in codifying and embedding norms and pushing ESG disclosure and transparency into mainstream financial markets processes. It can ensure that ESG is taken up in the boardroom and it can generate greater communication and engagement between the sustainability and finance professionals. Thought should be given to whether this should be accompanied by a third-party assurance scheme to certify the trustworthiness and comparability of data and information.
EU law is taking on board the need to set standards in ESG through initiatives such as the shareholder directive and the pensions directive. The review of the Non-financial Reporting Directive must in turn make a clear and explicit link between ESG factors and financial risk.
There is a role for regulation to set the agenda in a complex and confused landscape by mandating a set of core harmonised, consistent and comparable reporting standards. There are many good examples where the regulatory route is preferred – from mandatory reporting for US securities law, to South Africa’s legal mandate for sustainability reporting with third-party assurance, through to France’s Article 173. Smart regulation can nudge the market forward. The systematic and meaningful incorporation of ESG factors will require a regulatory push to improve the quality of the data presented and ensure its comparability. This is critical for investor confidence and will help to make sense of a crowded and confusing reporting landscape. The European Supervisory Agencies (ESA) can play a greater role. The European Securities and Markets Authority (ESMA) has already demonstrated a clear interest in disseminating information on corporate governance, and it could perform a similar role for disclosure and comparability.
Ultimately ESA’s duty to protect and safeguard investors is equally matched by an obligation and responsibility to provide clarity and safeguards for the financial and capital markets; and by extension, to assessing ESG-related risks.
The way forward is for a hybrid solution that combines the best of market practices with targeted and effective regulatory instruments to better integrate ESG into sustainable finance models.

Arlene McCarthy is the Executive Director of UK-based advisory firm AMC Strategy Limited. She is a former Member of the European Parliament, and was the Vice-Chair of the Economic & Monetary Affairs Committee. She is a Non-Executive Director of Bloomberg.