Having worked in the investment fund industry for more than two decades, let me start with a disclaimer: I strongly believe that sustainability is a must-have, not a nice-to-have. Money is a means, not an end. Ruining the basis of our existence to create money can never ever be called sensible.
OK, now we have that out of the way, let’s take a look at the urgent need we have for regulation if we still want to successfully turn the tide on sustainable finance and combat dangerous climate change.
Thankfully, politicians seem to have recognised the necessity for regulation on climate; a mere 24 years after the Kyoto Protocol.
But…
The time that has been squandered since then is now, it seems, to be made up for with an avalanche of activity.
The prime example of this is the EU’s huge sustainable finance push. The work done by its initial High Level Expert Group (HLEG) was a very good starting point. What happened next though is not a model of good legislation. As with building a house, you cannot pour the foundations, cover the roof, and install the electrics at the same time without this leading to serious problems.
Some may take comfort from the fact that there is at last a sense of action and determination here. But the road to hell is paved with good intentions.
One example is the EU Ecolabel. Of course it would be practical if investors could see at a glance whether a fund is sustainable or not; just like mattresses, paint and toilet paper.
Except here, that’s where the problems start: the costs associated with the large number of reports, verifications and tests required to obtain the label.
The ambition right from the start for the Ecolabel was that it was only intended for the “very best” or “very greenest” sustainability funds. That such funds may be dark green but not necessarily suitable for retail investors from an investment perspective was disregarded.
Most investors buy funds because they expect a reasonable return with an acceptable level of risk. Consumers buy toilet paper to…well, you know…
Relatively few funds are bought just because they are green and labelled. The difference between the two is that the “performance” of toilet paper is very predictable. The performance of funds, of course, cannot be predicted ex-ante at all. The very restrictive design for funds, combined with the fact that at the time of their ‘construction’ only a few companies from a probabilistically manageable number of sectors can overcome the entry thresholds into labelled funds, is likely to lead to a lack of diversification.
But this would again mean that such funds should simply not be marketed to retail investors. And the performance of these funds – to put it mildly – could be poor. That’s a nightmare for anyone who has spent the last decades desperately fighting against the equation: sustainable = poor performance. Now it could be revived by the EU through an overambitious eco-label.
If this leads to a new flower being added to the bouquet of existing labels it would have been much ado about nothing, and a missed opportunity to bring many investors across Europe closer to sustainability in investing.
But there is another additional disturbing development: national regulators are starting to impose their own additional rules in an uncoordinated way. As “Kafkaesque” as some of the things pouring out of Brussels already are, the uncoordinated behaviour of regulators in the various member states could deal a serious blow to the issue of sustainable investments. Or to use another image: it would almost be like opening the oven door prematurely with a soufflé inside.
How is this supposed to hang together?
On the one hand, the EU as a whole wants to promote sustainability. Starting with the financial market is unusual, but perhaps a clever move. (However, this is not enough: especially when it comes to climate change. Companies in the real economy must be provided with reliable, target-oriented framework conditions as soon as possible).
On the other hand, a multitude of different local requirements would again fragment the market for sustainable investment funds. Where is the vision of the Capital Markets Union?
To recall an obvious point: The goal will only be achieved if as many investors as possible invest in sustainable funds. And that becomes less likely the more expensive they become. Every additional document, every new indicator makes an investment product more costly.
How does it fit that we are supposed to advise clients in the best possible way, and at the same time the funds become more expensive due to such regulations?
How will investors feel when we tell them in a consultation: “You want ‘sustainable’? No problem. But please understand that we have to charge more for the flood of information we will shower you with.” We are already hearing concerns about the templates for pre-contractual information under the SFDR, which trials have shown are not understood by investors. It seems that the Commission has listened and will react to that, but one basic question remains: why is micromanagement on this level necessary?
In principle, I welcome the transformations we are seeing. But if I had one wish, it would be for good, lean regulation when it comes to sustainable investing. As much as necessary, but as little as possible.
And please, make it properly planned: co-ordinated, uniform, speedy, but not hectic.
John Godfrey Saxe, the lawyer-poet, said: ‘Laws, like sausages, cease to inspire respect in proportion to our knowledge of how they are made’.
We cannot afford bad ESG laws: the issues at stake are too important for that.
RI’s Secret Investor series is a chance for market participants to write candidly and anonymously about current developments in sustainable finance. If you’re interested in writing for the series, please contact elza@responsible-investor.com
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