A rising tide of expectations raises the bar in ESG

• Regulators signal growing concern about how fund managers use ESG data, and the data itself
• In a parallel move, ESG integration without positive impact or stewardship focus is losing its ‘ESG’ & ‘sustainable’ labeling advantage
• Fund managers in Islamic markets just starting their ESG journey will be affected by stronger ESG regulations, even if the latest round won’t directly impact them

Greenwashing is becoming a more common point of criticism within responsible investment. The expectations are no longer just centered on whether ESG information is considered, but on the way it is used. More asset managers and owners in Islamic markets are beginning to consider how regulators and market practices are evolving so as to not get caught flat-footed as expectations soar.

Two recent items highlight considerations about how quickly the value of ESG integration fades into basic market practice, and how much more regulated ESG data and its use are becoming as the UK leans in the direction of the EU regulatory approach rather than the US. One key between the UK/EU compared to the US in ESG regulation is in how much normalization of ESG there has or has not been.

In a “Dear chair” letter sent by the Financial Conduct Authority to chairs of UK fund managers, the FCA set out Guiding Principles on what it expects from ESG and sustainability funds, in response to fund authorization applications that have been “poorly drafted and have fallen below our expectations”. The FCA says its intent “is to be complementary to obligations under [Sustainable Finance Disclosure Regulation (SFDR)].”

At the heart of the difference is that the UK/EU approach excludes funds that integrate ESG for financial reasons only. The US SEC, in contrast, seems more focused on curtailing practices where fund managers say they are doing something they are not.

The gap in definitions leaves the door open for ESG funds that are not seeking to create a positive environmental, social or governance impact to be called “ESG” when they would be excluded from this label in the UK or Europe. Another related question attracting regulators’ attention is via an IOSCO consultation, which operates from the premise that the variable quality of ESG data underpinning these funds creates risks, owing to “a lack of transparency about the methodologies underpinning ratings or data products and an often uneven coverage of products offered across industries and geographical areas”.

The debate has moved on from whether ESG is financially material; it is recognized in the guiding principles and in Europe in SFDR Level 1 categorization that purely financially motivated ESG integration isn’t ‘ESG’ or ‘Sustainability’. In order for a fund name to justify calling it ‘ESG’ or ‘Sustainability’, the regulators are reiterating the need to define a positive impact or stewardship policy. It is not enough just to factor in financially material ESG issues, which has become a common market expectation.

In many areas of ESG relevant to Islamic markets — just as with the applicability of the EU Taxonomy in developing and emerging markets — it remains an open question whether the ESG data that are available today are sufficiently comprehensive and consistent (between countries and companies) to use as a gauge of outputs. However, it is clear that the changes in their home countries’ regulations are going to have an impact well beyond their borders.

Three conclusions can be drawn from changes encapsulated within the FCA’s Guiding Principles and IOSCO’s consultation:

• First, a financially motivated integration of ESG information is going to become common market practice and unremarkable for funds within 5 years or sooner.
• Second, investment funds are going to be seeking out and getting much better quality ESG data than they have today, with a nudge from regulators on the providers of the data where necessary.
• Finally, during the next 5 (or fewer) years, emerging and developing market companies are going to be facing much better organized, data-backed investors engaging to improve their ESG practices.

For asset managers in Islamic markets, and Islamic market-based asset owners that are heavily invested locally, it means a steep learning curve is coming, but the earlier they start the better equipped they will be.

Even apart from any common ground taxonomy or carbon border adjustment, the regulations of investment funds in the UK or Europe (and the US if they follow a similar path) will have a substantial future impact on listed companies in Islamic markets, and by extension, their local investors. They will be in a much more challenging spot if they try to follow the path of ESG in other markets rather than adapting to incorporate best practices from elsewhere.

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