Our industry is engaged in an important dialogue to improve sustainability through ESG transparency and industry collaboration. This article is a contribution to this larger conversation and does not necessarily reflect GRESB’s position.
ESG reporting fosters market competition by granting access to information that offers reliable assessments of risks that could impact future share value and profitability. As a result, the effectiveness of ESG criteria in encouraging businesses to act in environmentally and socially responsible manners hinges on the ability to make fair comparisons between companies. Thus, harmonization and a common version of the truth will be key to ensuring these disclosures are not just “sustainability on paper.”
The current growth of ESG reporting requirements in the EU and UK highlights the increasing importance of corporate transparency for sustainability. These regulations are paramount in ensuring the greening of the financial industry, and while groans can be heard from some corners of the financial community in response to new and sometimes costly obligations, the short-term costs of compliance pale in comparison to the importance of making sustainability disclosures a widespread norm.
However, the flurry of ESG reporting requirements, either current or imminent in the EU and UK, has caused some confusion and unexpected costs for firms as they strive to establish an efficient disclosure process that ensures compliance across various jurisdictions. Recent developments in ESG reporting internationally warrant a brief overview and a discussion of where we go from here.
Recent developments in the EU
In June 2023, the European Parliament agreed its position on the Corporate Sustainability Due Diligence Directive (CSDDD). The Directive aims to establish a responsible and sustainable approach to global value chains, requiring companies to take responsibility for their environmental and social impacts, as well as those of their suppliers. The CSDDD mandates that companies conduct due diligence on their operations and supply chains, evaluate potential environmental and human rights impacts, mitigate risks, and develop policies and procedures to address these risks. The draft has been approved by the European Parliament and Council and is set to be finalized during 2023.
Elsewhere, in recent months the Corporate Sustainability Reporting Directive (CSRD) has replaced the Non-Financial Reporting Directive and requires companies to disclose sustainability issues from a “double materiality” perspective, considering how such issues affect their business and how their business affects people and the environment. Non-EU companies with substantial activity in the EU and EU companies meeting certain financial thresholds must comply. Companies must disclose information on sustainability matters, including the resilience of their business model and their strategy to sustainability risks and plans aligned with the 1.5-degree Celsius global warming target under the Paris Agreement. The implementation of the CSRD will begin between 2024 and 2028, depending on company size.
Sustainable Finance Disclosure Regulation
Separately, the EU has issued new guidance on Article 9 classification under SFDR. In it, the Commission has reaffirmed its stance, defining it as a disclosure framework without specific criteria or benchmarks for sustainable investments. While this reduces regulatory risk for asset managers to a certain extent by allowing them to conduct their own sustainability assessments, it also exposes them to potential legal and reputational risks if their investment strategies are suspected of greenwashing. For investors, the absence of clear regulatory standards means they need to invest more time and effort in identifying financial products that align with their sustainability preferences while safeguarding against greenwashing practices.
More specific to real estate, in April the European Supervisory Authorities (ESMA, EBA, and EIOPA) published a consultation paper proposing amendments to the RTS as part of SFDR, which includes questions on real estate–specific Principal Adverse Impact (PAI) indicators. The first is whether to apply the social PAIs to fund managers or to property managers, while the second seeks feedback on the definition of energy inefficient real estate assets. Of particular contention is whether the PAI definition of “inefficient real estate assets built before 31 December 2020” should be expanded to align with the EU Taxonomy criteria, whereby it would meet both of the following:
- An EPC below C.
- Not within the top 30% of the national or regional building stock expressed as primary energy demand.
It is clear that much of the real estate industry continues to struggle with applying the existing energy inefficiency indicators (which rely on EPCs) to assets which do not have the appropriate certificate classification, such as assets in Germany where the EPC system is not lettered, or outside the EU where EPCs are not applied. Indeed, this is a point where the ESAs concede they do not have an easy solution, and where they would welcome the insights of practitioners as to how a more effective metric could be applied. The consultation closes on July 4, and the SFDR regime is expected to be updated at the end of 2023/early 2024.
UK regulations
While the EU has been acting as the first mover in the regulatory space, the UK has been a few cycles behind, perhaps learning from some of the stumbling blocks which the EU has encountered. The UK’s Sustainability Disclosure Requirements were proposed in October 2022, and while many hoped to see a close alignment between the EU and UK on investment product labeling, this has largely proved not be the case.
The proposed UK SDR introduces three labels (sustainable focus, sustainable impact, sustainable improver) which do not align with the three categories (Article 6, 8, and 9) specified in SFDR. The SDR is understandably more stringent as it is a labeling regime as opposed to a pure disclosure mechanism like the SFDR. This means that unless a Fund classifies as Article 9 under SFDR it is unlikely to be eligible for any of the proposed labels under SDR. In its current form, ambiguity remains around specific thresholds and whether the real estate sector will be considered as a different sector to liquid investments.
In essence, the SDR aims to label financial products based on their intentionality and the extent of sustainable investments. It thus provides greater clarity for funds in determining the appropriate label for their products and has the potential to offer investors greater certainty in selecting funds that align with their preferences.
A considerable number of companies that are based in the UK and market products within the EU will be subject to both the SDR and SFDR regulations. These companies will need to decide how to classify their funds under both frameworks and will likely prefer a more coordinated and harmonized approach between the two jurisdictions. The ASEAN Taxonomy and the proposed SEC ESG Disclosure requirement in the US are two more regional disclosure regimes which may add to this difficulty.
Moving forward
A rising concern among environmentalists in response to the expanding regulatory landscape is whether new rules will lead to a change in business practices at the pace required.
As many of these regimes are in their infancy, it’s easy to see why many firms would take the path of least resistance when faced with this myriad of new obligations. In the early phases of enforcement there are ways for companies to shirk accountability — for example, by disclosing insufficient data coverage; by opting for the ‘explain’ option over the ‘comply’; or by reporting based on isolated yearly snapshots, rather than demonstrating progress in relation to previous years. What is clear is that firms will require time to establish ESG data protocols and to implement sustainable investment strategies.
There is a case to be made that less time spent figuring out the differences between disclosure regimes means more time spent on strategy implementation. To that end, the new ISSB disclosure standards S1 and S2, issued in June 2023, should help with the establishment of a global baseline of sustainability-related financial language, on which jurisdictions can layer their own specific rules.
For regulators, achieving efficiency means striking a balance between transparency and avoiding an overly burdensome regulatory landscape. While it is commendable that international regulatory bodies are lifting the hood and shining an essential light on the financial system, one hopes that the bigger picture is also in sight.
This article was written by Patrick Rogers, Sustainability & Energy Consultant at Longevity Partners.
