An insight into Environmental, Social, and Governance (ESG) and Sustainable Finance Disclosure Regulation (SFDR).

Asset owners lead the investment value chain and as their buy-side sophistication and tilt towards ESG related investing products increase so does the relevance for sell-side analysts in coverage and product solutions.

In the traditional valuation landscape, the phrase ’cash is king’ often heralds a view that within the same risk framework the asset with the highest expected future cash flow would generate the highest current value.  However, the forces of ESG and the underlying principles of sustainability in the modern finance environment can see two assets with the same underlying cashflows and risk benchmark valued differently depending on their individual strategies for adopting ESG and sustainable practices. Sustainability initiatives are becoming the new valuation currency.

The concept of ESG and Socially Responsible Investment (SRI) is not new. For example, as far as way back in the 17th and 18th centuries religious groups adopted negative screening as a philosophy for their investment mandates [1].

However, according to the Global Sustainable Investment Review (GSIR) between 2016 and 2020, Sustainability themed investments registered a growth of 605% [2].

For analysts with coverage in Europe, an awareness of the SFDR is relevant. The SFDR came into effect in March 2021 and requires standardized disclosures on how ESG factors are integrated at both an entity and product-level [3].

The SFDR sits within a broader set of EU initiatives and policies including Taxonomy Regulation and the Low Carbon Benchmark Regulation.

The momentum for the increased disclosure regulation is to aid the European Green deal, which envisions a European economy that is climate neutral by 2050 [4].

Historically, sustainability disclosures for end-investors have been insufficient. The objectives of the SFDR fall under three broad categories:

  • To improve disclosures so that institutional asset owners and retail clients can understand, compare and monitor financial products’ and firms’ sustainability characteristics
  • To counter greenwashing
  • To ensure a level playing field for companies operating within the EU

With the improved regulations and disclosure requirements, both institutional asset owners and retail investors will have a much better understanding of their direct investment impact on society.

This increased transparency will create an increased shift in capital towards assets that are on par with the expectations of the SFDR and other regulatory requirements. For buy-side analysts, the expectation is for investment mandates to continue the upward trajectory of demanding ESG and sustainable related types of investments. For sell-side analysts, products created must be within the framework of ESG expectations and greenwashing must be avoided.

Much like corporate governance, more transparency on sustainability efforts by companies will have an impact on corporate valuation.

 

If you would like more information on our ESG and sustainability learning solutions then feel free to get in touch at info@amttraining.com

 

References:

[1] Certificate in ESG Investing, Official Training Manual;

[2] Global Sustainable Investment Review 2021;

[3] KPMG SFDR – Snapshot;

[4] Intuition.com