Green finance is a rapidly evolving area of the financial services sector. Demand has arisen from investors looking to invest consciously or chase the “greenium” of sustainable finance and “sustainable” or “green” funds are increasingly available. Ostensibly, the purpose of these funds is to provide an opportunity to invest in a curated set of companies that are climate/socially/environmentally friendly. Europe first enacted rules on sustainable finance in July 2020 and has been a trailblazer in classifying economic activity and spearheading the efforts to tackle greenwashing in the financial sector. Now, regulators around the world are following suit.
Why Are Regulations Needed?
As we’ve discussed before, there are differing views about what “sustainable finance” is or should be. This disconnect between what investors think funds do – and what the actual practices of those funds are – is partially what landed BNY Mellon in hot water with the SEC back in May. With much confusion surrounding green finance, regulators seek to provide clarity through regulation.
Here are a few countries eyeing or implementing regulations and a brief synopsis of their various approaches:
The EU Taxonomy
The EU is approaching sustainable finance through the use of their “Taxonomy Regulation.” This regulation provides six environmental objectives that make an economic activity or fund “sustainable.” For an economic activity to be labeled “sustainable” in the EU, it has to actively pursue one or more of the below objectives, while doing no significant harm to the others. These are:
- Climate change mitigation,
- Climate change adaptation,
- Sustainable use and protection of water and marine resources,
- Transition to a circular economy,
- Pollution prevention and control, and
- Protection and restoration of biodiversity and ecosystems.
This regulation applies to three main groups:
- Financial market participants offering financial products in the EU – regardless of where the financial company is based or otherwise regulated
- Large companies required to report under the NFRD (this list will be expanding when the NFRD is revised by the CSRD)
- The EU and its member states.
At the moment, there is a great deal of controversy around whether natural gas and nuclear energy should be included in the list of economic activities considered “sustainable.” The urgency of this matter was heightened dramatically as a result of the Russian incursion into Ukraine and the subsequent impact that had on balancing EU energy independence with its climate goals.
The SEC Fund Name and Disclosure Rules
The SEC issued two proposing releases to regulate sustainable finance:
- Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices (“Enhanced Disclosures Proposal”). This proposal identifies three categories of ESG funds – Integration Funds, ESG-Focused Funds, and Impact Funds. The extent of disclosure a fund must provide about its ESG strategies and impacts is determined by the category it falls into. This regulation is set to apply to all SEC-registered advisors.
- Proposed amendments to the “Names Rule.” This proposal states that if a fund uses a name implying that it focuses on a certain industry, geographic location, or other SEC-regulated focus, then that fund must be composed of at least 80% of assets in that area. The proposed amendment would add ESG-related fund names to the list of regulated names. Funds found in violation of this rule would be subject to enforcement on the grounds of being “misleading or materially deceptive.” This regulation would apply to all registered investment companies whose name suggest a focus in a particular type of investment.
UK FCA Comments
In June 2022, the UK’s Financial Conduct Authority (“FCA”) published a feedback statement and Primary Market Bulletin discussing rules applicable to sustainable finance. The FCA’s approach relies on existing regulations rather than newly proposed rules. In these publications, the FCA reminds financial institutions that Use of Proceeds (“UoP”) bonds must have frameworks that are consistent with the information in their prospectuses. The FCA also indicated that those offering such bonds would be wise to follow the ICMA principles and Guidelines to err on the side of caution in avoiding misleading statements, and thus potential regulatory action. This warning from the FCA implies that enforcement could begin immediately using existing rules and wouldn’t necessarily require additional laws or regulations to be passed.
The FCA has jurisdiction over, and can bring enforcement actions against, all firms engaged in regulated financial activities in the UK. Depending on the specific investment/firm, the FCA can enforce against non-UK entities.
ASEAN Sustainable and Responsible Fund Standards
The Philippines’ SEC introduced its proposal for ASEAN Sustainable and Responsible Fund Standards in February 2022 aimed at increasing ESG disclosure and reporting requirements for fund managers operating in the jurisdiction of the ASEAN. Qualifying funds will be listed as “ASEAN Sustainable and Responsible.” Funds in this category would be subject to periodic disclosures on ESG metrics and disclosures relating to the fund’s overall ESG strategy.
The ASEAN proposal would apply to all fund managers in the ASEAN jurisdiction.
Japan’s Draft Code of Conduct for ESG Evaluation and Data Providers
On July 12, the Japanese Financial Services Agency (“FSA”) unveiled its draft for a Code of Conduct for ESG Evaluations and Data Providers (“Code of Conduct”). Unlike the other items on this list, the Japanese Code of Conduct targets ESG data providers and ratings agencies, but the draft makes it clear that this is an effort to shore up the quality of information available to investors. The Code of Conduct asks ratings agencies to provide their sources of information and ensure that they have the appropriate staff to interpret their data. There are additional provisions that aim to help build transparency in ESG data reporting, like conflict-of-interest checks. Another unique aspect of the Code of Conduct is that it not a regulation and is only advisory in nature.
This Code of Conduct would only apply to data providers operating in Japan that choose to opt-in. Companies do so by making a public announcement indicating that they intend to comply with the Code. Even for those that opt in, enforcement of the Code of Conduct seems unlikely, as the FSA has stated that providers can adopt a “comply or explain” approach to the Code.
What This Means
Regulatory agencies are formalizing the world of sustainable finance. It remains to be seen if a global standard will emerge. Even if that happens, enforcement will remain a jurisdictional patchwork. Investors and financial service providers need to be aware of new regulatory changes. We are tracking these developments in our Financial Services Sector and Sustainable/Bonds Subject Areas where our members can learn more about the shifting regulatory landscape.