Should developing markets take a carrot or a stick approach to ESG regulation?

As European regulation exposes the challenges in addressing environmental, social and governance factors, developing markets, such as India, may wish to take a flexible approach.

ESG investing is big business, amassing $35tn last year. In some cases, however, it has also led to misrepresentation and greenwashing. Regulators have started to pay attention as they attempt to both level the playing field and ensure stakeholders are getting what they expect.

But ESG is still a new area for all, which poses the question: what shape should regulation take? Should it be descriptive guidance-style regulation? Should it be based on transparency, using a ‘comply or explain’ regulatory approach? Or should it be prescriptive, such as a codified set of rules where asset managers have absolute clarity on what is expected and are effectively told what they need to do? And can this approach fit an evolving and dynamic investment landscape?

A suggested regulatory framework would be to give asset managers choices in two main areas: first, select the investment theme and asset (for example, what shade of green); then, describe the framework for selecting that asset (what dataset to incorporate, having your own proprietary scoring or data system etc).

Regulating the ESG credentials of the asset manager and strategy is only one piece of the puzzle. The characteristics of the target ‘asset’ also need taking into account. Are the investee companies ready to be screened and support asset managers meet their ESG disclosure obligations or are we putting the cart before the horse? Are asset managers dealing with an even investment universe?

Determining regulatory scope

Developing markets present a very different backdrop to developed markets. Regulators need to be careful that they are not just looking at the end of the chain and finding the weakest link. However, it is also important to consider the scope of the regulations: how far they should reach and what clear limits should be set to avoid unintended consequences.

The EU is advanced in terms of defining applicable investment instruments, as since March 2021, asset managers must document and disclose their sustainability practices and outcomes in line with the Sustainable Finance Disclosure Regulation. As an example, an important part of the new regulation within the EU is the classification of funds; article 8 funds are defined as promoting ESG features with lower minimum reporting standards under SFDR, while article 9 funds are subject to higher minimum standards.

Additionally, the UK has divided funds that promote ESG features into two subcategories within its fund classification rules. The purpose here was to also be inclusive of funds that have transitional investments, where underlying assets may not yet meet sustainability criteria but are acting on a mandate to transition. But asset managers across Europe are often still confused about definitions.

Meanwhile, Hong Kong is even stricter in some areas and is requiring all pension funds to integrate ESG at some level in each product. Therefore, consumer choice as a pensioner is now being restricted in this region as we write.

Aiming for clarity

In India, the Securities and Exchange Board of India had begun with mandating a business responsibility report (BRR) for the top 100 listed companies in 2012, gradually expanding the universe to the top 1000 companies, comprising 98 per cent of market capitalisation, while also guiding the reporting standards to be more objective, with a new business responsibility and sustainability report (BRSR) replacing the BRR from April 2022.

It then linked disclosure to investment — a recent consultation paper suggested restricting all ESG-mandated investments to companies that have published a BRSR (from October 2022, with grandfathering of existing portfolios). While the ESG universe in India is small (about 0.3 per cent of mutual fund assets), it raises an important question on the scope of the regulators. Should they intervene and influence portfolio construction, or should regulatory principles be restricted to transparency and choice?

From the regulators’ perspective, asset managers are subject to regulatory oversight that includes investment philosophy, and transparency about their investment universe, among others, as part of their fiduciary duties. The current BRR and the proposed BRSR aim to provide clarity about a company’s performance, including the three segments of ESG. These quantifiable metrics should help investors make meaningful choices and reduce greenwashing.

We hope regulators will keep in mind the need to balance the objective of investor protection with not being so onerous that this creates barriers for asset managers wanting to change their activities and comply. Regulations that are too prescriptive also risk creating a homogenous product field, stifling innovation and inadvertently limiting investor choice. Finding that fine balancing line is the key, so that regulators step in and mandate only what is necessary, while trusting the efficiency of market forces to judge and allocate capital to reflect investors’ demands of them.

Tirthankar Patnaik (pictured) is chief economist at the National Stock Exchange of India; and Paul Smith is the founder of SustainFinance and the former CEO of the CFA Institute