March 10th 2021 was a watershed for financial markets, marking the day that the Sustainable Finance Disclosure Regulation (SFDR) came into effect. SFDR means that financial service providers are now required to disclose how sustainability risks are integrated in the investment process. In addition, the entity or manager will be required to report on the adverse impacts of investment decisions on sustainability factors such as climate change and human rights.
Until now, sustainability considerations in investment decisions were often limited to their potential to cause financial loss. This was referred to as financial materiality. Now under SFDR, managers need to account for the impact their investment decisions have on the planet and society, or to explain why these considerations have not been made and when they expect to start.
The regulatory technical standards (RTS) which are expected to apply from 2022, will provide further guidance on the metrics to be disclosed and enable much-needed standardisation of sustainability data. Above all, SFDR will increase transparency and allow better assessment of financial services providers so investors can make informed investment choices.
SFDR is part of a much larger framework – the EU’s action plan on financing sustainable growth. In 2016, the European Commission established the EU High-Level Expert Group (HLEG) on Sustainable Finance, a mix of industry experts, civil society, and academia. Their mandate was to report on the scale of the challenges and opportunities around sustainable finance while identifying steps to protect the stability of the financial system from risks related to the environment.
For years, it had become increasingly apparent that environmental, social and governance (ESG) issues not only have a material impact on a company’s financial performance, but also on the stability of the wider financial system.
Despite this, sustainability considerations are still not taken seriously enough in financial markets. The HLEG found that too much short-term thinking and externalities as a cause of market failure, were behind this damaging trend.
Short-termism and Externalities
Our brains are wired to focus on the here and now. Technology and informational factors fuel this behaviour and heighten our fixation with short-term performance. This, however, puts our human development at odds with the natural environment. Our short-term thinking is the reason for our failure to protect the environment, despite nature providing us with the essentials we need for life, including clear air, water, and food.
Similarly in markets, short-term performance comes at the expense of long-term goals. The vast majority of investors don’t hold their equity positions for long periods, a trend that has only exacerbated over time. The average holding period of a stock in the US has dropped from 7 years in the 1940s to around 7 months today. There is also a focus on short-term performance when we evaluate companies, generally on a quarterly basis. This results in businesses emphasising short-term profitability at the expense of competitiveness and an inability to invest for the long-term. Short-term thinking does not address sustainability issues, it has quite the opposite effect.
Externalities as a cause of market failure refer to the hidden costs to society and the planet associated with unsustainable business practices. These costs are not yet reflected on companies’ profit and loss (P&L) statements. Climate change is an externality which is exacerbated by a market that continues to allocate capital to activities that greatly contribute to carbon emissions far above the safe levels, leading to potentially irreversible damage to the natural world and to society. These externalities are not yet priced into markets. Governments will need to create the pricing mechanisms to ensure that companies pay the cost of their externalities. One such mechanism would be to set a carbon price that truly reflects the cost of climate change to society. However, such a policy change could lead to market instability by triggering a sudden fall in asset prices (such as stranded fossil fuel assets for example) and cause disruption in financial services.
Regulations are Made to Protect Us
Avoiding the above scenario is at the heart of SFDR: It asks financial service providers and investors alike to ensure they understand the risks of sustainability and how they can affect the value of their investments. Risks such as climate change and biodiversity loss are too great and systemic in nature and policy changes to reflect this are unavoidable. Investors and financial market participants must begin to position themselves to take advantage of forthcoming policy measures on sustainability. At a more personal level, regulation on sustainable finance is helping develop a shared narrative of values, one in which to prioritise our choices and rethink what matters to us.
Carolina Angarita-Cala is Sustainability & Responsible Investing Manager at Cantor Fitzgerald Ireland.
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