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Fly to ESG: best practices for sustainable investments

Sustainable investments are no longer simply a passing trend; they are here to stay. After the sell-off of risky assets, investors in the process of rebalancing their portfolios. So now is the time that we need to realize that sustainable strategies are real opportunities for requalifying portfolios. To quote a much used – and abused - slogan during times of crisis, fly to quality, today we can rephrase that as fly to ESG. Sustainable ESG strategies, the new frontier of quality, are worthy replacements for traditional safe-haven assets (German bunds, US T-bonds, gold, etc.), and are setting the pace, as they are closely correlated to the riskiest asset classes.

A sustainability orientation improves the potential portfolio yield, and during times of uncertainty (Covid-19 being just one example), investors can view ESG factors as defensive characteristics. Since February 2021, ESG equity in Europe is outperforming regional indices by 14%, and in the Asia-Pacific by 8.9% and 9.6% respectively. In addition, choosing a sustainable fund does not penalize performance, particularly in times of widespread volatility. Further proof of this comes from a study by Morningstar published in June 2021 which analyzed around 4,900 funds and Exchange Traded Funds (ETFs) domiciled in Europe. Of these, 745 are sustainable and belong to seven of the most popular categories, such as large cap global equity, US, Eurozone and corporate bonds in euro. This study compared results at three, five and ten years, and during the Coronavirus epidemic. Moreover, from 2010 to 2020, around 65% of sustainable funds beat out their traditional counterparts (considering only those that survived the ten-year period ending in 2020).

Asset allocation is traditionally defined as diversification by asset class with varying degrees of risk. And this process will endure if we build it within the investible universe selected on the basis of major issues that revolve around people and the context in which we live (the ESG-compliant universe).

Central to this context is the taxonomy of eco-compatible economic activities, in other words, a classification of activities that can be considered sustainable in view of their alignment with the environmental targets set by the EU, and with respect to certain provisions regarding social issues introduced in EU Regulation 2020/852 of the European regulatory framework. This taxonomy provides a guideline for companies in evaluating their activities; establishing corporate policies with an eye to greater environmental sustainability; and producing more complete, comparable reports for stakeholders. In addition, this classification enables investors to factor sustainability into their investment practices and comprehend the environmental impact of the economic activities they invest in today or may invest in tomorrow. Finally, public institutions can utilize this taxonomy to establish or enhance their policies for ecological transition.

To understand the potential impact of the European regulations in terms of market growth in the sustainable finance sector, we need to conduct an integrated analysis of the requirements, objectives, and timelines for applying the principal regulatory provisions that have already been introduced and/or are being implemented. In fact, the key to effectiveness is the coordination and harmonization of regulations put forward by the EU Commission (Corporate Sustainability Reporting Directive (CSRD), Taxonomy Regulation (TR) and Regulation 2019/2088 (SFDR)).

These three measures are summarized below.

The CSRD, published in April 2021, aims to revise the application perimeters for the Non-Financial Reporting Directive (NFRD) to comprise all companies headquartered in Europe with more than 250 employees (the current NFRD sets this threshold at 500 employees) and all the SMEs listed on European markets (excluding micro-enterprises). In addition, common reporting standards will apply, as developed by the European Financial Reporting Advisory Group (EFRAG), which will also set standards specifically designed for SMEs.

According to the TR (Regulation 2020/852 on the taxonomy of eco-compatible economic activities), companies subject to the NFRD and subsequently the CSRD must report on how their activities align with the taxonomy. Specifically, non-financial companies are required to publish information on: the share of turnover from products or services associated with economic activities aligned with the taxonomy, and the proportion of capital expenditure (capex) and operating expenditure (opex) relative to activities or processes associated with economic activities aligned with the taxonomy. Financial companies, instead, must publish indicators that reflect the percentage of alignment with the taxonomy of the assets under management. These reporting requirements will be gradually phased in from 2022 to 2024.

The SFDR calls for information transparency on sustainable finance and obliges financial consultants to inform investors as to how they assess environmental, social and governance-related risks and impacts at a subject and product level. The regulation sets down specific disclosure requirements for products that promote environmental and social concerns and those with sustainable investment objectives.

The overarching aim of the CSRD, TR and SFDR is to elevate market transparency. Each of these three regulations serves to produce data and information that meet the transparency requirements of the others. What takes on critical importance within this framework is greater effectiveness and information access with regard to sustainable products. This will guarantee clarity and coordination among various EU regulations on one hand, and on the other the dissemination of best practices among all operators in the finance industry.

Clearer and more effective disclosures on ESG issues reduces information asymmetry and has a negative correlation with cost of debt for the companies in question. Consequently, investors in financial debt are inclined to accept lower remuneration on interest rates from companies that show greater transparency and in turn lower information asymmetry.