“I am superior, sir, in many ways. But I would gladly give it up to be human.” -Data
It’s an observation made by the fictional lieutenant commander in the 1987 pilot episode of Star Trek – The Next Generation. But Data’s moment of reflection could also illustrate the thinking of E.U. authorities faced with global climate change. As they push through a regulatory disclosure agenda for financial firms, despite significant gaps in ESG data, their implicit logic is that protecting the public must be the first and most urgent priority.
Hence the first ESG disclosures for financial entities that must adhere to the technical standards of SFDR and the Taxonomy Regulation will be required beginning on 1 January 2023 – which is before much of the data they need will become available. (For example, the reporting framework for corporates under the CSRD won’t require companies to report their relevant ESG data until 1 January 2024 at the earliest.)
ESMA Executive Director Natasha Cazenave voiced the need for a human approach to this data challenge recently in a podcast with Eurosif (an industry partnership of sustainable investment stakeholders):
“We have this issue of lacking data for the moment. . .. So we want to make sure that in that phase, everybody is responsible because, at the end of the day, we want to make sure that we maintain trust in the system.”
In practical terms, E.U. regulation on occasion provides some instruction relating to missing ESG data:
- For a financial entity’s website disclosure of principal adverse impacts on sustainability, under SFDR, the regulatory technical standards (RTS)[i] require searching for missing sustainability data on a “best efforts” basis:
“Where information relating to any of the indicators used is not readily available, financial market participants shall include . . . details of the best efforts used to obtain the information either directly from investee companies, or by carrying out additional research, cooperating with third-party data providers or external experts or making reasonable assumptions.”
- For disclosure of a financial product’s investments in environmentally sustainable activities, in pre-contractual and periodic statements under SFDR and the Taxonomy Regulation, a relevant ESMA Q&A[ii] states that a failure to find the data needed requires indicating that no such sustainable investments were made.
But the lack of underlying ESG data is fairly widespread and, even when available, problems with its reliability, clarity, and comparability have plagued firms’ compliance efforts. With the date of 1 January 2023 approaching, for ESG disclosure compliance under the RTS, data expert Chantal Mantovani has worked with firms scrambling to overcome these challenges, both from a compliance standpoint and as part of their investment strategies. As Product Manager (RegTech and ESG Analytics) at Confluence, Mantovani hears these three problems mentioned most often regarding sustainability data:
- Inconsistency is often necessitated by reliance on different ESG data vendors.
- Ambiguity and the consequent need to make sense of that data for investors.
- Costs associated with procurement of the data.
While firms must contend with these issues, for the time being, the situation should gradually improve as the data vendor market consolidates, ESG regulatory disclosures produce more reported data, and firms become more accustomed to sustainability compliance. Meanwhile, the most important factors for success for investment firms employing ESG data are described by Mantovani as follows:
“The use of advanced technologies to seamlessly integrate ESG data and process into a broader company workflow can produce critical efficiencies. This approach entails end-to-end, and if possible front-to-back office, ESG processes to allow consistency in building, monitoring, and reporting.”
It is by now acknowledged – including by regulators such as ESMA as cited above -- that achieving perfect and comprehensive ESG data sets is currently impossible. Investment managers are finding themselves needing the requisite regulatory knowledge and access to multiple data sources that will help them get over the line in these still-early days of sustainability compliance.
While many firms have faced this challenge and have invested in systems and automation to streamline their efforts, other firms have yet to take those steps. The latter group will face pressure as 1 January 2023 approaches, and they will devote resources to gathering and reporting their ESG information manually. But from a longer-term point of view, it’s not too late for them. Regulators (and even some investors) will perhaps be in a more forgiving mood as these first sets of ESG technical disclosures come due. Looking back five years from now, any firm that chose to invest in ESG data analysis and reporting at this moment will still view that decision as a wise one.
The Regulatory Horizon
ESMA Executive Director Cazenave’s recognition of ESG data challenges, quoted earlier, is supported by ongoing regulatory efforts. This includes the proposed improvement of ESG reporting standards. The ISSB (International Sustainability Standards Board), an institution launched by the IFRS foundation at the U.N.’s 26th Climate Conference in Glasgow in November 2021, undertook a consultation on standards for corporate sustainability reporting that closed its comment period in July 2022. ESMA saw fit to contribute comments, wherein it suggested that the ISSB work closely with the GRI reporting standards as well as with EFRAG (the European Financial Reporting Advisory Group) in formulating its standards. Currently, the ISSB is analyzing the voluminous comments it received, responses to its surveys, and feedback from its extensive market engagement activities.
For its part, EFRAG, which provides the European Commission with draft European Sustainability Reporting Standards (ESRS), launched its consultation for corporate reporting under the E.U.’s new Corporate Sustainability Reporting Directive. After considering public comments, which were due on 8 August 2022 (and included a contribution by ESMA as well), EFRAG is expected in November to submit its first set of draft ESRS to the European Commission, which will consider them for adoption by way of delegated acts.
With sustainability reporting standards on a path to coalesce somewhat, regulators also have another target: ESG data and rating providers. In early 2022, the European Commission and ESMA sought stakeholder feedback on the regulation of that industry. By June, ESMA was able to present to the Commission the results of its call for evidence on the matter. ESMA concluded that insufficient data, particularly about SMEs and non-listed companies, fundamentally impacts the usability and relevance of ESG ratings. ESMA also noted:
- The low transparency of rating methodologies and data sources
- A lack of comparable and standardized data
- Misalignment on the definition of “ESG”
- Delays in updating or correcting underlying ESG data
- Ratings methodologies biased toward larger, listed, and U.S.-based companies
Suggesting possible future regulatory action, ESMA stated that the input it received may prove “useful for a possible assessment around the need for introducing regulatory safeguards for ESG rating products.”
By this time, the Commission was undertaking its separate consultation and call for evidence on the use of ESG ratings to assess that industry as well as the costs and appropriate type of "intervention at E.U. level" that may be needed. By August, it could issue its summary report, which cited the overwhelming majority of respondents acknowledging problems in the ESG rating provider industry, as well as favoring regulatory intervention. The Commission’s report also addressed the regulation of credit rating agencies to the extent they consider ESG factors. Here, support for regulation was more muted, with most respondents favoring a non-legislative approach (in the form of guidelines or supervisory actions), and half of the respondents considered that current practices are satisfactory.[iii] From these efforts, the Commission expects to adopt an initiative on ESG ratings in the first quarter of 2023.
Realistically, E.U. regulatory efforts addressing ESG data (or indeed such efforts anywhere else) face a substantial road ahead before they become effective. In other words, investment managers will probably encounter a multi-year period in which some disparate, incomplete, and unreliable data will continue to exist in the marketplace. Their current priorities, therefore, must acknowledge and reflect this reality. Or, as Mantovani put it, “The path should be toward robust but flexible ESG data management and reporting.”
[i] RTS (6 April 2022), Article 7(2).
[ii] Questions related to Regulation (EU) 2019/2088 on SFDR, Sec. B, pp. 10-11.
[iii] Credit ratings agencies are currently subject to disclosure requirements under the CRA Regulation. Relevant guidelines, which include advice on transparency of any ESG factors driving credit ratings, were published in 2019 by ESMA (an institution which in fact was created, in 2011, for the original purpose of regulating credit rating agencies).
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