By Erin Weaver

Whilst ESG investing is running rampant globally, regulations have been slower to catch up - but catch up they will. In order to see what these might look like in Australia soon; we can look to Europe now.

Europe’s regulatory influence on Australia

Australia has historically followed Europe and the UK in adopting financial regulations.

Recent examples include:

The DDO (Design and Distribution Obligations) followed on from “treat your customer fairly” in the UK, which followed on from MIFID in Europe.
CDR (Consumer Data Right) followed on from similar legislation in the UK/Europe.
Future ESG regulations in Australia will likely look a lot like Europe’s SFDR.

SFDR – Sustainable Finance Disclosure Regulation

The European Union’s Sustainable Finance Disclosure Regulation (SFDR) was enacted March 2021 and provides comprehensive and standardised disclosure and reporting guidelines on the sustainability of investment funds, covering a wide range of ESG criteria, both at the product and company level.

It should come as no surprise that Europe has been the first global economy to enact widespread regulation around ESG. Already at the forefront of global social change, Europe also hosts the world’s top sustainable markets.

The SFDR is a fundamental pillar of the EU Sustainable Finance agenda and is the first set of regulations towards this plan.

In the creation of SDFR, the underlying theme was “we need to intervene and innovate if we are to create sustainable businesses of the future”. In introducing these regulations, SFDR aims to link finance and sustainability by re-directing investment capital towards more sustainable products and businesses.

Key points of the legislation include:

Improving transparency around sustainable investment products to provide ease of choice and comparison for investors interested in sustainable investing
Provide standards for reporting and disclosure on sustainable practices
With the introduction of the former two, the prevention of greenwashing and any potential litigation arising from this
Accountability is broad in its reach, covering both businesses and financial advisors

I found this article by JP Morgan particularly helpful in understanding SFDR in more detail:

SFDR explained | J.P. Morgan Asset Management | J.P. Morgan Asset Management (jpmorgan.com)

Australia’s “intention vs action” on ESG

ESG investing has seen a meteoric rise in Australia in the past few years. Increasingly, investors are demanding investment funds more closely mirror their own values. With so many Australians affected by the very real effects of climate change in the form of floods, droughts and bushfires, the collective social conscience is becoming increasingly aligned to core ESG values.

Intention

Australian companies are starting to respond to this call to action from shareholders, with many now including ESG metrics into corporate incentive plans.

Corporate governance researchers, Guerdon Associates, released a report in 2021, focusing on how companies across all the major global markets are incorporating ESG metrics into executive plans. The report found that Australia led the world in how these metrics are incorporated, with 81% of ASX 100 companies including ESG metrics in their CEO’s remuneration.

Australia also leads the world in how ESG metrics are weighted in incentive plans, at 30%, whilst the global average is at 20%.

Source: GECN-Guerdon-2021-Global-ESG-Plus-Rpt-Final-Web.pdf (guerdonassociates.com)

Action

However, the “intention to action gap” on ESG accountability across Australian companies is significant. A report released by Refinitiv in 2020 found that many Australian companies were setting environmental policies without delivering on targets.

“The number of companies with emissions policies in Australia have jumped from just over a third (31%) in 2014 to almost half (46%) in 2018. However, the number of companies with specific reduction target emissions has remained relatively stable with only a 7% increase (12% in 2014 to 19% in 2018).”

PWC backed up these Refinitiv findings in a 2020 report that analysed the ASX 200 on ESG reporting.

42% of the ASX 200 did not warrant inclusion in the review due to insufficient reporting
While more than 80% of the 115 that were reviewed provided their ESG strategy, most companies didn’t explain how ESG strategies are worked into core corporate decisions or present set short, mid or long-term goals

In summary, PWC found that:

ESG reporting falls short of the standard for financial reporting, and therefore below stakeholder expectations
Companies need to reshape how they think about and report on their corporate strategy
Lack of clear targets and accountability limits trust
Integrity of ESG reporting needs to be upheld

As the report explains, as investors demand more and more clearly-defined metrics on ESG performance, companies run the risk of being seen as “ESG-optional” by not including an ESG strategy into their core business plans.

Response to greenwashing and climate-related litigation

Another statistic of note is that Australia led the world in climate change-related litigation per capita, in 2021. Only the US had more total litigation cases. Not coincidentally, neither country has federal regulations around ESG investing, at present.

Unsurprisingly, accountability around ESG and sustainability claims has become a key area of focus for Australian regulatory bodies in recent years.

ASIC’s corporate plan for 2021-2025 states that greenwashing of financial products and disclosure around climate risk and governance practices continues to be a focal point
APRA developed CPG 229 Climate Change Financial Risks in response to requests from industry for greater clarity around regulations and expectations and serves as a guide for APRA-regulated entities to better manage climate-related risks and opportunities
The ACCC will continue to target sustainability and environmental claims in its effort to prevent greenwashing

The future, we think…

With no overarching regulations in place yet in Australia, companies are very much operating on the recommendations and guidelines of the various regulatory agencies, which may not be enough for much longer. Companies run the risk of losing the support and confidence of their shareholders or fall victim to increasing fines and litigation costs with no clear regulatory framework to reference.

Whilst we can certainly speculate on the future of ESG in Australia, we tend to agree with Nathan Lim, Head of Wealth Management Research at Morgan Stanley:

“Europe leads the world on responsible investment, there are a lot of offerings and sophistication, there is a lot more depth than in Australia. If you want to see what Australia will look like in 10 years, then look to Europe.”

Our thinking

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What Europe can reveal about the future of ESG regulations