Democratic sweep could transform ESG regulation in the US
The gap between how the US and Europe regulate sustainable investing is considerable. Even as Europe introduces new rules to prevent ‘greenwashing’, US laws have placed limits on pension funds’ sustainable investments.However, new political leadership could prompt a reversal of US regulatory policy, creating an extra incentive for US investors and companies to integrate sustainability into their business models.
Europe has a greater proportion of companies considered ‘sustainable leaders’ than the US, according to Fidelity International’s proprietary sustainability ratings. The reasons for this are complex and interconnected. They include culture, market structure, and the legal and regulatory backdrop. For some years now, the European Union (EU) has forged ahead with regulations to promote sustainable behaviour by investee companies and, by turn, sustainable investing. By contrast, the Trump administration has tried to limit it.
Europe’s emphasis on environmental, social and governance (ESG) factors has made it the global epicentre of sustainable investment (see Chart 2). But a change of direction in the US under the new Biden administration could open up the floodgates to sustainable investment across the world’s largest economy.
Changing the regulatory mindset
Current US regulation assumes that improving the sustainable characteristics of a company or portfolio means sacrificing risk-adjusted returns. An example is the Department of Labor’s new ‘Financial Factors in Selecting Plan Investments’ rule. Effective from 12 January 2021, it prevents funds with a sustainability mandate from being a default option for defined benefit retirement plans. This prohibition extends to any fund that excludes certain sectors or includes ‘non-pecuniary’ factors in its decision-making process.
In fact, non-financial ESG considerations have increasingly been shown to improve long-term financial performance. In addition, Fidelity research shows companies with high ESG ratings outperformed laggards in 2020, both during the Covid-19 crash and when markets began to recover. The new administration has an opportunity to align US rules with a growing body of evidence that challenges the current mindset of US legislators and regulators.
Standardising disclosure and avoiding greenwashing
At present, US companies need only report what management considers to be financially material ESG factors. This means disclosures can vary significantly, even between companies in similar industries. Some US investors had been hoping that the Securities and Exchange Commission (SEC) would standardise US companies’ ESG disclosures in a recent update to regulation S-K, which establishes reporting requirements for SEC filings. Instead, the SEC reasserted the status quo.
In contrast, across the Atlantic, regulators are acting. The EU plans to introduce Sustainable Finance Disclosure Regulation (SFDR) that requires asset managers to make specific, detailed disclosures of how they integrate ESG factors into investment decisions, both at firm and fund level, including any ‘adverse impacts’ this may cause. This is a challenging piece of regulation for asset managers to incorporate. But it will improve the comparability of funds across the market and reduce the risk of ‘greenwashing’ (labelling something as sustainable when it isn’t). It should also boost demand for funds with higher standards of ESG integration and incentivise laggards to improve.
Other sustainability initiatives are gaining momentum in Europe. The UK government announced in November that companies, pension funds and asset managers will have to publish reports in line with the Task Force on Climate-related Financial Disclosures by 2025. It also said it would issue its first green sovereign bond in 2021, alongside a green taxonomy. This follows the European Central Bank’s announcement last summer that it would include green bonds as part of its asset purchase scheme.
ESG revolution won’t happen overnight, but would be meaningful for investors
President-Elect Biden has an ambitious policy platform on climate, tacitly supported by the Federal Reserve which recently joined the global central banks’ Network for Greening the Financial System. ESG regulatory changes will be necessary to support this. These won’t happen overnight, though a Democrat-controlled Senate (albeit with a slim majority) increases the chances of more progressive candidates being appointed to key legislative and regulatory positions, including the chair of the SEC.
Such changes would have meaningful investment implications. There are early signs that Europe’s SFDR implementation is increasing demand for strategies that fully integrate ESG. Should a similar trend take shape in the US, it will increase the pool of capital available to more sustainable companies, creating further incentives for firms and investors to place environmental and social considerations at the heart of their decision-making.
 Source: MSCI 2017: Has ESG affected stock performance? - MSCI; ESG and financial performance: Aggregated evidence from more than 2000 empirical studies, Journal of Sustainable Finance, October 2015 (Friede, Busche and Bassen)