Sustainable investment: when transparency becomes opaque

A world of paradoxes

Directing capital flows towards more virtuous companies to meet environmental and social challenges is essential and is part of the European Commission's regulatory initiatives via the green deal.

While some companies are directly involved in the climate transition or the preservation of biodiversity through their activity, this is not the case for all of them. Some do not respond directly but have initiated a transition via their production methods or a reorientation of their product or service offering. Others, on the other hand, still seem unconvinced by the climate emergency and believe that financial performance does not go hand in hand with sustainability.

Nevertheless, it is necessary to accompany all these actors towards sustainability and it is partly for this reason that sustainable finance regulations exist. It encourages good practices and forces the most reluctant to become more responsible.

The other key role of regulation is to avoid greenwashing and to this end, it wishes to control the use of terms that are too easily used, such as ESG, sustainability, responsible.

If we start from these observations, we should be on the sustainable finance highway and see increasingly ambitious practices marching alongside us. The reality is a little more mixed.

Because today, if you are sustainable, you have to prove it. And that's where the problem lies:

1. Creating a so-called "sustainable" fund requires more transparency, particularly through reporting, which is becoming increasingly numerous and complex. As we said, this logic starts with a good intention: to avoid greenwashing. However, even some committed players are not able to explain their strategy and fit into the boxes of the SFDR regulation (this is the European Union regulation concerning the information to be provided on sustainability in the financial services sector)
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2. The regulations, however demanding, are not always simple to understand and many grey areas remain. Investors interpret the definitions and the regulations struggle to create a true standard.
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We therefore find ourselves with financial actors who either do not wish to comply with all the requirements of sustainable investment, or who do not understand what is required of them by the regulations and are afraid to put themselves at risk.

For many, the easiest solution is not to strengthen their ESG commitments.

This is what a recent Morningstar study shows us: 307 Article 9 funds have been downgraded to Article 8!

Let us recall that today an investment qualified as sustainable in the sense of SFDR is an investment in Article 9, whose pocket is made up of 100% of companies that have already made an environmental and/or social transition. This notion of sustainability seems to exclude companies currently in transition.

A definition that does not seem to suit everyone, as many investors wish to include companies in transition in this definition and are even encouraged by the French regulator to do so.

But then, between what is officially said, what is encouraged and what is done in practice... how to find your way?

A road full of pitfalls

To illustrate our point, let's take the example of an investor who wants to create a green fund (in the sense of Art. 9 of the SFDR regulation), committed to an environmental theme.

Should this investor only focus his portfolio on companies whose activity is already considered low-carbon? Or can they look at companies that are less virtuous today but have ambitious commitment plans to accompany them in their transition?

Faced with what seemed to us to be a general vagueness, the WeeFin teams analyzed for several weeks 17 asset management companies (AMCs) and 3 data providers in order to understand what methodologies these companies use to define sustainable investment and its operational application.

If we start from the framework given by the SFDR regulation on sustainable investment, we can highlight 3 conditions to be met. At first sight, these conditions are quite broad and are very much inspired by the European taxonomy.

According to SFDR regulations, a sustainable investment :

1. Must contribute to an environmental and/or social objective, measured by key indicators

• 67% of the SGPs studied in our study use the Sustainable Development Goals (SDGs) framework to prove the positive contribution of companies to environmental and social issues. This figure is surprisingly high, as the SDG framework is also vague and generalized.
  
  Companies currently have no methodology to follow to prove that they contribute to an SDG.
  
  If we take the example of our investor who wants to create an Art 9 fund, he will have no methodology to rely on to ensure that the company in which he wants to invest meets an SDG.
  
  In the absence of a methodology, investors use a mix of qualitative and quantitative analyses, adding a layer of opacity, notably by relying on providers with different rating scales or by framing this SDO score by a global ESG score, specific to the entity... enough to get lost and see very different practices taking place.
  
  At WeeFin, we recommend using these SDGs with a preciseframework and defining the same KPI per SDG to judge a company's contribution to an SDG in the same way
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• 11% of the actors studied use the taxonomy framework to define a sustainable investment. While this is the path recommended by regulators, we find it imperfect because at the time of writing, the taxonomy only takes into account climate issues. What about biodiversity? What about social issues?
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• Finally, 17% of the actors studied who established the definition at the issuer level use the SBTi framework. While this approach seems to us to be a good idea, it is unfortunately not tolerated by the current definition of sustainable investment because it is precisely focused on transition and commitment plans. The financial actors do not respect to the letter the definition of the European Commission which is to choose only companies already transited.

2. Shall not prejudice any other environmental or social objective
   ‍Almostall (representing 97% of the AUM) of the actors analyzed use the primary adverse impacts (PAIs) to verify no prejudice to environmental or social objectives. However, none of the actors considered all 14 PAIs, due to a lack of available data. Therefore, other methods were sometimes used to be able to integrate them, notably through exclusions or internal scoring...
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3. Must have good governance practices
   We identified two methodologies often preferred by the actors interviewed:
   

• A consideration of controversies on the governance theme that are then integrated into "Governance" scores. To establish these scores, companies mix qualitative elements, research and supplier scores...
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• Companies will consider governance-related IAPs. For example, IAP #10 (UNGC violation) is an IAP that participates in the assessment of good governance. The problem being that this IAP is more related to Human Rights and does not really apply in the case of an investor who needs to ensure the good governance of a company he wants to invest in.
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Step by step

As we said at the beginning of this article, a rapid and clear transformation of investment practices must take place. But finance will only become more sustainable if it abandons its traditional opacity.

The regulator needs to establish clearer rules so that investors are fully aware of what is expected and no longer see regulation as an unclear constraint that puts them at risk.

In addition to the urgent need for guidelines from the regulator, it is in the management of data that the most important work remains. Greater visibility is not only needed in strategy, but also in scoring methodologies, because at the moment, it is the financial players who ultimately decide on the methodology and the level of severity used in their own definition.

Moreover, it is only with increased transparency and more refined management of ESG data that it will be possible for each player to enhance its own vision of sustainability and for the final investor to make an informed choice about his investments.

We are also convinced that the definition of sustainable investment must include actors in transition, something already desired by most market players and by the AMF.

If the most reluctant investors can be discouraged by this complexity and the most committed actors, tired of the slowness of things, let's not forget that Rome was not built in a day and that it is by being numerous to want to change the methods of investment, that we will be able to make things happen.

And of course, part of the solution for investors may lie in partnerships with fintechs. Technology can help facilitate the deployment of regulation and a tailored ESG strategy.

At WeeFin, we have created a SaaS platform that allows our clients to cross-reference numerous ESG databases from different providers, to test their quality, to define customized indicators according to their investment strategy, and to produce all the reports, including regulatory ones, that are required on ESG