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Increasing Divergence of US and UK/EU ESG Regulations Will Not Deflect Progress says Fitch

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The US and the UK/EU are on different regulatory pathways regarding ESG but the long-term structural trends in favour of ESG investing will persist, says Fitch.

According to Fitch Ratings, divergence between US and EU/UK regulations regarding sustainable investing is increasing, as seen with the disparate interpretation and application of Environmental, Social and Governance (ESG) rules for pension funds.

The diverging regulatory paths are unlikely to converge in the near term given the US Department of Labor’s (DOL) historical conservative stance amid the evolution of ESG investing in the EU/UK. While these differing approaches are not expected to immediately affect ratings assigned to investment managers, pension funds and/or the institutions sponsoring such plans, Fitch anticipates they will translate into differing investment considerations, risks and potential returns over the longer term.

Shampa Bhattacharya, Director, Non-Bank Financial Institutions at Fitch Ratings, told TMI: “This divergence has a limited impact on the credit profile of most investment managers. We also do not expect market players in the EU to outperform their US peers due to this in terms of any return differentiation.” However, she added, “players on the two sides of the Atlantic are clearly differing in their investment approaches, with the DOL opting for a more classical view of investment analysis.”

Fitch expects the long-term structural trends in favour of ESG investing to persist. Funds that invest in line with ethical principles attracted $59bn of inflows globally for the first half of 2020, bringing the total of ESG assets under management to $2.2tr. globally, according to Lipper.

The shift in social and political attitudes that has fuelled demand for sustainable investing is accelerating as investors, public institutions and corporations increasingly prioritise ESG measures as part of their investment criteria. Growth has been also driven by market participants with the increased belief that ESG factors can have material impact on long-term investment returns.

The DOL proposed a rule on June 23 for private pension plans governed by the Employee Retirement Income Security Act (ERISA) stating that private employer-sponsored retirement plans are not for furthering social goals or policy objectives but rather to provide for retirement security of workers.

On August 31, the DOL proposed a further rule that would require plans to cast shareholder votes only on issues that have an economic effect on a retirement plan, implying they may not vote on ESG-related issues unless they have a measurable financial impact. Approximately$28.7tr. of assets were managed under ERISA rules at 1Q20, according to the Investment Company Institute.

Public feedback and pushback against the proposed DOL rule noted that prohibiting ESG funds from being a default investment option in pensions would limit inflows and reduce the growth potential for ESG investing. Also noted was that the rule could lead to worse outcomes for retirees, as investment managers may not otherwise fully consider ESG risks. Respondents also suggested that both the US and EU/UK rules conflate ESG integration strategies and economically targeted investments such as impact investing.

In contrast to the DOL’s approach, regulation in the EU and UK promotes the integration of sustainability and ESG concepts into financial decision making, which has become a more common and/or formalised consideration for pension fund managers. The European Commission’s proposed amendment to Markets in Financial Instruments Directive (MiFID) II rules would mandate that investment firms consider the ESG preferences of their retail clients when providing investment advice.

Fitch says that the proposed amendment to MiFID II rules could increase the cost of regulatory compliance of investment managers and expose them to additional litigation and reputational risk if investment managers fail to meet or under-deliver the clients’ expected financial and non-financial targets.

It also says the pandemic has done little to deter the expanding focus on ESG investing, as fund managers increasingly seek to invest in sustainability-conscious assets. Global ESG fund assets in 2020 have almost doubled since the end of 2015; Europe has a high share of global ESG funds (around 75%), while the US accounts for around 20%.

Fitch believes the growth of sustainability investing could be further accelerated by increased market standardisation and transparency in terms of ESG scoring methodologies, common definitions and categorisations.

Given investor demand for ESG credibility, could firms begin to take it upon themselves to go beyond regulatory expectations in the US? Bhattacharya told TMI that from a survey of the feedback received in response to the DOL proposal “it was clear than many major firms have a different or more holistic view of the role ESG factors have to play in investment analysis”.

Investor demand, as evidenced from the recent flows, are also clear, she added. “However, the DOL proposals might make it more difficult and/or process intensive to pursue ESG goals and act as a deterrent in some cases.”

Separately, regarding the SEC amendments to the disclosure rules, Bhattacharya says it is more likely investors will press on with what they deem to be appropriate disclosures on ESG factors, “as evidenced most recently by State Street’s letter to corporate boards asking for more and clear disclosure on the company’s goals on diversity and measures of the diversity of the company’s employee base and board”.

Shampa Bhattacharya, Director, Non-Bank Financial Institutions, Fitch Ratings

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