What does ESG in the EU mean for Emerging Markets?

There is undoubtedly significant market noise and commentary on these initiatives but, despite their obvious significance to many EU-based entities, their relevance to non-EU-based entities is not always so clear.

In this article, we take a brief look at a few of the key EU initiatives and developments in this space and what they might mean for those focused on, and operating in, the emerging markets.

Sustainable Finance Disclosure Regulation ("SFDR")

The SFDR – currently, the most advanced component of the SFAP – imposes sustainability-related disclosure requirements on financial market participants and financial advisers. Broadly speaking, it affects entities offering and advising on fund products in the EU.

In-scope entities may be required to disclose, amongst other things, how they integrate sustainability risks within their investment services and how they assess the principal adverse sustainability impacts of their investment activities. There are also requirements to disclose detailed data about the design of their products, alignment with the EU Taxonomy (see below for further details) and the sustainability credentials of the assets and investments that underpin their product offerings.

Whilst many entities in the emerging markets are not directly caught by the SFDR, they may still be impacted by it. The SFDR is representative of a shift in the investment industry in the EU towards greater transparency of the sustainability credentials of financial products. Non-EU based entities may, therefore, find themselves subject to additional ESG and sustainability scrutiny and related information requests from entities subject to the SFDR in order to allow them fulfil their regulatory obligations.

Taxonomy Regulation (EU) 2020/852 ("EU Taxonomy")

The EU Taxonomy establishes a detailed framework for determining whether economic activities are “environmentally sustainable”, helping investors to assess whether their investments meet standardised and robust environmental standards. The EU Taxonomy will have broad application in the EU. It is not only an important component of the SFDR, but will also apply in a range of other contexts, including corporate disclosure via the EU Non-Financial Reporting Directive (“NFRD”), the proposed Corporate Sustainability Reporting Directive (“CSRD”), and the proposed EU Green Bond Standard.

As with the SFDR, we expect emerging markets entities that are not subject directly to the EU Taxonomy to nevertheless receive additional information requests from in-scope counterparties about their sustainability credentials. The aim of the SFDR, NFRD and the CSRD is to create a disclosure chain that allows end investors to obtain robust sustainability data and allocate resources and investment accordingly. It remains to be seen whether the data produced by these initiatives does indeed fulfil the EU’s primary objective of “reorienting capital flows towards sustainable investment” but the regulatory push in that direction is clear.

Green Asset Ratio ("GAR")

Under the Disclosures Delegated Act, in-scope EU banks will be required to report their GAR, i.e. the proportion of assets invested in EU Taxonomy-aligned economic activities.

The basic intention of the GAR is for it to be used to publicly monitor the alignment of banks’ portfolios with EU sustainability goals. It is therefore likely to become an increasingly important part of the integration of ESG and sustainability considerations into EU lenders' credit decisions and therefore relevant to all borrowers, including to those in non-EU emerging markets.

ESG ratings

Investors in Europe are increasingly looking to ESG ratings to help inform their investment strategies. Despite this increased attention, the market structure for ESG rating agencies is fragmented, and the agencies’ operations remain largely unregulated. The recently published outcome of the EU’s Call for Evidence on the functioning of ESG ratings (available here) highlighted a range of shortcomings in the sector and further regulation seems likely.

Whilst, clearly only one factor in the range of investment and lending considerations, there is, however, potential for a low rating from an ESG rating agency to have a drag effect on investment decisions and the availability of funding. It remains to be seen how future regulation affects the development of ESG ratings, however, their increased prominence is undoubted.

The financial landscape in the EU (and beyond) is undergoing significant change at the moment and ESG and sustainability considerations are increasingly important.

Even where emerging market entities are not directly subject to these new rules, it seems likely they will be affected. If you would like to discuss in more detail, please do get in touch.