CySEC Investor Guide to Sustainable Investing

What is Sustainable Investing and why it is important

Introduction

Sustainable Investing has seen a significant expansion in recent years, particularly post-pandemic where environmental, social and governance (ESG) factors are increasingly driving investing decisions. This is a key area for financial regulators and new rules are being introduced to direct capital towards sustainable investments, while increasing transparency and combating greenwashing.

What is Sustainable Investing?

Sustainable Investing and ESG investing both refer to investments that prioritize environmental, social and governance, where investing is made with consideration of the environment and human wellbeing, as well as the economy. These 3 factors are used to measure the sustainability and ethical impact of an investment. It’s also known as “socially responsible investing”, “impact investing”. Socially responsible investors will check companies against ESG criteria to screen investments. Sustainable investing is based on a broader principle that encompasses responsible and ethical business practices in a holistic way.

How do we know if a product is really environmentally friendly?

Greenwashing occurs when organisations make broad claims about sustainability without evidence or overstate the positive environmental effects, deceiving customers into believing that an investment has a greater environmental impact than it actually has.

Regulation aimed at combatting greenwashing has been ramped up and will remain a key feature in 2023. For Europe, more detailed disclosures from firms will be required and ESMA’s ruling on the use of ESG related terms in fund names is also to be finalised.

Examples of ESG Investing

Clean Energy

Includes companies with involvement in the generation of renewable energy or supporting products/services.

Energy Efficiency

Includes companies that provide products and services that significantly improve energy efficiency of industrial processes, consumer products, or buildings.

Water

Includes companies whose products and services provide access to water, increase water efficiency and/or contribute to the sustainable management of water resources.

Health & Wellbeing

Includes companies that manufacture medicines, equipment and/or technologies that address major or neglected diseases, enhance health and wellness, and improve life expectancy.

Sustainable Agriculture & Food

Includes companies involved in sustainable food systems across the value chain, including agri-tech, sustainable food retail, packaging, alternative proteins.

Sustainable Forestry

Includes companies that provide forestry and wood products in a sustainable manner, or those involved in the use of sustainable forest products (sustainable paper packaging, building materials).

Sustainable Transportation

Includes companies that provide sustainable transportation products/services, including vehicles, technologies and equipment, and infrastructure.

Circular Economy & Resource Efficiency

Includes companies that have products and services that support a circular economy, including increasing the efficiency of resource use or enabling recycling and resource recovery.

Sustainable Real Estate

Includes companies involved in the development or management of sustainable buildings. This may include building energy efficiency, the use of sustainable or recycled building material, the use of renewable energy sources, as well as the adoption of bioclimatic design aiming at reducing the environmental footprint of real estate.

How do ESG investments compare to non-ESG investments

The rationale for investing in companies and products that make a strong ESG impact is that if capital is deployed in companies which represent positive trends for the benefit of mankind and engage in ethical and sustainable business practices, more companies will adopt these policies. Over time, the lower cost of capital will enhance their investment returns, whilst growing demand for their products and services and driving good labour practices. Hence, ESG investment is seen to achieve relatively strong investment performance.

Any other investment that does not rely on ESG principles may be considered a non-ESG investment. Non-ESG investments do not usually take into account the aspects of sustainability and social responsibility during the investment decision process. Such investments can be labelled as more traditional and possibly ignore their impact on the environment, society, and governance.

The bulk of sustainable investment fund worldwide are concentrated in funds domiciled in Europe, which is estimated to account for three-quarters of all such funds and represents almost a fifth of all European assets under management. In other markets, sustainable funds represent a lowly 2-3% of total invested assets under management.

Although stocks which represent the key constituents of ESG funds underperformed sharply in 2021 and early 2022, the crisis in Ukraine has seen sentiment start to improve towards ESG funds, and these have been boosted further by new government policies on energy security and the energy transition trends for clean energy and energy efficiency products. Prior to this, managed sustainable funds outperformed traditional funds both relatively and in absolute terms in both 2019 and 2020, and this has helped to drive the popularity of sustainable funds.

Over the longer term, the return on sustainable funds as an asset class has marginally exceeded traditional funds on most longer-term 5-year performance measures, although this gap significantly narrowed in the past year.

What’s the difference between ESG investing and SRI investing?

Socially responsible investing (SRI) is a type of investing that screens investments to pick and exclude companies based on certain criteria. Profits still matter for SRI investors, but they must balance financial returns against their beliefs and principles. Investors will eliminate companies going against certain good values and focus on those that make a positive impact on society. Most investors would exclude companies involved in gambling, tobacco, weapons, and alcohol for example.

What are the key themes that ESG fund managers look to when building their portfolios of funds?

• Climate Change & the transition To Net Zero

This is the most readily identifiable trend behind ESG investing, where there is a growing focus on judging the credibility of a company’s climate commitments, evidence of credible targets based on science, against which managements have provided verifiable action plans to achieve their ESG targets.

Favourable tax treatments and legislation are encouraging strategies to reduce carbon, such as using photovoltaic solar and wind energy and these have become more cost competitive as a result of scaling of production, as well as maturing technology. There is also an increasing focus around the hydrogen economy.

• Biodiversity and Natural Capital

Attention to biodiversity in investments has risen following moves to improve transparency around nature related impacts, risks and opportunities, the adoption of the Global Biodiversity Framework and the launch of the Nature Action 100. This has resulted in the creation of thematic funds focused exclusively on targeting the theme of biodiversity and ecosystem restoration.

• Human Capital & Labour

Investor attention on social issues started to rise during the Covid pandemic, while the subsequent high inflationary environment has highlighted labour practices and personnel management. There is a rising trend for companies to publish employee turnover data and the results of internal employee engagement surveys, which is increasing public scrutiny and accountability in this area.

• Human Rights & supply chain Due Diligence

An increase in regulation around corporates’ obligations and transparency related to environmental and human rights risks and the condemnation of forced labour is universal. In Europe, the EU Corporate Sustainability Due Diligence Directive has set out obligations for companies to identify potential environmental and human rights impacts which may lurk in supply chains. The sectors most affected in this way are Consumer and Technology.

• Board Effectiveness & Director Accountability for ESG

Company AGMs and more specifically the election of directors are increasingly being targeted as a proxy for views on corporate ESG governance practices and can be seen in the reduction in support for director nominees in recent years. There has also been an increase in proxy solicitations targeting governance committee chairs, where they have failed to provide explicit disclosures concerning the board’s role in overseeing ESG issues.

• Executive Compensation

Historically remuneration committee proposals on director pay have received majority support, although this too has witnessed changes since the pandemic. Consultation with institutional investors on the inclusion of ESG metrics in executive compensation are increasing in Europe notably with respect to the inclusion of material ESG considerations in long term incentive schemes.

Relevant regulations in Europe in relation to the evolution of corporate reporting of ESG

The EU’s Sustainable Finance Disclosure Regulation (SFDR), implemented in March 2021, sought to direct capital towards sustainable investments, while increasing transparency and combating greenwashing. The requirement was for funds to label themselves as Article 8 (those that promote environmental or social characteristics and follow good governance practices) and Article 9 (those with explicit sustainability objectives). Double materiality is enshrined in the regulation, as fund managers are required to disclose how they integrate sustainability risks into their investment process and how they consider principal adverse impacts of investment decisions on sustainability factors. The MiFID II suitability requirement was enacted in late 2022 requiring all active fund managers to incorporate client preferences on sustainability into suitability assessments.

The European Securities and Markets Authority (ESMA) has proposed new rules on using ESG or related terms in the names of investment funds. Under this proposal any fund that has any ESG or related term in its name, must have at least 80% of its investments supporting ESG characteristics, with an additional threshold (50%) if the fund is using sustainability, meaning that at least half of the 80% threshold should be in sustainable assets under SFDR.

CySEC’s commitment to ESG standards

Sustainable finance is a key consideration in CySEC’s policy making and strategic planning.

CySEC gives priority to developing and supervising sustainable finance standards for all financial services organizations.

In this context, CySEC informed all supervised entities that they must ensure full compliance with the SFDR disclosure obligations and their ESG responsibilities.

Furthermore, CySEC created a dedicated section on its website in order to provide information on Sustainable Finance to the investors and the public.

What is more, CySEC participates in World Investor Week (WIW), held annually by the International Organisation of Securities Commissions (IOSCO) aiming to educate and inform investors and the public. Each year, via numerous online and physical-presence activities, CySEC spreads the global campaign’s key messages that address crucial topics, including among other, sustainable finance.