Sustainable Finance in Practice for Fund Managers - Remarks by Patricia Dunne, Director of Securities and Markets Supervision

Thank you to William Fry for the opportunity to speak to you today on such an important topic.

The challenge climate change represents has become even clearer over the last number of months.  We have seen significant climate events take place all over the world at an ever-increasing pace.  From the forest fires in Hawaii, Canada and Greece, unbearable heatwaves across Asia and Europe, powerful ice storms and hurricanes hitting the United States, extreme climate events are increasingly common. 

Closer to home the impacts of climate change are also being felt, though for now, we are fortunate that these are not as consequential as in other parts of the world.  In July last year, we saw the highest temperature recorded in Ireland since 1887.^[1]  This year, following on from the warmest June on record for Ireland, the month of July looks likely to be the wettest ever recorded.^[2]  The volatile nature of changing weather conditions is increasingly evident in our day-to-day lives.  

This should perhaps be unsurprising.  Eight years ago, in Paris, at the COP21 Leaders Summit UN Secretary-General Ban Ki-moon opened the event by stating that:

"Paris must mark a turning point.  We need the world to know that we are headed to a low-emissions, climate-resilient future, and that there is no going back."

His remarks went on to outline the importance of limiting the global temperature rise to below 2 degrees Celsius while recognising that “the world’s Small Island Developing States have even less room to manoeuvre, and are desperately asking the world to keep temperature rise to 1.5 degrees.”

As Christine Lagarde, President of the European Central Bank, outlined recently in a speech - the window of opportunity to achieve this goal is closing before our eyes. The past eight years have been the warmest on record worldwide and the critical 1.5 degrees Celsius threshold for annual temperatures will likely be exceeded in at least one year before 2027.^[3]

We are now three years into a critically important decade.   A decade where we need to cut global emissions by over 40%, if we hope to limit warming to 1.5 degrees.  Last year, total global CO2 emissions climbed by approximately 0.8%.  While it is positive that global emissions remain below the high set in 2019 and have been relatively flat since 2015, stabilisation will not be enough.  Emissions need to decline rapidly.^[4]

Climate change and the transition to net zero is something which is affecting the whole of society. The financial sector has a critical role to play and, in many ways, the sector is to the fore of the risks and opportunities these changes present.^[5]

In light of this, an ambitious sustainable finance agenda has been embarked on in the European Union.  It is shaping the very nature of the regulatory landscape and changing how regulators supervise the financial sector.  It has resulted in changes to our supervisory and gatekeeping work taking account of (i) the changing risks faced by regulated firms and (ii) the changing nature of financial product disclosure. 

But increasingly regulators and policy makers must also respond to changes in the types of services and products being offered by financial firms.  These changes are driven by a number of different factors.  It could be as a result of the increased client or investor demand for products which incorporate certain ESG criteria.  It may simply be due to industry responding to legislative changes and seeking to comply with new requirements.  Or increasingly we are seeing firms seeking to be innovative in terms of designing new products or services to support the transition to a net zero, sustainable, economy.

In the remainder of my remarks, I would like to unpack the changes we are seeing and how this is influencing our work at the Central Bank.  Firstly, I will outline what the data is telling us in terms the Irish funds sector and the sustainable finance agenda.  I will then turn to the status of the European and international regulatory agenda.  Finally, I will share learnings from our supervisory and authorisation work.  

In all of this, I will be highlighting areas where I believe enhancements could and should be made.  This will of course include how firms are currently implementing certain existing requirements particularly under the EU Sustainable Finance Disclosures Regulations (SFDR).  But also areas where further regulatory or legislative change may be required to ensure the sustainable finance agenda has the desired effect. 

Irish Funds Sector

In terms of what the Irish funds landscape currently looks like, as of the 30 June:

• Article 6 funds comprised 4,690 funds with approximately €2.5 tn in assets under management (AUM);
• There were 1,664 Article 8 funds with approximately €1.2 tn in AUM; and
• Finally, there were only 159 Article 9 funds with approximately €30 bn.
  

That may be a little surprising.  After all, a large majority of the sector does not promote ESG characteristics.  However, in terms of new funds being authorised, we can see that the split between Article 6 products or Article 8 and Article 9 funds is more balanced.  Over the last 12 months, of the newly authorised funds, we have approved 131 article 6 funds, whereas there have been 134 Article 8 or Article 9 funds.^[6]

European and international regulatory agenda

Turning now to the EU and international policy, the agenda continues to evolve, and while the pace of evolution has naturally slowed, we continue to see new developments. Let me give you a brief update on what has been happening recently and what is yet to come in the near-term.

As many of you will be aware, the European Commission is the global leader in sustainable finance policy making, and from the initial Sustainable Finance Action Plan in 2018, the Renewed Strategy in 2021, and more recently, the June Package of additional proposals, we have moved from a regulatory framework essentially devoid of sustainability considerations to one that is  comprehensive and challenging. Ultimately, the development of a sustainable finance framework seeks to remove impediments to investment in a sustainable economy by supporting investment in the green economy and by providing additional transparency for investors. Having developed key pieces of legislation to help achieve this, such as the Taxonomy Regulation, the SFDR, amendments to MiFID and the banking and insurance regulations, the focus now has broadly switched to implementing and consolidating what has been developed.

The package introduced by the European Commission in June clearly captures this intention.  Firstly, the Taxonomy is now augmented by additional technical screening criteria for economic activities making a substantial contribution to one or more of the non-climate environmental objectives. Secondly, the Proposed Regulation for ESG rating providers seeks to enhance transparency for sustainable investments by providing more clarity on ESG ratings methodologies, objectives, characteristics, and data sources. It also seeks to address potential conflicts of interest, and improve the operations of ESG rating providers.  This is a particularly important development which will impact on the funds sector where some products rely extensively on ESG rating providers when determining what assets to invest in.

In the funds sector we continue to seek enhancements to the framework.  Within ESMA we have been strongly supportive of the initiative to introduce requirements on fund naming conventions which use ESG-related terms. ESMA has done significant work on this and had a public consultation earlier this year seeking stakeholders’ views on a proposal.  A fund’s name is the first insight an investor has in respect of a potential investment. Having naming rules in place will enable investors to differentiate between ESG funds and will build trust and confidence in these products supporting the transition to a carbon neutral economy.  ESMA is now assessing the feedback to determine the next steps to be taken on this matter.  In July, ESMA also launched a Common Supervisory Action (CSA) on sustainability which will assess funds’ compliance with SFDR and the Taxonomy Regulation. The Central Bank has already commenced work on this CSA and issued a questionnaire to a sample of Fund Managers in scope on 15 August. For reporting purposes to ESMA, the CSA will be split into two phases: Phase 1 (due to conclude by 31 January 2024) will specifically address greenwashing risks and Phase 2 (due to finish by 30 September 2024) will focus more generally on sustainability and disclosure risks. The Central Bank, along with other NCAs, will continue this supervisory work into 2024.

Also as many of you will be aware, with a mandate from the European Commission, the ESAs recently published their Progress Report on Greenwashing in the Financial Sector. As key contributors to this work, we have sought to define greenwashing and identify within the banking, insurance and pensions and of course capital markets sectors, how greenwashing can occur, its main drivers, and possible remediation. the ESAs are working on delivery of the final report by May 2024.

With the upcoming review of the SFDR, we can also expect further consideration of its effectiveness and success to date in meeting its objectives. From our experience in supervising the requirements, particularly in the context of the funds sector, I believe further enhancements are required in order to make the framework achieve its aims.  For now, I would urge you as stakeholders to consider, either through your representative bodies or individually, responding to that review when the occasion arises.

Beyond the EU, there is of course an international element to the development of sustainable finance. As a committed member of IOSCO, where our Deputy Governor Rowland is an elected Board member, we support the attempts to harmonise the global regulatory response to climate change. In this context, it is worth noting that the EU’s Proposed Regulation for ESG rating providers arose from IOSCO recommendations to oversee such entities. One of the most significant international developments is the work of the International Sustainability Standards Board, supported by IOSCO, whose recently approved standards set a global baseline for sustainability reporting.  We can expect further work from IOSCO in the space of greenwashing, audit and assurance standards, carbon markets, and transition plans, and we look forward to contributing to this work.

Implementation of existing requirements

As you will be aware, when approaching implementation of the SFDR and Taxonomy Regulation for investment funds the Central Bank adopted a pragmatic approach consisting of a streamlined filing process in conjunction with reviews on a sample of the submissions made.   Today I want to outline some of the most significant findings from those reviews and give you a sense of the learnings we have made in terms of SFDR implementation.  In due course, based on our experience, we will look to publish additional clarifications in terms of how funds should meet their disclosure obligations.  We do acknowledge that there are challenges with SFDR implementation and more clarity around the legislation is needed.  However, we have seen interpretations of SFDR which while there may be an argument that they comply with ‘the letter’ of the requirements, certainly do not meet the spirit of the rules.  We will hold a workshop with key stakeholders in the funds industry to discuss these findings and seek ways to address the issues identified.

Finding 1: ‘What environmental and/or social characteristics are promoted by this financial product?’

The first area I wish to highlight relates to Article 8 products.  The SFDR Level 2 template requires certain disclosures under the banner of “What environmental and/or social characteristics are promoted by this financial product?” We have found that in the context of index tracking funds, the disclosure will often outline what the relevant index will exclude, for example tobacco, nuclear weapons but not what this means in the context of the fund.  We expect that this section of the SFDR template be completed from the perspective of the fund and should clearly indicate what environmental and/or social characteristics are promoted by the fund by applying these exclusions.  While the European Commission Q&A suggests that exclusion strategies are permissible for Article 8 products, we do not believe the intention was to water down the Article 8 designation to such an extent that funds with a list of limited investment exclusions should be deemed to be promoting an environmental or social characteristic.   As such, we believe that funds must address the disclosure requirement by positively indicating what characteristics the fund promotes.^[7]

Finding 2: Disclosure related to the minimum proportion in sustainable investments with an environmental / social objective or the minimum proportion of investments used to attain the environmental or social characteristics promoted by the fund

The next area I wish to highlight is where, in a number of instances for Article 9 products, we have identified issues with disclosures of the minimum proportion of the portfolio to be allocated to sustainable investments with an environmental or social objective.  This includes where:

• The disclosure provides that the minimum proportion provided may be subject to change and such updates can be found on a website.  We expect that the minimum proportions disclosed in the pre-contractual documentation to be accurate and not subject to change (unless by way of amendment to the prospectus or supplement); and
• The disclosure of a range for both the minimum proportion of sustainable investment with an environmental objective and a minimum proportion of sustainable investments with a social objective.  In some instances, the ranges included were between 0%-100%.  Clearly, this is not meaningful information for an investor assessing what the allocation to minimum investments with an environmental or social objective will be.  
• Finally, we found some Article 8 funds where the minimum proportion aligned with environmental or social characteristics is low or even zero. This raised questions with us as to the appropriateness of the fund being subject to Article 8 of the SFDR given the low impact on the strategy and the composition of the fund’s portfolio.

Finding 3: Disclosure related to index tracking funds which employ an exclusionary screening methodology

Finally, the last area I wish to highlight relates to index tracking funds where the index employs an exclusionary screening methodology.  These funds operate by tracking indices which apply ‘screens’ which are used to assess each index constituent against a pre-determined list of criteria.   If a relevant investment is determined to be inconsistent with the criteria, the index will exclude that asset on its next rebalance.  While this may significantly improve the environmental and social characteristics of the index, there are nevertheless issues when it comes to the fund’s disclosure. During our review, we have found different approaches to these disclosures.  Worryingly the majority of funds have adopted an approach whereby they disclose that the assets of the funds are close to 100% aligned with the environmental or social characteristics promoted.  These disclosures appear to be based on the fact that the relevant index provider has determined that the constituents of the index are not inconsistent with the screening criteria employed.  In other words, there does not appear to be any additional assessment undertaken of the fund’s assets to assess their environmental or social characteristics.

The examples I have set out today are very practical, live, disclosure issues.  However, we are also adopting a future focused approach.  As part of this, we are examining new ways to monitor and supervise this area.  This includes expanding our ESG analysis to incorporate machine learning practices, in particular natural language processing, in order to extract information from fund and industry documentation. We are examining ways to active convert fund documentation and text data into database formats.  In time, this will allow us to assess new types of data ranging from social indicators to hazardous waste, water, land usage and recycling practices.  Our goal is to implement a broad data approach, incorporating data which can be used to assess veracity of individual claims made within fund documentation. As you know, the ESG universe is highly varied, with key-term analysis often highlighting over a thousand individual terms associated with ESG practices and methodologies.  As a result, we need to develop supervisory processes which can be deployed at scale.  I look forward to sharing further updates in this regard as our supervisory approach evolves.

Let me conclude.  The issues I have outlined today are quite technical in nature.  These matters will require further consideration.  However, I expect that all of the issues identified as part our reviews will need to be addressed.  It may be possible, in some cases, that this should be done as part of the broader review of the SFDR and on a pan European basis.  However, in a number of instances, the issues are of such significance for the Irish funds sector, I believe it will be important to address the issues in a timely manner via domestic clarifications.   In that regard, as I mentioned earlier, we will shortly host a workshop with key stakeholders to explain the findings in more detail and discuss how the issues can be resolved.

I started my remarks today setting out the striking challenge which climate change is already bringing in terms of extreme weather events.  It is incumbent on the whole of society to play its part in supporting the transition to a net zero sustainable economy.  My hope is that the Irish funds sector sees its role at the forefront of those endeavours.  Not as a follower, but as a leader in sustainable finance.

Thank you.

[1]              Met Eireann, Highest Temperature Recorded in Ireland since 1887 – Available at: https://www.met.ie/sweltering-heat-forecast-from-15-19th-july-what-to-expect

[2]              Met Eireann, July 2023: Provisionally Ireland’s wettest July on record – Available at: https://www.met.ie/july-2023-provisionally-irelands-wettest-july-on-record

[3]              Remarks by Christine Lagarde, President of the European Central Bank, at the Summit for a new global financing pact.  Available at: https://www.bis.org/review/r230623b.htm

[4]              World Economic Forum (2022), Analysis: Global CO2 emissions from fossil fuels hits record high in 2022 – Available at: https://www.weforum.org/agenda/2022/11/global-co2-emissions-fossil-fuels-hit-record-2022

[5]              Remarks by Deputy Governor Donnery - “Much done, much more to do – climate risks and the banking sector” – Available at: https://www.centralbank.ie/news-media/press-releases/much-done-much-more-to-do-climate-risks-and-the-banking-sector-remarks-by-deputy-governor-sharon-donnery-12-june-2023 

Remarks by Derville Rowland - Breaking new ground - regulating for emerging risks – Available at: https://www.centralbank.ie/news-media/press-releases/breaking-new-ground-regulating-for-emerging-risks-speech-by-derville-rowland-deputy-governor-consumer-and-investor-protection-at-the-annual-irish-funds-uk-symposium

[6]              Note: the split of classification is 114 article 8 and 20 Article 9 funds

[7]              For the avoidance of doubt, this also applies for Article 9 funds with regard to the requirement in Annex III “What is the sustainable investment objective of this financial product?”