Sustainability is currently a leading topic in the financial industry. In recent years, client interest and demand have been steadily increasing, meaning sustainable investing has moved from a niche market to mainstream investment. However, requirements and the level of complexity have significantly increased with the latest regulatory wave. The EU Action Plan combined with the EU Taxonomy and the Sustainable Finance Disclosure Regulation (SFDR) are part of an ambitious legislative framework that will significantly shape sustainable investing.

Wiebke Merbeth, Head of Public Affairs and Sustainability at BayernInvest, and Ingo Speich, Head of Sustainability and Corporate Governance at Deka Investment, discuss current trends in sustainable finance and how the EU regulations impact not only the European market, but also the rest of the world.

How has the market for sustainable investments developed in recent years?

Ingo Speich: Growth in the sustainability market was and is extremely high in terms of assets under management (AuM). The annual growth rate over the past decade has been about three to four times higher than in the asset management industry in general. While the market dynamic is high, market penetration is still relatively low, thereby providing a great opportunity for many players to position themselves in a market that has been largely unregulated. Until now, it has been relatively easy for providers to take advantage of this: all that was needed were significant volumes to achieve economies of scale. However, with the new regulations, the business is becoming a lot more complex.

Wiebke Merbeth: There is also a downside to the high demand. The market is under significant pressure to offer sustainable products in almost every asset class. I have seen requests for green bitcoins or green FX derivatives. All business units are now looking deeper into the topic. The difficulty to fulfill the high expectations from clients also leads to discussions whether a Green Bond with low scores on the Freedom House Index can still be sustainable. It will be imperative to remain realistic in the future. Sustainable finance is about a process of transition which has just begun and will take time. Decent conflicts between sustainability objectives, especially between environmental and social will undoubtedly arise.  

With the EU Taxonomy and the SDFR, requirements for sustainable products have significantly increased. How does this affect market dynamics?

Wiebke Merbeth: The new requirements have an effect on the entire value chain, from distribution over product and portfolio management, to reporting. Prospects and clients will be asked for their ESG preferences, and sustainable products need to show their actual attainment and impact in the periodic reporting. This requires changes in various existing processes and a sound governance structure. With many different regulations coming into effect in parallel, it will be important to coordinate the various projects and to develop a future business and operating model.

Ingo Speich: The market is transitioning from an unregulated high growth market into an established regulated one. This transformation usually goes along with market consolidation, where larger players increase their market share. They have the infrastructure and research in place to cope with the regulatory requirements. In terms of regulation, large providers could come under pressure in grouping of products. Product conversion may be necessary to comply with the new regulatory framework.

How do you assess the effect of EU regulation on non-European countries and regions?

Ingo Speich: So far, Europe has tried to fulfill a leadership role with a large regulation of the financial market. It will be interesting to see whether the rest of the world adapts the SFDR and the Taxonomy. From the perspective of an asset manager, global regulation is mandatory. It will be difficult for clients to understand why there are hundreds of fragmented regulations all over the world with different levels of ambition. A common sustainability framework for company reporting and institutional investments will be necessary to build a harmonized market for sustainable products and to avoid a clear segmentation. All in all, an internationally harmonized market helps to drive down costs due to fixed standards.

Wiebke Merbeth: With the SFDR, Europe is taking a huge step forward, setting the rules for non-European asset managers as well as for the non-European corporate sector. Non-EU asset managers need to comply with the EU regulation offering their products in the European market. Non-EU companies will need to provide an increased and more reliable set of sustainability data on the one hand and will face an increased engagement on the other. That's exactly the pioneering role that we will be playing. I expect that the EU standards will be integrated into the development of frameworks outside of Europe in the coming years. In addition, the industry is thankful for having the ISSB located in Frankfurt.

Will other countries and regions adopt the very high ambition level of the SFDR and the Taxonomy?

Wiebke Merbeth: Money flows will determine this answer. Countries that are closer to Europe will probably transfer or adapt the standards sooner. Hong Kong has already implemented even higher climate standards and almost copied the BaFin Guidance Notice on Dealing with Sustainability Risks. On the other hand, the UK has so far not committed to SFDR and Taxonomy. On a global level, it is only a question of time before the standards will converge. I would expect that in the medium-term there will be a uniform, global standard for sustainability similar to IFRS for corporate accounting. I think that the investment industry worldwide has understood that sustainability will be a key driver for risk and return.

Ingo Speich: If China adopts similar standards, it would have a multiplier effect on the entire Asian market. However, the majority of assets are held by Americans. For Europe, the decision by the US will be more decisive. It would be desirable for the US to develop the same ambition as the Europeans.

Can politicians accurately assess the long-term effect of their regulations on the capital market?

Ingo Speich: For us as asset managers, the current question is whether sustainability criteria should be the result of political negotiations or based on scientific findings and inherent risks. We think, it will be important that the EU Taxonomy is not just a political framework, but asset managers can derivate implications on companies, valuations, and risks. In particular, we have to avoid merely transferring brown assets to the private market rather than transferring them. It will be crucial that integration of sustainability factors can lead to better risk-adjusted returns. In this case, other countries will automatically follow.

Wiebke Merbeth: I agree, but would like to add that companies with a lack of sustainability will automatically face a decrease in demand by investors in the future. This will have an effect on stock prices which will also drive management compensation. Even though the European market is not the biggest in the world, the marginal demand will still have an impact. From an economic point of view, this also reflects a pricing of externalities. A good investment management firm will already anticipate this development. Therefore, I appreciate the high level of ambition that the EU is currently targeting.

What are the challenges for product providers?

Ingo Speich: Historically, the sustainable investment market was mainly based on exclusion criteria. Reliable data were hardly available and thus exclusion of sectors, market segments, or issuers were required. This means that the portfolio management process has to change. We need to integrate the new data in our analysis, not only for sustainable products, but for all investment decisions. It will be interesting to see whether the regulation will push for an increase in the niche market with very strict sustainability criteria or if it will try to integrate sustainability criteria in the mass market and tighten the criteria over time. This will definitely influence what our future products will look like and how our investment processes will work.

Wiebke Merbeth: Short-term, we face increasing costs for data providers. Historically, the data was not determined. Now, they are step-by-step, so the demand for well-thought analysis with increasing complexity and conflicts of goals will follow. The integration of sustainability criteria within the value chain is also time-consuming. We need to create a common understanding of sustainability, internally as well as externally. You currently observe this in diverse ESG ratings for the same company by different providers.

What developments do you see in the market for sustainable products?

Ingo Speich: In the retail segment, the amendments in the distribution (MIFID II and IDD) will change things quite a bit from August 2022 and create additional demand for sustainable products through requests for sustainability preferences. Asset managers need to set up an attractive product range. Conversely, they need to quickly adapt to the new regulatory requirements. I think that the new framework will significantly drive product conversion.

Wiebke Merbeth: The definition of sustainability has become a lot more challenging. Just to provide an example: Historically, renewable energies were automatically seen as sustainable. With the DNSH criteria of the Taxonomy and the PAIs of the SFDR, we have to consider a lot more factors within the investment process and look at sustainability from a 360-degree view. Besides this bottom-up view, from a market and investor perspective, sustainability is a moving target. Something that is sustainable today, might not be seen as sustainable tomorrow due to new technologies and according to the transition cycle. At the same time, we need to commit to a minimum threshold of sustainable investments. The effort to deliver sustainable products has become a lot higher.

Which providers will tend to benefit?

Ingo Speich: Larger asset managers tend to have an advantage in building the necessary infrastructure Sustainable investing will be largely driven by automated big data systems supplemented by individual high-quality research, which is expensive. The standardization fostered by the European regulation will also make it more difficult for smaller boutiques. We expect to see market consolidation in the sustainable investment market, as we have already seen with ESG data providers.

Wiebke Merbeth: I doubt size matters as credibility and adaptability are key. The requirements will significantly increase over the coming years. Providers that only aim to fulfill the regulatory minimum now, will face difficulties in the future coping with the fast-paced developments in the market. A sound governance structure will also be key in establishing minimum requirements for sustainable products and in developing a harmonized product framework for private as well as institutional clients. This definitely requires the attention and commitment of the management.

How will sustainability affect the role of the portfolio manager?

Wiebke Merbeth: Sustainability will be an integrated topic within portfolio management. Historically, sustainable investment managers were a separate team that managed their own portfolios. In the future, the role of a sustainability analyst might not even exist anymore. The classic research will need to integrate ESG factors and global compact understanding as well as a regulatory ‘new normal’.

Ingo Speich: Sustainability will be incorporated into all products up to a certain degree. The market will also transition away from sustainability ratings to more granular data. Portfolio managers will have access to a large amount of new data that could potentially influence the risk and return profiles of their portfolio companies. Being able to quickly adapt to this new environment and identify the main drivers will be key. This also requires a sound understanding of sustainability. We are transitioning from the collection of data, to the interpretation of it. Some asset managers have already incorporated the importance of sustainability ratings into their investment decisions, as we have seen with credit ratings.

More and more asset managers are also committing to a net-zero-strategy. Can the majority of asset managers simultaneously achieve such an ambitious goal?

Ingo Speich: A long-term net-zero-target can be set. However, medium-term targets are difficult to achieve as we do not know how the capital market environment will develop over the next couple of years. In case of market turbulence, CO2-intensive sectors have been a defensive safe harbor for investors. However, it remains important for us asset managers to continue to be able to diversify and manage risks. Our ability to decarbonize our portfolios will also strongly depend on the commitment of the corporate sector. Here, we need a strong collaboration.

Wiebke Merbeth: I think that we should not underestimate the pricing of CO2 in the future. Independent of the economic cycle, large emitters will face increasing costs. On the other hand, providers with very ambitious CO2 targets may find themselves in a situation where they have to purchase emission certificates. This could create a trade-off between the ability and the costs of actually attaining the CO2-reduction objective.

The EU regulation increases data costs for providers and research is becoming more expensive. In response, the EU is planning an EU Single Access Point. Do you think that this initiative will be a success?

Wiebke Merbeth: I actually believe that the European Single Access Point will significantly decrease data acquisition costs in the medium-term and neutralize the information bias of asset managers against ESG rating agencies. This is a huge opportunity and every asset manager will gratefully accept the better access to data. But we have to go through the ‘valley of tears’ first and live with increased costs in the short-term.

Ingo Speich: The idea of the EU platform is excellent, but the question is whether it is really feasible in this form. The whole coverage of the big research houses in sustainability, the analytical tools, the networking and also the vertical integration into the IT infrastructure of asset managers are strategic competitive advantages, which cannot be so easily solved by this EU platform. It will be hard to compete against the established big ESG players that are able to leverage the data.

What challenges are arising for research houses?

Ingo Speich: In the future, pure data provision will be a commodity. The new platform makes a significant amount of data freely available. Therefore, the business model of the research houses will be completely turned upside down; away from that of a data provider, to an integrated research house that evaluates and interprets the data on a customized basis. We should not underestimate the expenditures of research companies in R&D and we may see a continued consolidation of the market.

Wiebke Merbeth: The marginal benefit of an additional data provider is limited. Providers need to differentiate themselves by the quality of their ESG research or by focusing on niche topics. They will be assessed by the reliability of their forecasts.

Doesn't this create a danger similar to the financial crisis of 2008, where the market relied on headline ratings of a few rating agencies, while they underestimated the risk of certain financial products?

Ingo Speich: The financial crisis or the fixed-income area, where these ratings very much defined their creditworthiness, were different to the current situation. We will look at a large set of granular data points and try to draw conclusions on sustainability. Asset managers will differ in their research approaches to show their added value. We, for example, have already transitioned away from using sustainability data. This can also create a competitive advantage for asset managers if they can identify incorrect classifications earlier and react before the rating agency.

Wiebke Merbeth: Sustainability is a hot topic as bubbles—either green, brown or stranded—may arise. Increasing the definition of risk by underpinning sustainability issues won’t lead to an underestimated risk—in fact, it’s the contrary.