Imagine an automobile market where manufacturers cannot assess customer preferences and the size of relevant market segments, from small electric cars to heavy-duty diesel SUVs via hybrid saloons; and where consumers have no reliable car specs data, including energy consumption. How to price cars? The same opacity is currently affecting the global stock market.
On the demand side of the market, the Global Sustainable Investment Alliance (2023) can only estimate that $30 trillion is globally invested in sustainable investing assets (i.e., more than a quarter of global assets under management). Unfortunately, it has proven impossible to assess who is adopting what sustainability investment philosophy and, thus, how to segment the market along shades of ESG.
On the supply side, corporates have been positioning their securities along a broad spectrum of sustainability profiles, considering both the nature of their activities and the quality of their operations. However, the disclosure of non-financial information has been lacking, both in terms of quantity and quality. It has not been feasible to perform any supply-side segmentation beyond a rough analysis.
ESG rating agencies have sought to provide a solution by attempting to segment the market through simple ratings. The approach has only highlighted the limits of the current market setup.
The European Union is the first jurisdiction to seek to bring some order to this capitalistic mess. With the SFDR* (demand side) and the CSRD* (supply side), the European Union is equipping the market with the tools to segment itself. Both pieces of regulation have significant drawbacks, but they will improve, consultation after consultation, as market participants become more sophisticated.
The 2021 SFDR* has allowed asset managers (including private equity) to de facto label their funds along two shades of ESG. Today, 60% of EU assets under management (c.$5 trillion) have formally classified themselves as ESG funds. To complete the picture, the European Union is now asking firms to enhance their disclosure of non-financial data through the CSRD,* a directive coming into force this year.
The UK, a country that is well-versed in capitalism, is now following suit. From July onwards, asset managers can stick one of four labels on ESG funds following the Sustainability Disclosure Requirements (SDR). On the supply side, the UK is expected to adopt the ISSB* this year.
The U.S. is not immune to this regulatory evolution. Quite extraordinarily, the CSRD has broad extraterritorial reach. It requires that non-EU companies with a modest presence in the EU disclose non-financial information as well, following an implementation timetable to 2028.
I expect US and other non-EU companies to adopt essential features of the CSRD before being required to do so for two reasons. First, they will be naturally incentivized to disclose non-financial data voluntarily to maximize their appeal to EU funds and support these funds’ own disclosure requirements. Second, non-EU investors who will need to integrate non-financial data to be able to price EU assets will gradually expect equivalent disclosure from US companies. Globalization might be challenged in many places, but not in the financial markets.
It will take years to enhance the markets’ capital allocation efficiency. The game for all market participants, including when considering M&A and IPOs, is to see today what everyone else will see tomorrow.
* SFRD: EU’s Sustainable Finance Disclosures Regulation
* CSRD: EU’s Corporate Sustainability Reporting Directive
* ISSB: International Sustainability Standard Board