Double materiality is the new reality when it comes to ESG

As the world around us evolves, it is becoming increasingly apparent that environmental and social challenges – and the actions we must take in order to address them – will come to define this century. This evolving landscape has altered the European Union’s political agenda significantly, with major knock-on effects on global financial markets. ESG and sustainable investments are defined in the law and meeting the requirements of sustainably-minded investors, supervisory authorities and society is a matter of economic survival. 

Double materiality is the new reality

Implementing the new requirements introduced by the EU’s action plan for financing sustainable growth is THE challenge that the financial services sector will need to address in the next few years. The new requirements are taking the duties to be performed by financial product managers, institutional investors (insurance companies, pension funds) and investment advisors in a completely new direction: non-financial, sustainability-related criteria must now be considered at the same level as financial information (“double materiality”). This applies in particular to financial products which pursue an ESG or a sustainable goal or which are marketed as ESG-compliant or sustainable. In any event, ESG risks should also be measured and taken into account for all other financial products. This is a sea change.

Competitive edge and key success factors

Many asset managers as well as fund managers have already realised that adopting a truly sustainability-oriented investment philosophy and bringing their fiduciary duties into line with ESG values can give them a truly competitive edge.

1. Unlocking previously untapped value-creation opportunities 

Taking into account and/or investing in sustainable goals, which are aligned with the UN’s SDGs or the EU’s taxonomy, generates value-creation opportunities. A significant potential for creating alpha lies in identifying service areas and supporting them in their transition to becoming more sustainable. 

2. Managing physical and other ESG risks: 

EU regulatory authorities as well as central banks increasingly require that physical and ESG-transition risks be identified, managed and disclosed. The consequences of those requirements will determine not only public perception but they will also influence the value of the target investments. 

3. Redefining fiduciary duties:

Thinking that making a profit is incompatible with pursuing ESG and/or sustainable goals belongs in the past. Actually, the introduction of new rules relating to ESG risks and principal adverse impacts (PAIs) will result in ESG creating – or impairing – value and ultimately becoming a key investment criterion. 

4. Securing investors and building the investor base

Implementing an ESG strategy successfully and choosing sustainable assets will determine how attractive any given fund is. Given that investors themselves are increasingly required to take into account ESG risks as part of their regulatory or fiduciary duties, those portfolio managers who do not position at least part of their products or strategies accordingly are bound to lose market share. 

5. Maintaining continued focus on changing stakeholder expectations:

As is already the case for a number of other business aspects, stakeholders will also continue to influence ESG efforts as they focus on ESG criteria and have expectations in this area. While some of these expectations are clear and defined formally (for instance, legally binding framework conditions), others are more difficult to interpret and are liable to change quickly (for instance equity markets and public opinion). Continuously adapting to and managing those considerations and expectations will play a key role in making the financial services sector credible and its investment strategies successful.

Luxembourg as a solution provider

Luxembourg currently has a market share of over 30% of ESG / sustainable UCITS in the EU. This market position can mainly be attributed to the structural changes made to existing products but also to the Luxembourg ecosystem’s skills and success factors in the area of sustainability.

1. ESG policy

For the past few years, Luxembourg has followed an active ESG and sustainability policy at government level in general and in fiscal policy in particular. Back in 2018, Luxembourg’s Finance Ministry launched the “Luxembourg Sustainable Finance Initiative” together with the Environment Ministry. This programme, combined with the “Luxembourg Sustainable Finance Roadmap”, identifies sustainability goals, priorities and ambitions and supports market participants in addressing the challenges involved in adapting their products, services and processes. Among other things, this support takes the form of the PACTA Climate Scenario Analysis – Luxembourg 2021, which enables market participants to simulate their investment portfolios’ CO2 emissions at no cost.

2. The Luxembourg stock exchange and LuxFLAG

Luxembourg realised early how relevant to the financial markets sustainability was and how it would change things for the industry. The first green bond in the world was launched in Luxembourg in as early as 2007. Today, 50% of the green and social bonds issued in the world are listed on the Luxembourg Green Exchange (the secondary market of the Luxembourg Stock Exchange). This means Luxembourg has considerable expertise and data to support this growing market segment, which will develop even further following the announcement that the EU will issue green bonds amounting to 30% of NextGenerationEU's total issuance. Luxembourg’s capital market expertise is complemented by national initiatives such as LuxFLAG, which awards environmental labels to funds.

3. Luxembourg service providers

Only if ESG-related data challenges are managed successfully can a true sustainable strategy be implemented. Regardless of any regulatory developments, Luxembourg financial services providers are already pioneers in this area as they are exposed to ESG and sustainable investments through their existing product offering. The production and value chains in the areas of fund accounting, investment restriction management and risk management are being redesigned in order to optimise the ESG data-capture processes and streamline the data collected in a meaningful and insightful way. 

4. Luxembourg supervisory authorities

The Luxembourg supervisory authorities mostly operate on the basis of the guidelines issued by the EU and ESMA. Because of the great number of ESG, sustainable or impact investment funds they deal with, the Luxembourg authorities have already implemented an orderly authorisation procedure as part of their administrative practice. The authorities have introduced a “fast track” process for conversions as at the reporting date in order to expedite the authorisation procedure for market participants and products that already had an ESG focus before the EU requirements were implemented. This process already proved effective in March when it came to meeting the deadline for SFDR disclosure requirements. Also, the authorities have not unilaterally defined ESG, sustainability or minimum exclusions beyond the EU rules. As a result, market participants are able to tailor their products to their clients’ needs, taking into account the solutions and implementation possibilities available both in EU markets and in the rest of the world.