TMF’s Micilotta: Bringing transparency to ESG reporting

This article is sponsored by TMF Group

Greenwashing is about to get more difficult. The EU’s Sustainable Finance Disclosure Regulation, which is entering into force in a series of stages, aims to prevent funds from being marketed as ‘green’ or ‘sustainable’ unless they meet a specific set of technical criteria. In addition, complementary regulations are in the pipeline in several other jurisdictions.

Flavia Micilotta, ESG solutions director for fund services at TMF Group, tells Private Funds CFO that stronger disclosure and reporting requirements will ultimately benefit the industry through the creation of a level playing field. She notes, however, that GPs are still generally ill-prepared to cope with the new requirements and face significant hurdles in providing the data required by regulators.

How will emerging regulations on ESG affect fund managers?

Regulators are trying to scale up a degree of standardization into everything to do with ESG. Let’s not forget that, for a long time, there was a complete lack of standardization. Any manager could market their funds as ‘sustainable’ or ‘ethical’ or with ‘ESG’ criteria without meeting any regulatory standard – because there was no one standard and virtually no one verification possibly. It was basically self-attestation.

This situation produced several different types of products, all marketed under a ‘sustainability’ denomination, but not offering a good level of comparability or evaluation to investors. This, coupled with the need to generate significant growth around sustainable finance (mainly to help fight climate change), persuaded the European Commission to start working on new regulations in 2017. The aim was to help investors determine a good degree of transparency in relation to these types of investments, in order to ascertain, with some degree of accuracy, which investments are truly aimed at contributing to the transition economy and which ones are only making empty claims.

As the level of requirements increases in line with the degree of transparency needed, things are improving but it’s a journey and there is still some confusion as to what good really looks like and what needs to change. I think that everybody would agree that the most important new requirement is the SFDR. In addition, the UK is bringing in similar regulations and many other countries are also engaged in a race to the top to streamline sustainability in finance.

In practical terms, this will give way to new challenges, particularly as players throughout the investment chain will need to be able to increasingly access data to meet transparency requirements. Very few private companies have been willing to structure their non-financial reporting up to now. Not many use standards such as the Global Reporting Initiative, for instance.

Deciding on what data companies need to report on, and then choosing the right format, entails a series of challenges that are quite substantial for all the players involved.

Is the sector well-equipped to meet these challenges in ESG disclosure?

Clearer standards are eventually going to benefit the industry because they will create a more level playing field. But, in my experience of working with different market participants, I would say that, in general, most are not at all prepared for the changes. As a matter of fact, you can see how consultancies have been mushrooming lately to capitalize on managers’ needs for help in meeting new regulatory compliance requirements and to fill data gaps that are present in the market. This is clear evidence that not everybody is ready – far from it, in fact.

What skills does an ESG investment adviser need?

They need to have a good understanding of how ESG issues affect their clients, and how embedding ESG into enterprise risk management can add value for companies. They also need to be able to advise clients, not only from the perspective of risk, but also on strategy relating to ESG.

These skills are in very short supply. We see many professionals who are clearly overstating their ESG skills and know-how at the moment. Trying to sell knowledge/services without expertise is very common – it’s a clear indicator of how much greenwashing is endemic.

Being able to make data available to clients around ESG and match ESG data to conventional financial risks is going to add value. AI is playing a huge role in that. A lot of players are trying to leverage on AI as much as possible to provide wider coverage and scale for a low cost. But consultants will have to build partnerships to be able to use ESG data and support investors in making strategic use of sustainable models. Providing a wide range of datasets on different ESG topics demands a lot of resources. It will be hard for participants to come up individually with a well-articulated value proposition that meets all these complex needs. Partnerships are going to be key.

We see it happening already with rating agencies and also with consulting firms. They are increasingly keen to partner with different kinds of players that can offer them specific resources, for instance, in applying metrics on climate change or producing climate scenario analysis for the purposes of TCFD reporting.

What changes do GPs need to make to their corporate governance and strategy to deal with ESG requirements?

When you look at private equity, a process like running ESG due diligence is something that is left to a few players – it is not really done by default. With the new requirements, the importance of embedding ESG across all the steps of the investment value chain will have to be recognized much more widely. Unless it becomes more common for firms to reject acquisitions on ESG grounds, the regulatory changes will fail their purpose for the industry.

Also, I feel that there is still not enough conversation about ESG on corporate boards in general. I’m a big advocate of having ESG representatives at board level or on the investment committee because it does represent the best way to ensure that sustainability is actually being tackled within the firm. Boards need to have a good understanding of the kind of liabilities and accountability that they have and the risks ESG can pose to the whole company. Linking ESG metrics to the incentive structure for GPs would also encourage change in a faster way.

Are requirements on transparency around ESG likely to increase engagement between different actors in the investment ecosystem?

The increased demand for transparency and reporting on ESG is only going to be achieved if there is a good degree of collaboration and exchange of information around ESG between managers and investors. It starts with awareness, discussion and understanding of what are the main KPIs that are typically needed from within a GP-LP structure.

GPs need to be engaged in their relationships with portfolio companies and provide robust oversight of their ESG performance. This means that GPs themselves need to have a good knowledge of ESG risks and opportunities. This way they can have a proper understanding of the kind of material issues that need to be looked at and will know when these might become a risk or an opportunity likely to significantly impact the business.