As the financial world becomes more socially conscious, “sustainable investments” are dynamically standing across “traditional investments”. While the strategy of the latter primarily focuses on the highest returns at a given level of risk, "sustainable investing” integrates in its decision-making process environmental, social, and governance (ESG) factors alongside traditional financial metrics.

This Article navigates through the following:

1. How ESG affects Fund Managers.

2. The Investors’ perspective on “Sustainable Investments”.

3. The challenges of Fund Managers towards “Sustainable Investing”.

HOW ESG AFFECTS FUND MANAGERS

Fund Managers are directly affected by the ESG principles through the amended Alternative Investments Fund Management Directive (AIFMD) as of 2021, and the Sustainable Finance Disclosure Regulation (SFDR), effective as of 2021. AIFMD requires Fund Managers to integrate and consider “sustainability risks” in the management of Alternative Investment Funds (AIFs) and SFDR promotes transparency (disclosures) on how Fund Managers consider “sustainability risks” in their decision-making process.

Fund Managers who offer or promote (market) “sustainable investments” (Article 8 or Article 9 under SFDR), are required to determine whether an investment is considered environmentally sustainable in accordance with the criteria of the EU Taxonomy (how and to what extend).

Fund Managers are also indirectly affected by the Corporate Sustainability Reporting Directive (CSRD), entered into force in 2023, which replaces the Non-Financial Reporting Directive (NFRD). Affected companies should report both how sustainability issues affect their business and how their business activities impact society and the environment (the “double materiality”). Thus, Fund Managers investing in entities that are covered by the CSRD should use such reporting for assessing the sustainability performance of their investments.

INVESTORS’ PERSPECTIVE ON “SUSTAINABLE INVESTMENTS”

Interest in “sustainable investing” has significantly increased in recent years. Millennials and Generation Z (Gen Z), as per recent surveys, are more likely to be interested in “sustainable investments”.

“Transparency”, “risk mitigation” and “alignment of financial incentives with values” are characteristics of “sustainable investments” which attract investors’ interest. Risk mitigation is considered as a component for achieving, among other factors, long-term financial performance, while transparency is considered as a dynamic tool which can affect the performance of their investments in the long-run.

By prioritizing the ESG factors, investors aim to minimize risks and create value through their investments.

THE CHALLENGES OF FUND MANAGERS TOWARDS “SUSTAINABLE INVESTING”

Shifting to “sustainable investing” encompasses a series of challenges for Fund Managers. A nonexhaustive list is outlined below:

1. Profitability: Fund Managers should ensure that focusing on sustainability indicators will not distract them from the objective of generating profits. “Sustainable investing” balancing and/or aligning investors’ sustainability objectives with performance expectations. Integrating ESG considerations into the decision-making process requires a holistic risk assessment approach.

2. Lack of standardized measurement: Integration of sustainability risks into the decisionmaking process requires appropriate measurement to ensure transparency and accountability towards investors. Such methodologies are currently not available on a universal basis leading to difficulty in finding traceable data to support investment decisions.

3. Greenwashing: Lack of standardization on risk measurements may lead to unjustified or subjective assumptions and “false” ESG ratings. Such results may “open the door” for misrepresentation and/or “greenwashing”.

4. Avoidance due to complexity: Many funds refrain from promoting their sustainable initiatives to avoid being accused of “greenwashing” and/or due to the complexity of regulatory reporting. In many cases, ESG turned out to be a confusing and disrupting movement rather than a positive development.

5. Financial cost and lack of resources: Shifting to “sustainable investments” will potentially involve engaging external parties for professional advice or upgrade existing systems and tools to meet the disclosure, assessment and reporting requirements. Smaller industries like Cyprus are reasonably concerned of the financial impact and the need for additional resources for managing “sustainable investments”.

6. Who should “pay” the cost? ESG monitoring and reporting is associated with higher costs. The answer is not, however, straightforward as investors with sustainability objectives are not necessarily willing to assume the cost.

THE PATH TOWARDS ESG COMPLIANCE

The evolving regulatory landscape is positing a thread on smaller financial market participants like Fund Managers in Cyprus due to increased adaptability demands. The one-size-fits-all approach of regulatory developments is clearly a challenging aspect which requires the attention and support of the National Competent Authorities (NCAs) of Fund Managers.

This concern has been embraced by the Chairman of CySEC in his recent Article on “The Impact of the sustainability framework on a small island nation”. As it was noted by the Chairman, it is crucial to support regulated entities by giving them time to understand and implement the changes, while at the same time, stressed the importance of Regulators to take the required time to build capacity and expertise during this transition.

Creating long-term value is undoubtedly a key aspect of shaping the future of financial markets. However, the adoption of realistic expectations and the principle of proportionality are aspects that EU policymakers and NCAs should be considering while ensuring smooth transition of all affected parties.