Malaysia’s updated sustainable & responsible funds regulation tackles common concerns in ESG

The connection between funds’ names and their sustainability strategies continues to be a hot-button issue for regulators tackling greenwashing. One of the most challenging elements is that of measurement when comparing a fund’s activities with either its own strategy or a common reference point. Malaysia’s updated Sustainable & Responsible Investment Fund rules cover several important topics that shed light on bigger issues facing responsible finance more broadly.

• Malaysia’s updated Sustainable & Responsible Investment Fund rules cover fund naming, sustainability objectives, and ways in which funds demonstrate ongoing alignment
• Differences in how fund managers and regulators in different parts of the world define concepts in sustainable finance, and a lack of common standards on disclosure, will continue to be a challenge for market development
• New empirical research highlights the ways in which fund managers’ ‘specialization’ on ESG can improve their ability to use non-financial data in investment decision-making, especially where ESG ratings diverge

Malaysia’s Securities Commission (SC)?has released?a revised set of?Guidelines on Sustainable & Responsible Investment (SRI) Funds. These largely focus on incorporating qualifications required under the ASEAN Sustainable & Responsible Fund Standards to Malaysia’s SRI fund requirements, thereby increasing the qualifications and disclosure requirements for funds. In so doing, it covers some of the biggest ongoing challenges facing responsible investment.

The strong growth of ESG funds over the past several years has sometimes caused fund managers to face investor concerns and regulatory investigation for overstating their sustainability criteria. Varied definitions of ‘responsible investment’ and ‘ESG’ have contributed to the issue, as have limitations on the availability and comparability of available data.

The elements of the SC’s new regulations that have a wider impact include fund naming, definitions for fund strategies and mitigating other sustainability impacts, and the share of ‘SRI’ fund assets. Fund names have been a common area of concern across responsible finance because of a wider lack of definition around terminology in responsible finance.

For example, in the European Union, the Sustainable Finance Disclosure Regulation (SFDR) broke down fund classifications into three groups: those with sustainable objectives (Article 9), those that promote sustainability (Article 8); and those that don’t incorporate sustainability (Article 6). When the initial fund labelling regime came into force, but before the ‘Level 2’ requirements for enhanced disclosure, a wide range of fund managers classified their funds as Article 9. As the deadline for Level 2 disclosures approached, however,?tens of billions?of previously Article 9 funds were downgraded to Article 8 in the closing months of 2022.

In Malaysia, the new regulation requires fund names to “accurately and proportionately reflect the sustainability features […] without overstating or overemphasizing the sustainability features”. The sustainability objectives must connect with the UN Global Compact principles, Sustainable Development Goals, or other approved criteria, although a fund can achieve the objective in any number of ways.

For example, a fund could use positive or negative screening, have a thematic approach (e.g., focused on clean water or renewable energy), or focus on impact investing. From here, there is some variation from emerging regulations in other markets because the SRI Fund framework allows for funds using ESG integration and ethical or faith-based screens to qualify.

In the UK, for example, a recent?Consultation Paper?from the Financial Conduct Authority included a draft sustainability disclosure and investment labeling regulation stating that “products without a sustainability objective, but which may use strategies such as ‘ESG integration’,?would not qualify for a sustainable investment label” (emphasis added).

The UK’s regulation would require specific and measurable sustainability objectives that may diverge from what would be required in sustainability objectives for a Malaysian or ASEAN SRI Fund label. Other prominent labeling regulations in Europe and the United States apply their own definitions of what is required for a ‘sustainability objective’ to be sufficient.

Once a sustainability objective is defined across the various thresholds applied in different markets, there are further questions about how to measure whether a fund manager follows a fund’s stated strategies to achieve the objective.

The European Commission has?released a paper?to assess what would make good ESG benchmark indices, which included minimum thresholds for performance on environmental, social and governance issues. This mirrors a recommendation from France’s regulator AMF to set “minimum environmental criteria” for Article 8 and Article 9 funds.

Under Malaysia’s regulation, the threshold is defined in relative rather than absolute terms. A fund manager would develop a strategy and policies in relation to the fund’s selected sustainability objective. Then, while the fund is operating, it would be required to maintain 2/3rds of its investments in accordance with its own sustainability policies.

This type of quantitative threshold approach has also been considered elsewhere, including in Europe by the European Securities and Markets Authority (ESMA). Its upcoming ESG fund labeling regulation would require specific quantitative thresholds for fund naming. This has?attracted pushback?from an association of fund managers (EFAMA) on the grounds that many concepts in sustainable finance still lack ‘clarity’.

One of the topics that belies easy measurement is evaluating the way that funds address conflicts between sustainability objectives, where progress on one ESG metric is associated with poor performance on another. The Malaysian regulations include requirement for fund managers to ensure that policies are “not inconsistent with any other sustainability considerations”, which may be another way to ensure that sustainability objectives include multifarious types of impacts and the trade-offs involved in balancing sustainability priorities.

The issues described above are among the most challenging issues relating to ESG and responsible finance, and there is no conclusive answer for the best way to achieve the desired outcomes. However, an empirical report recently released suggests that regardless of the challenges still to be addressed, there remain substantial opportunities available for fund managers on impact and returns grounds.

The paper gives some interesting details on why ESG is likely to grapple with a push-and-pull between sustainability claims and impacts (financial and otherwise). The research addresses the?‘complex materiality’ of ESG ratings?by evaluating how much a large sample of US-based mutual funds deviates on ESG ratings from their underlying benchmarks. It was motivated by the observation that ESG ratings are subject to substantial variability even for the same company, and the researchers looked at how much the “Active ESG Share” contributed to performance. They found that it was positive particularly where ratings conflicted.

The authors said the findings resulted from the ’specialization’ needed to address ESG issues. The conclusion that greater opportunity in ESG from understanding what items are meaningfully material could explain how ESG is useful for investors, without implying that ‘best-in-class’ strategies were the only way to benefit from it. As investors look forward to?a continued increase in sustainability disclosures, one important conclusion to take away from regulators and standard setters’ efforts to improve disclosure isn’t going to lead to a single useful metric, but to better inputs for specialized investors to draw out valuable information.

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