Navigating the Maze: Sustainable Investment Regulations, Tech, and the Quest for Actionable Data

As we reach the halfway point in this critical decade, it is imperative to reassess the record of public policy and private investment in tackling shared sustainability challenges. After all, the climate and biodiversity plans that governments must deliver in the coming months will rely heavily on their ability to mobilize private capital. It is also useful to reflect on how institutional investors can move forward – inclusive with the support of AI – without waiting around for the regulators.

To date we have seen divergent policy approaches. The US has focused on incentivizing investment in clean energy technologies through tax credits, while Europe has sought to channel capital to sustainable economic activities by developing a dedicated regulatory framework.

As we shall outline, the European approach, though ambitious and well-intentioned, has its shortcomings. It faces challenges both in accurately identifying sustainability leaders and laggards through corporate reporting rules and in creating investment vehicles that effectively drive net-zero and nature-positive transitions in the real economy.

As a matter of fact, companies and financial institutions have spent too much time on compliance and not enough making sustainable investments. Europe is already reappraising its approach towards the Sustainable Finance Disclosure Regulation (SFDR), and may do further under the Draghi recommendations. Regulators and standards-setters globally should note its missteps as they direct their efforts to simplifying, clarifying and aligning across jurisdictions.

Meanwhile asset managers and owners have an opportunity to generate long-term value by streamlining compliance, enabling effective decision-making and offering choice to clients. Further, technology can be a critical ally, supporting information flows and enabling insights to drive effective capital allocation.

Challenges in Europe’s Sustainable Investment Regulations and Frameworks

Europe’s approach to boosting green capital flows rests on multiple pillars. Amongst them, it introduced the EU Taxonomy to come to a common understanding of what is meant by environmental sustainability, the SFDR to encourage sustainability related disclosures by investment products, the Corporate Sustainability Reporting Directive (CSRD) to provide information on individual firms’ sustainability performance, and amendments to the Markets in Financial Instruments Directive (MiFID) to integrate client sustainability preferences into existing investment suitability processes.

By some measures, the SFDR appears to be succeeding, with funds claiming sustainability characteristics or objectives capturing more than 60% of the European investment market in 2024 reporting combined assets of €5.95 trillion.¹

SFDR was conceived as a disclosure regime not a classification system, but the market has converted Article 6, 8 and 9 into de facto product categories. Asset managers have spent much time and energy shifting between these categories, fearing accusations of greenwashing as regulators sought to better define sustainable investments.

In reality, there has been little meaningful difference between many Article 6 and 8 funds, undermining claims that SFDR has driven investments to more sustainable projects. It’s worth noting that the UK’s Sustainable Disclosure Requirements have sought to address SFDR’s flaws with the fund labels it rolled out earlier this year – and that the Commission has indicated openness to replacing SFDR with a similar regime.

Moreover, SFDR has asked asset managers to disclose their sustainable investment practices without much of the underlying data being available by companies. Comprehensive corporate disclosures will only become available with the phased rollout of the CSRD, which comes years after SFDR. As a result, investors have had to manage data gaps, often on the majority of companies, in their SFDR implementation, making greenwashing – intentional or not – an unresolved challenge.While the CSRD will improve transparency over time, it won’t cover all regions and company sizes, leaving European investors with continued challenges in ensuring sustainability across their portfolios.

For now, regulation intended to support sustainable investment has not consistently delivered on its ambitions. The EU Taxonomy should be a valued guide to investors, with its capex KPI, for example, predicting firms’ future sustainability alignment, potentially signifying unrealised economic gains. But a safety-first approach by asset managers has led many to underplay the extent of their investments’ alignment. Rather than integrating the Taxonomy’s indicators into their investment process, some managers have indicated 0% alignment to avoid greenwashing claims.

The Long Road Ahead for CSRD Implementation in Europe

There is also a growing likelihood that CSRD introduction will not be smooth sailing and that its initial implementation will not suddenly deliver on hopes of a new era of transparency for investors.

By the European Commission’s estimates, from January 2025, the first wave of roughly 2000 companies will report.² By January 2026, more than 11,000 large firms will be reporting, providing up to 1,000+ data points across 10 sectoral themes, paving the way for a further 40,000 smaller firms in coming years. This is a heavy lift.

With European businesses still reeling from blows dealt by the pandemic, geopolitical instability and inflation, firms are struggling to dedicate resources to this unfamiliar, vast, and complex set of reporting requirements. Many are experiencing a steep learning curve as they report metrics for the first time, while those that reported under the Non-Financial Reporting Directive – or publish bespoke ESG reports – are not certain to make all of the CSRD’s required disclosures.

In one study, Clarity AI analysed the disclosures of 2,100 in-scope firms of quantitative metrics and policy disclosure points selected from across 10 themes. The results showed that even the most common metrics are being reported relatively infrequently by companies set to be in the first wave of CSRD disclosures (see Table 1). Overall, only half of these data points were being disclosed already, meaning many in-scope companies – conditional to their materiality assessment – will be breaking new ground to meet CSRD obligations.

Table 1. Percentage of Companies Already Reporting on CSRD Metrics

Rethinking Sustainable Investment Regulations for Real Impact

These past or potential bumps on the road offer plenty of food for thought for policymakers and investors. For the former, the US$265 billion mobilised by the US Inflation Reduction Act for clean energy investments over the past two years provides evidence that both carrots and sticks drive direct private capital to green ends.

And the lengths taken by asset managers to comply with – or avoid falling foul of – European sustainability regulations reinforce the limitations of rules-based approaches in an industry where there are many ways of doing things. With a new Commission coming in, the EU will have the opportunity to consider a more principles-based approach to regulations. And there may be occasions where this would be preferable. For example, having broad guidelines for transition-focused funds, allows investment professionals more space to focus on opportunities to decarbonise the economy, not just their portfolios.

Finally, as different jurisdictions develop their sustainable finance frameworks, the need for deeper and more meaningful levels of interoperability is becoming apparent. Standards bodies have been keen to emphasise their efforts to coordinate in the interests of the end-users, but market feedback suggests this is still a work in progress, with many practical gaps to be filled. The International Sustainability Standards Board faces a significant challenge in ensuring that country-level implementation of its standards allows interoperability and equivalence with other jurisdictions and frameworks.

Plans to further align taxonomies at COP29 are being greeted with anticipation, but such ambitious initiatives will not yield results overnight.

Harnessing Technology to Close the Data Gaps

Asset managers and owners have to play within the rules as the regulatory landscape evolves. And technology-based innovation is making it increasingly possible to reduce the compliance burden, leverage available data to develop attractive and sustainable investment offerings, and offer greater value and insight for clients.

Reporting requirements can be automated in a number of ways. For example, periodic reporting under Article 8 of SFDR can be executed by solutions that draw on pre-contractual information and other sources, completing both numerical and qualitative inputs automatically for human review, potentially reducing workload by 80%. Similarly, fund disclosures across multiple jurisdictions and frameworks can also be automated, with the technology performing the mapping to fill gaps in interoperability.

Moreover, the sequencing, shortcomings and potential delays to CSRD reporting are being addressed through the sourcing of estimated, aggregated or alternative datasets. These too can fill in gaps left for now by regulation, but with the caveat that the user understands the underlying methodology and assumptions, applying the appropriate confidence levels. Are the estimated and reported data being separated, for example, and is the latter being rigorously audited or self-reported?

Technology innovation is also finding new ways to improve the availability and reliability of data from which investors can derive new insights into climate and nature risks and opportunities. User dissatisfaction was evident in Bloomberg’s 2024 European ESG Data Trends Survey, which found that 63% of market participants are concerned about quality and coverage.

To address this, data vendors are deploying artificial intelligence and natural language processing to enhance data collection, while machine learning programs can improve data reliability by identifying patterns that suggest inaccuracies. Our own research has demonstrated the challenges for investors, reporting that 13% of data points diverged by 20% or more when comparing three sources of carbon emissions data.

Conversely, in situations where investors are faced with too much data rather than too little, the synthesis capabilities of AI can support investors through its capacity for processing and summarising data rapidly, accurately and at scale.

This will help investors not only once the CSRD delivers more comparable and accurate corporate sustainability disclosures, but also as more forward-looking inputs – such as transition reports – become part of the mandatory reporting landscape.

By analysing 300 transition plans via a large language model, Clarity AI research recently revealed that just 40% of high-emitting firms had fully quantified and attributed the impacts of their decarbonisation measures. The ability to leverage a proxy for transition plan credibility will help managers of transition-focused funds to efficiently fulfil their regulatory remit and accurately direct capital to support change in the real economy.

These same technology-led capabilities can help asset managers and owners to provide transparent and targeted communication to clients and beneficiaries. The generative AI and synthesis tools that support regulatory disclosure requirements also have the capacity to enable clients to interrogate their portfolios, offering greater insight and value than prescribed statements.

Innovating Through Uncertainty

As we have seen, the power of regulation has its limits. Regulators and policymakers recognize that they are in the early stages of constructing effective rules to drive finance to shared environmental goals. In Europe, despite the best intentions, they are not yet delivering and may in some cases be distracting from the overall objective.

The roles and responsibilities of the public and private sector in this unique and urgent collaboration are not clear cut. The best way to stimulate sustainable investment flows is still open to debate. But perhaps the lesson we can take at this point on the journey is for the rules of the road is to allow the space to innovate. As Sasha Sadan, Director of ESG at the UK Financial Conduct Authority, reminded the investors at PRI in Person in Toronto this year, investors do not need to wait for the regulators to act.

References

1. IPE. “Article 9 Funds Outflows Continue Amid Ongoing Regulatory Uncertainty.” IPE, October 15, 2024. https://www.ipe.com/news/article-9-funds-outflows-continue-amid-ongoing-regulatory-uncertainty/10072973.article
2. European Commission. Commission Staff Working Document: Impact Assessment Report Accompanying the Document Proposal for a Directive of the European Parliament and of the Council on Corporate Sustainability Due Diligence and Amending Directive (EU) 2019/1937. SWD(2021) 150 final, 2021. https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52021SC0150