What About the S and the G of ESG?

This article does neither intend to put forward a new interpretation of the EU Sustainable Finance Disclosure Regulation (SFDR), nor to explain to fund industry practitioners the compliance requirements the SFDR introduced. Much more simply it raises the question which gives the title to the article: “In the discussion around and about ESG, has attention not focused predominantly (if not exclusively) on its environmental dimension and substantially remained silent on its other (equally relevant) dimensions, namely the social and the governance ones?”. In short, "What about the S and G of ESG?”

Dr. Stefan Kratzsch, Team Lead at the United Nations Industrial Development Organization (UNIDO), and Dr. Matteo Menegatti, Partner at EY Luxembourg, discuss the relationship between the SFDR regulation (and thus ESG) and the UN Sustainable Development Goals (hereafter SDGs in short). It appears that the environmental aspect is not, and has never been, the sole dimension the SFDR intended to tackle. Second, they unpack the important role that impact investing can play within the ESG regulation for the achievement of the SDGs and the wider EU and UN policy agenda. SDGs as the policy context for the SFDR As a starting point it should be noted that the relationship between the SDGs and the SFDR has gone rather unnoticed since the latter's introduction in 2019. In a sense this is quite surprising. In fact, anyone venturing to do a full reading of the SFDR will quickly note that SDGs are already referenced in the introductory SFDR paragraphs (to be precise three times in its first and once in its second paragraph). In a sense, SDGs constitute the macro-policy background and the overall context of the SFDR and thus ESG itself. And in this regard it is worth highlighting how sustainability risks are defined in the SFDR (see sub 22 of art. 2), namely as an “environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment“. As it appears clearly from this broad definition, ESG is not limited to environmental risks. And although it needs be acknowledged that throughout the SFDR text there are other (and more frequent) references to the Paris Agreement (which relates to climate change), the focus for SFDR was never meant to be limited only to this environmental dimension. Interestingly, even pre-SFDR, various investment managers had been active in the venture capital and private equity space with a geographical focus centered around Africa and South America and in other developing countries. In certain instances these players included micro-finance components in their investment strategy and acted/ invested in close cooperation with the development community at large (UN, national agencies and NGOs) at the boundaries between technical assistance and the private sector in developing countries.¹ In general, Public-Private Partnerships (PPPs) seem to be very common in the sustainable investment space.² Most importantly, it should be highlighted that these impact investment players did not attract the same interest that others did as the attention was catalyzed by the environmental aspect, also due to the focus given by investment vehicles with a geographical focus in developed countries such as the US and the EU.

Impact investing and the achievement of the SDGs The SFDR presents an important step forward for EU-based investment managers to re-orient their performance criteria that helps expected sustainability returns from their investments. Specific attention here is on showing compliance with SFDR Art. 8 vs. Art 9 in terms of promoting environmental and social outcomes (Art. 8) vs. putting them at the core of the actual investment (Art. 9). If these SFDR Articles have become a sort of classification standard in the industry, a key question should be raised: how do they align or, to borrow a technical term from the world of international standards, how “interoperable” are these SFDR Articles with other existing global metrics on ESG performance, impact investing (e.g., the IRIS or the Global Impact Investing Network, GIIN) and most importantly the world’s 2030 Sustainable Development Goals (SDGs)?³ The SDGs are referenced as overall context in the introductory paragraphs of the SFDR but nowhere again in the Regulation itself, especially when defining “sustainable investment” as per its Article 2 (17).⁴  This poses a challenge to securing more buy-in for the SDGs by those who manage the funds that are urgently needed to address the staggering annual investment gap of USD 4 trillion (grown from USD 2.5 trillion in 2015) that needs to be overcome to meet the 2030 SDGs.⁵ The world is far off in raising such amounts of investments with identifiable social and environmental contributions and hence, unsurprisingly, the UN’s SDG Summit attested in September 2023, that the 2030 SDGs are “woefully off track”.⁶

The majority of fund managers may associate the SDGs with 17 colorful squared icons that describe abstract solutions to address the world’s most pressing challenges until 2030. But they are much more than that. They represent, at a higher political level, a consensual anchor bringing the UN, national governments and the private sector around the table, expressly including investors, fund managers and development finance institutions (DFIs). But there is also an operational dimension in them in that the SDG framework offers granularity, making them suitable to become a risk and reporting management instrument for fund managers and investee companies – besides the 17 goals, there are 169 targets and a total of 231 unique indicators.^{7, 8}  This represents a solid set of sustainability metrics that deserves a closer look. Clearly, the existence of a measurement framework alone will not be enough. It needs to be complemented with capacity building, coordination and awareness building activities, especially in developing countries, to move towards direct measurements of environmental and social outcomes instead of relying on fuzzy proxies or expressed impact intentions at only the pre-investment stage.⁹ 

The classification of assets under SFDR Art. 8 or Art. 9 have already converted, intentionally or not, into a type of sustainability seal in the financial industry and have become an integral part of branding of investment portfolios for the increasingly ESG-minded investor community. This is a positive momentum and should be an opportune moment for the SDGs to become a principal reference in the SFDR, as opposed to being treated as merely a contextual high-level political discourse on the future of our planet, people and prosperity. In this regard, the High-Level Expert Group on scaling up sustainable finance in low- and middle-income countries final recommendations, recently published ¹⁰, clearly shows the commitment at an EU level to facilitate the transition towards sustainable development by mobilizing finance effectively. Moreover, such mobilization clearly involves leveraging public and private capital and also promotes innovative financial mechanisms and collaborations to unlock investment opportunities that align with the ESG principles. The views expressed in this article are those of the authors based on their experience and on prior research and do not necessarily reflect the views of neither the UNIDO Secretariat nor of EY.