The ever-growing regulatory jungle
Dr. Mariana Wiederkehr Senior Legal Counsel
In the last two decades, the regulatory landscape surrounding impact investing and other sustainability-related matters has experienced profound transformations. Back in the early 2000s, regulatory frameworks pertaining to impact investing were practically non-existent. There were only a few mere “seedlings”. Today, impact investing has not yet received the regulatory priority it deserves to flourish. However, we live in a jungle of ESG-related legislations (Link leads to German publication).
In this exploration, we will:
- Sketch two contrasting portraits: one of the early 2000s and the other of the present day.
- Chronicle the growth from those initial seedlings to today's dense regulatory forest.
- Anticipate the future blossoms of this ever-evolving landscape.
From seedlings to a lush canopy
During the early 2000s, the sparse regulatory seedlings were a consequence of the economic and social context. Governments, market actors, and civil society had just began recognizing the magnitude and urgency of environmental and social (E&S) challenges. As a result, only a handful of regulatory instruments explicitly catered to impact investing.
Today, E&S challenges made it to the top of the agenda on the global stage.
The sense of urgency to effectively tackle these issues and to act on climate risks is palpable. Consequently, private investment has gained significant traction in the impact realm. This shift has influenced regulation - however, the results are still limited.
In the maze of contemporary regulations, pinpointing instruments that effectively cater to the unique needs of both impact investors and investees remains challenging. Some examples covering the investee side include benefit corporations’ laws in the United States and Latin America, as well as the banking regulation enabling small companies’ financial inclusion. The European Social Entrepreneurship Fund (EuSEF) Regulation in the EU, along with a slew of national and international green, social, and sustainability-linked bonds standards, are examples on the investor side.
Most impact investment transactions take place in emerging markets, where the majority of the underserved populations dwell. The burden of regulations such as the EU SFDR, though well-intentioned, tends to add layers of red tape to these transactions. Furthermore, the EU Taxonomy, primarily tailored for the EU’s real economic, poses challenges for investees in emerging markets who may not yet be equipped to meet its stipulations.
The evolution of the Jungle in three stages
Observing how the regulatory jungle grew and evolved, we see that investors and the market developed in three stages:
1. Stage
Financial loss management
In the late 20th century, investors primarily aimed to sidestep losses from E&S risks. National laws, like the "polluter pays principle" from the 1992 Rio Declaration, guided these actions.
2. Stage
Corporate E&S responsibility
Investors then transitioned to proactively avoiding harm. As they recognized the broader implications of their actions, regulatory frameworks, such as the Equator Principles, emerged to promote responsible investment.
3. Stage
Positive E&S impact
Moving beyond mere responsibility, investors are aiming for a deliberate positive environmental and social imprint. Pioneers like the Global Impact Investing Network (GIIN) and the Impact Reporting and Investment Standards (IRIS) provided tools and standards, propelling impact investing into the spotlight.
Accompanying these stages, real-economy companies evolved, mirroring the shift in investor focus over the decades.
Source: ECOFACT Blog, February 2023
Nowadays, ESG-related regulations affect nearly all financial actors and influence both impact and traditional impact investors. These laws cover areas such as due diligence requirements, investment products, reporting mechanisms, governance practices, strategies, and risk management frameworks. So far, transparency-related law has been the most vibrant in the regulatory jungle.
Source: ECOFACT Policy Outlook, July 2023
The blossoming future of impact investing laws
Looking ahead, some key instruments are expected to influence the future of impact investing. These include both impact-investment focused regulation as well as broader regulatory frameworks.
In the panorama of actually upcoming regulation, we see examples of international, regional, and local law developments:
International
Convergence among various soft law initiatives is underway. The International Sustainability Standards Board (ISSB) is pivotal in framing holistic reporting and governance norms for impact investors.
Regional
The European Union remains at the forefront, fortifying the realm of sustainable finance, including a robust definition for greenwashing and a social taxonomy. Laws from the EU are likely to affect laws in other jurisdictions. The implementation of the Corporate Sustainability Reporting Directive (CSRD) will legally link E&S impacts directors' duties, which already is a common attribute of impact investing.
Sustainable impact label
The UK’s Financial Conduct Authority proposed “sustainable impact” label for investment for products with an explicit objective to achieve a positive, measurable contribution to sustainable outcomes. These are “invested in assets that provide solutions to environmental or social problems, often in underserved markets or to address observed market failures”.
However, these strides won't satiate the demands for impact-centric legislation. Fresh regulations, akin to the UK's model, should be curated to address the intricacies of investing in the world's more disadvantaged regions, facilitating the flow of capital from affluent nations.
The future beckons for...
- Adapted investment structures: Custom configurations addressing the nuanced needs of investees, while alleviating investor apprehensions about redemption and liquidity.
- Impact-optimized reporting: Streamlined reporting and due diligence, underlined by transparent directorial obligations.
- Enhanced financial backing: Incorporation of third-party guarantees via blended finance.
- Favourable tax structures: Fiscal advantages that alleviate some risks from the investor's shoulders.