With only one week to go until the EU Sustainable Finance Disclosure Regulation (SFDR) comes into force, there are mixed opinions on how prepared the industry is for the 10 March deadline.
Affecting all EU financial market participants and financial advisers, the rules aim to improve consistency and strengthen existing policies on sustainability risks with broad disclosure requirements covering remuneration and risk policies, investment and internal processes and systems and general product governance.
All financial market participants should be aware of the regulation, with financial advisors, firms invested in the EU or with investors from the EU and firms and financial products, regardless of whether marketed as environmental, social and governance (ESG) focused all falling within the scope of SFDR.
The changes will take effect at both an entity and a product level, with a series of actions required over the next two years.
On 10 March, entities must publish information on their sustainability policies and assessment of sustainability risks on investment decisions, either by complying or explaining why they do not consider such impacts; disclose the impact on the sustainability of strategic decisions; reveal how remuneration policies are consistent with sustainability principles on both a quantitative and qualitative basis.
Meanwhile, at the portfolio level, managers must disclose any impacts on the sustainability of strategic investment decisions either by complying or explain why they do not consider such impacts and explain how products with ESG characteristics or objectives such as ‘impact funds’ meet those goals.
Article 6, 8 and 9
There are different categories of financial products under SFDR, article 6, article 8 and article 9 products.
Jag Alexeyev, head of ESG insights at Broadridge Financial Solutions, explains that fund managers have found it difficult to perform detailed reviews on each of their funds to identify which category each falls into.
Alexeyev states: “The issue is the requirement for asset managers to differentiate between ‘article 9’ financial products that contribute to a sustainable objective, ‘article 8’ products that promote environmental or social characteristics and embrace good governance practices, and products that do not qualify as either sustainable or ESG products.”
“Given the diverse range of approaches to integrating sustainability, the complexity of the regulation and marketplace, and lack of uniform standards, it has not always been clear where certain funds fit best,” he adds.
On 7 January the European Supervisory Authorities (ESAs) sent a letter to the European Commission seeking clarification on two questions which deal with the scope of SFDR.
The ESAs suggest it is unclear whether below-threshold/registered alternative investment funds (AIFs) are in scope and application to AIFs managed by non-EU managers and placed through the national private placement regime (NPPR).
Marc-Andre Bechet, deputy director general of the Association of the Luxembourg Fund Industry (ALFI), says it is “hoped” that the commission will take a position on this before 10 March 2021, which is the date when the main provisions of SFDR will become applicable and the date by which financial products will have to declare themselves as article 6, article 8 or article 9 products.
Challenges
Experts believe that the main challenges around SFDR include risk management, lack of Level 2 regulatory technical standards, and data.
Regarding risk management, Bechet notes that “it is a bit of a carte blanche” because the different texts are not providing any kind of hints as to what you should be doing.
He suggests that this is a moving target to watch over the next 12 to 18 months because the industry will have to adapt to a new paradigm, and it will have to define what risk management is when it comes to ESG and sustainability.
The lack of Level 2 regulatory technical standards text ahead of the deadline on 10 March, is also a cause for concern.
Broadridge’s Alexeyev: “The tight timeline to prepare for the regulation to come into force in March has also been a challenge, compounded by the delay in the Level 2 regulation. As such, asset managers were forced to adopt a cautious approach in interpreting the requirements as they planned to articulate the sustainability considerations in their business practices and product sets.”
Meanwhile, data is also another challenging aspect of the new regulation. Preparing for the SFDR is not a trivial task for asset managers, with the collection of the correct and accurate data the most daunting issue, and once the relevant data is collected, experts say firms will also need to address the potential inconsistencies in approaches to data collection, data quality and accuracy across their portfolio.
Karan Kapoor, head of regulatory solutions and regtech at Delta Capita, highlights that data will need to be gathered from multiple sources in order to fully comprehend the sustainability risks involved with the firm’s investment activities.
“Moreover, this data must be processed efficiently and in a simplified format,” he adds.
There are also some concerns that the type of information provided by data providers may not align with the information that’s required for SFDR disclosures.
“ESG is a relatively new concept in the industry, so we may not even have access to all the required data yet. Also, data collection for environmental aspects during one time period may not be accurate in the future, because climate conditions are so unpredictable. This means data must be collected and processed on a more regular basis,” Kapoor comments.
“In addition, not all non-financial data is available in a retrievable format, but there is a consultation of the European Commission which is working to provide a single access point in Europe for financial and non-financial information disclosed by companies (ESAP). The commission is pushing for common definitions and a common set of data available in a retrievable format,” Bechet explains.
Meanwhile, meeting the deadline for SFDR has also been noted as a challenge because the regulation is new and unfamiliar.
Kapoor notes that compliance and administration can be costly and burdensome for firms who are also facing other regulatory demands and operational challenges as a result of the pandemic.
Are you ready?
With meeting the deadline as one of the challenges, Andy Pitts-Tucker, managing director, Apex ESG Ratings & Advisory, suggests that the industry is “woefully unprepared” for this landmark regulation.
At this stage, Pitts-Tucker says all financial market participants and advisors should understand how it applies to them and be making the necessary preparations for the new regulation, however, “this is far from the reality we are seeing”.
But instead “there is a scramble for the line”, which he highlights is similar to what the industry saw ahead of General Data Protection Regulation (GDPR) several years ago.
Pitts-Tucker says: “The concern is that managers will be so focused on rushing ahead of this looming deadline, that they will not put in place sustainable processes and systems with the capability to respond to future evolution or expansion of mandatory ESG disclosures.”
Also weighing in, ALFI’s Bechet says the industry is simply not ready because SDFR and the EU Taxonomy regulation are very important developments.
The EU taxonomy is a classification system, establishing a list of environmentally sustainable economic activities. The EU taxonomy is an important enabler to scale up sustainable investment and to implement the European Green Deal.
Notably, by providing appropriate definitions to companies, investors and policymakers on which economic activities can be considered environmentally sustainable, it is expected to create security for investors, protect private investors from greenwashing, help companies to plan the transition, mitigate market fragmentation and eventually help shift investments where they are most needed.
Although there are concerns about how ready the industry is, Alexeyev says there is “general readiness” in the industry, indicating that managers will be able to meet the deadline albeit under the usual pressures that come with preparing for large scale regulations to come into force.
Greenwashing
One problem that has been highlighted within the industry is ‘greenwashing’. In order to tackle greenwashing, Bechet says the industry first has to agree on a definition of what greenwashing is.
“To me, it means betraying the trust that investors put in you, essentially telling investors what you intend to do and doing something different, or not properly disclosing or reporting,” Bechet explains.
Looking at the way the regulation is written and combining Level 1 and now Level 2, especially the published RTS on disclosures, Bechet says: “The framework is really very prescriptive in terms of what firms have to disclose to investors, on products, and at entity level.”
“Be it for the documents which firms will put at the disposal of investors (prospectuses), marketing communications, funds’ annual reports, the information that comes on the website of each asset manager — the RTS contain a precise list of the minimum requirements and those that are binding.”
He highlights that most of the products are regulated products that are registered with, and supervised by, national competent authorities. These products are also audited. Bechet adds: “Considering all of this together, I hope and trust that the danger of greenwashing would be really limited.”
The industry hopeful that the introduction of SFDR disclosures should improve the transparency of ESG understanding in the industry. Pitts-Tucker suggests that SFDR is “a game-changer” and is the “biggest statement of intent yet from regulators to harmonise ESG reporting standards and therefore discourage greenwashing”.
Although the industry remains positive that SFDR will help prevent greenwashing, the regulation alone may not be enough, according to Kapoor.
He explains that the EU Taxonomy aims to provide a ‘benchmark’ to classify activities as ‘sustainable’ or not, which should further reduce greenwashing as it will clearly define if environmental/social factors are actually considered — and not just being promoted for marketing purposes.
“However, there are still some challenges to fully combat greenwashing. In the RTS report, the ESA’s state that the disclosure of granular data should combat greenwashing, but reporting will be challenging given the complexity of information associated with financial products,” he adds.
The extent to which greenwashing is completely eradicated depends on the honesty of SFDR disclosures.
Kapoor says: “For example, a firm could turn a blind eye to an ‘unsustainable’ investment. It is possible that they could claim the investment is meeting social goals, even if it isn’t. The definitions provided by the ESA’s should prevent this, but social factors can be extremely subjective.”
Although SFDR will be a large contributing factor to the prevention of greenwashing, Bill Prew, CEO of INDOS Financial says regulators, investors and market best practices will align over time to reduce the risk of greenwashing.
Prew notes: “Asset managers should expect investor scrutiny and be prepared to explain or rationalise their approach to SFDR and ESG investment practices to reassure stakeholders that greenwashing is not taking place.”
What next?
As the SFDR deadline is almost upon the industry, what will be next in terms of sustainable finance?
The EU Taxonomy, which supplements SFDR, is expected to follow soon and its provisions will apply from 2022, following the publication of the delegated acts in June 2021.
The Low Carbon Benchmark Regulation has introduced two new benchmark categories related to climate change, the first is the Climate Transition Benchmark and the second is the Paris-Aligned Benchmark.
Kapoor says: “Benchmark administrators must also disclose any sustainability factors which are included in their benchmark methodologies. The first deadline is 31 December 2021 for methodology disclosures, then 1 January 2022 to update benchmark statements to reflect ESG factors.”
With financial services continuing to transcend jurisdictional boundaries, so too will the need for globalised regulations implementing equivalency to SFDR.
Chris Johnson, senior product manager, market data, securities services markets and securities services at HSBC, highlights how the Task Force on Climate-related Financial Disclosures (TCFD) is being adopted more widely as a mandatory requirement, as evidenced by announcements by the UK and New Zealand in recent months.
Regulators in Asia, such as the Hong Kong Monetary Authority (HKMA) and Securities and Futures Commission (SFC) in Hong Kong, and the MAS, are also consulting on ESG regulations.
Johnson says: “There are also significant initiatives being proposed to achieve harmonisation and standardisation of ESG data.”
Meanwhile, the European Securities and Markets Authority (ESMA) has written to the European Commission sharing its views on the need to ensure the quality and reliability of ESG data, according to Johnson.
In addition, Johnson reveals that the International Financial Reporting Standards Foundation (IFRS) is pursuing an initiative towards achieving a global set of internationally recognised sustainability reporting standards to allow for consistency, comparability and transparency of reporting, which is supported by the International Organization of Securities Commissions (IOSCO).
This year is set to be a very important year for sustainable finance, and it is safe to say that green investment will become more and more prevalent in the entire asset management and fund industry.
Jean-Pierre Gomez, head of regulatory and public affairs Luxembourg, Societe Generale Securities Services Luxembourg, comments: “Most of us agree on the necessity to invest by taking a strong and serious account of those ESG factors. However, being pragmatic, it will take time to achieve the European Commission objective regarding sustainable finance.”
A change of attitude and/or to the way of investing is therefore expected, according to Gomez, with education and the increasing awareness regarding environmental impacts also acting as key drivers.
The current SFDR will be rolled out over at least the next two years, with different texts entering into application up to January 2023.
While the technical screening criteria are not yet final, Bechet says drafts have been published for two of the six environmental objectives, which will keep all stakeholders busy in the years to come.
Based on this, Bechet concludes: “I believe we are only at the beginning of a long journey.”