EU’s SFDR rules are a taste of things to come

While the first round of the EU’s Sustainable Finance Disclosure Regulation has been broadly welcomed by responsible investors, there are also concerns it is vague and imprecise in places


The recent implementation of the first phase of the European Union’s Sustainable Finance Disclosure Regulation (SFDR) has largely been welcomed as a landmark moment for responsible investors, as it should offer them further clarity and guidance on a product’s green credentials. Concerns have, however, been raised about a lack of detail in parts of the legislation, with some commentators suggesting the real hard work is only just beginning for the financial services sector.

As of 10 March, Level 1 SFDR requires asset managers to publish both pre-contractual statements – for example, in a fund’s prospectus – and disclosure statements on their websites about which of their products fall into three distinct categories:

* Article 9 funds – that specifically have sustainable goals as their objective, for example, investing in companies whose goal it is to reduce carbon emissions.

* Article 8 funds – that promote environmental or
social characteristics but do not have them as the overarching objective.

* Article 6 funds – that are not promoted as having environmental, social and governance (ESG) factors
or objectives.

Morningstar’s EU Sustainability Disclosures report describes the SFDR as “a landmark for investors” as it raises the bar for funds looking to describe themselves as green and “strikes a balance between preventing greenwashing and making it unduly onerous to be an ESG product”. It also points out that, while some products will scale back on ESG references in their names and objectives, many will double down to offer investors a clearer choice when evaluating investments.

‘Meaningful difference’

“The disclosure requirements should make a meaningful difference to the quality and consistency of information available to investors,” believes Morningstar director of EMEA policy research Andy Pettit. “The additional measures will add substance to both the stated ambitions of firms and their products and the degree to which those ambitions are achieved over time. The moves to make the information more fact-based, quantitative and standardised across products will make information more comparable and consumable to investors.”

ThomasLloyd founder and CEO Michael Sieg says any initiative or criteria that helps market participants define, measure and report on the sustainability attributes of their economic activities is to be welcomed. “This will make it easier and more transparent for end-investors to understand how ESG and sustainability are aligned with their investments,” he adds.

A Moody’s sector comment report on asset management in Europe also takes the view the new sustainability disclosure rules will benefit fund firms, reasoning: “Requiring asset managers to disclose how they account for ESG risks will contribute to establishing industry-wide standards for sustainable investment. The disclosures align with investor demand for ESG-compliant products, which has increased because of the coronavirus pandemic, and should boost net inflows.”

The report also predicts it will not be long before global asset managers that distribute investment products in Europe consider adopting the criteria across their entire product ranges. Mirroring the impact of the EU’s Markets in Financial Instruments Directive, Moody’s suggests that, in the SFDR, the bloc has created a benchmark for other regions.

‘Vague and imprecise’

Nevertheless, Moody’s does note some issues with the SFDR rules with regard to clarity and availability of data. “The disclosure rules are relatively onerous, and collecting, calculating and processing sustainability-related data so new reporting obligations are correctly fulfilled will be a challenge,” says the report. “Most of the data is not financial or market information, such as pricing data, but relates to less immediately measurable metrics, including greenhouse gas emissions and human rights.”

Candriam head of ESG development David Czupryna is more critical still, observing that, while the SFDR will be remembered as “a stepping-stone in making finance sustainable”, it is also likely to end up as the source of more confusion. “SFDR is vague, imprecise, open for interpretation – and probably knowingly so,” he adds, before acknowledging it could also prove a deterrent for so-called ‘greenwashers’.

“Let’s face it – through disclosures, the SFDR aims to define a minimum standard for sustainable products,” says Czupryna. “By setting the bar sufficiently high in terms of mandatory disclosures and indicators, SFDR aims to dissuade would-be half-hearted ESG asset managers from emphasising sustainability among their credentials.”

A further worry is the possibility that mistakes have been made in the rush to hit the 10 March deadline. “We remain concerned that asset managers have been so focused on rushing to meet the deadline they have been shortsighted and not put in place sustainable processes and systems with the capability to respond to future evolution or expansion of mandatory ESG disclosures,” says Hari Bhambra, global head of compliance solutions at Apex Group.

“The requirements on those are going to increase as ESG legislation develops. To prevent being unprepared as reporting requirements evolve, businesses should – as soon as possible – put in place systems that collect data currently seen as optional, as well as the information needed to monitor and track ESG performance over time.”

And while former Green MEP and professor of economics and finance at the University of Roehampton Molly Scott Cato agrees SFDR will have “a big impact” and is an “important step forwards” in terms of transparency in ESG products and documentation, she maintains the regulation “must go further”.

“While negotiating the SFDR as shadow rapporteur for the Greens-EFA Group in 2018, I was deeply disappointed that the EU Council allowed a ‘comply or explain’ exemption,” Scott Cato says. “This avoids full transparency, since smaller firms can refuse to disclose
so long as they give a reason why.”

While “not perfect”, she is hopeful the SFDR will shed further light on portfolios that are investing in companies that are potentially damaging the planet and people’s lives. As an example, she points to BNP Paribas and HSBC continuing to finance the mining company involved in the Fundão dam disaster in Mariana, Brazil – Samarco Mineração – and argues many savers who have pensions or investments with banks remain unaware their money is being used to invest in companies whose weak safety standards result in the loss of life and the devastation of precious environments.

“Even in its current form,” says Scott Cato, however, “we cannot deny the regulation’s merits and the fact that it is a clear signal of a shift towards a more transparent and open financial industry.”

The next level

Now asset managers have got to grips with complying with Level 1 of the SFDR’s high-level and principle-based requirements, they need to turn their attention to the Level 2 technical standards, whose detailed requirements on the content and presentation of information are set to come into effect on 1 January 2022.

“While asset managers may feel broadly comfortable with the initial Level 1 SFDR disclosure requirements, they will now need to reflect on some more onerous challenges that lie ahead around Level 2 requirements – notably around data,” says Charles Sincock, ESG lead at Capco.

He warns that, while these may have been “watered down significantly”, there are still issues that will be “extremely challenging” and require time and effort. He adds: “The regulation initially specified reporting on 34 principal adverse impacts [PAIs], but this was reduced to 18 mandatory PAIs and a number of voluntary ones. Most managers, however, will need to report on more than the core PAIs, considered from a materiality perspective, if they are to provide a full and rounded disclosure, and create a holistic picture of their ESG profile.”

Furthermore, according to Sincock, if portfolio investments sit in SFDR Article 8 or 9 categories, claiming ‘social’ or ‘environmental’ credentials, then data will be needed to support these assertions. “Managers need to understand what ESG assets are in their portfolio and access data to report on key indicators,” he explains. “Some of this data can be purchased from traditional providers but much of it does not exist or is certainly not readily accessible in a structured data set.

“Not only is the data not collected by a provider, it is not always collected by the underlying company either, effectively making the task of meeting some Level 2 SFDR requirements even more challenging. Businesses may need to adopt more operational resource and financial firepower to meet those challenges – something that may be beyond the scope of smaller firms.”

Nevertheless, believes Apex Group’s Bhambra, the first layer of SFDR implementation is just a taste of what is to come. “The SFDR is only the beginning of ESG regulation for global financial services – a sector that transcends jurisdictional boundaries – and we anticipate the imminent introduction of regulations in various markets that implement equivalency to the SFDR,” she says.

“Non-EU managers should see the current time as an opportunity to get ahead of the game and to ensure they can collect and analyse relevant ESG data before the inevitable introduction of new regulation in their domestic markets.”

Natalie Kenway is editor of Portfolio Adviser‘s sister brand ESG Clarity


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