New European Union rules that aim to combat greenwashing and make product comparisons easier could lead to asset managers overhauling their business models to become fully fledged responsible investors.
The sustainability-related disclosures in the financial services sector (SFDR) requires asset managers to disclose strategic policy and business decisions. It was adopted in 2019 but the regulation will only apply from spring 2021.
It imposes transparency obligations on financial entities, such as asset managers, to evidence how they have integrated ESG considerations into their decision-making process.
It also discloses to end investors how they have integrated sustainability risks and considered adverse sustainability impacts, both at entity and portfolio level.
‘Firms will want to take stock of their current business model’
A spokesperson at the Commission told Portfolio Adviser sister publication Expert Investor: “Although the SFDR is framed as a disclosure framework, compliance with its three sets of sustainability-related disclosures are, indeed, expected to have behavioural effects on firms; and, secondarily, on business models of investee companies.
“However, the SFDR does not impose certain investment strategies.”
Lorraine Johnston, counsel at UK-headquartered law firm Ashurst, explains to Expert Investor: “Firms will want to take stock of their current business model, consider how they want to strategically position themselves in the market in light of the disclosures that will need to be made and whether their current policies and procedures are fit for purpose in order to make those disclosures required under the SFDR.
“This may mean that firms that do not currently consider sustainability risks or principals adverse impacts revise their systems in order to make this change before the SFDR begins to apply, and they have to make relevant disclosures,” she said.
Mismatch
James Andrews, managing director and hedge fund practice leader, Europe, at US-based ACA Compliance Group (ACA), explains that the regulation will also allow investors to compare products, and aims to combat greenwashing.
The regulation will apply from 10 March 2021, once the European Supervisory Authorities (ESAs) have finalised and submitted draft Regulatory Technical Standards (RTS) on ESG disclosures to the Commission.
However, speaking at a virtual conference by City & Financial Global, Martin Spolc, head of unit, sustainable finance at the European Commission, explained that more work needs to be done on indicators.
He also pointed to a mismatch in the current timeline of when disclosure regulations become effective for corporates and the financial sector and explained that the EU will find a solution.
Apples with apples comparisons could ramp up investor demand for ESG
Johnston suggests that the shift towards wider integration of ESG in businesses could be driven by investor demand.
“When underlying investors and clients are able to compare, on a like-for-like basis, those firms who do take into account ESG factors, with those who disclose that they don’t, their behaviour will need to change in order to drive that shift in the asset management market,” she explains.
The regulation addresses all market participants.
At entity and product level, it partially relies on a ‘comply or explain’ approach. Disclosure requirements for products with an ESG focus or objective are mandatory and follow additional obligations.
Roxana Nadershahi, principal consultant, private markets practice specialist at ACA, believes that the regulation could impact firms differently.
Those with less ESG background or products will be most impacted by the regulation, as they will have to make a decision about whether to fully engage with the reporting requirements, she believes.
Dani Williams, principal consultant at ACA, speculates about how influential investor pressure will be in this case.
“If an investment manager doesn’t, right now, want to comply, but they start speaking with their clients and investor base, and there’s a huge appetite to want the firm to offer an ESG product, then that would probably be the direction they go,” she says.
Investors could push for compliance if they realise that a fund is less sustainable than they believed it to be, she adds.
Draft rules could lead to cumbersome reporting standards
But critics have said that currently drafted reporting indicators by the ESAs could impose an overly heavy reporting burden on asset managers, which could also lead to non-compliance and a backlash against the regulation.
One key proposal by the ESAs is that financial market participants with more than 500 employees should apply 32 indicators if they decide to report on principal adverse impacts.
Williams commented: “It’ll be an interesting development to see if the appetite for ESG is still out there, once firms actually see what it’s going to take to comply moving forward.”
While recognising the potential reporting burden, a spokesperson at the European Securities and Markets Authority (Esma) commented that the ESAs will take note of the feedback to the consultation and amend its proposal for impact reporting where deemed appropriate.
The spokesperson at Esma told Expert Investor: “While the ESAs are aware of the challenges to collect key indicators of adverse impact from investee companies, it is important to bear in mind that the objective of the RTS is to achieve meaningful and comparable disclosures of the principal adverse impacts of investment decisions on sustainability factors.
“This requires the development of indicators that identify the key principal adverse impacts, covering the key areas of environmental and social impacts.”
Stakeholders have also pointed out that incoherent legislation poses an additional reporting burden.
The Principles for Responsible Investment (PRI) wrote, in its consultation feedback on the RTS framework, that they are concerned that disclosures appear to be developed independently of the EU taxonomy.
“This presents a fragmented and potentially confusing framework for investors and end-users of the disclosures,” it said.
The spokesperson at the Commission explains that “there are several interplays between the SFDR and the taxonomy regulation”.
“The taxonomy regulation lays down additional disclosures for financial products that qualify as those referred to in Articles 8 or 9 SFDR (so-called ‘light’ and ‘dark’ green financial products) and by other mainstream financial products. This also means that the RTS under the SFDR will need to be complemented and adapted,” it says.
Meanwhile, the spokesperson states that “it is currently premature to opine on the scope of the RTS, as they are being developed at the moment.
“What is however clear is that sustainability-related ambition is a marketing advantage of utmost importance.”
Strategic decision making
When complying with and implementing the regulation, Nadershahi emphasises the importance of defining a consistent approach.
“You have to be really clear about why certain factors were chosen for one fund over another,” she says.
Firms need to decide what to measure, whether you can do that consistently across your fund range and what it will mean if the measurements fall outside of your threshold or tolerance.
“Is a certain adverse impact going to mean that you close that position?
“That’s exactly where firms right now are thinking about this, because that’s the practical implication of complying; and that’s not something that can be decided overnight,” she notes.
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