The European Union's ambitious plan to make the financial industry more sustainable has reached an important milestone, requiring asset managers to disclose whether their funds have environmental, social or governance (ESG) risks and to spell out the degree to which each fund has sustainability as the investing focus. But lingering questions remain about many of the disclosure requirements and fund classification process which means that with just over a month now left to the March 10th deadline, many asset managers, both in the E.U. as well as firms based in the U.S. and the U.K. have so much to do and only so little time.
The Sustainable Finance Disclosures Regulation (SFDR) is the important first, big step in a longer E.U. ESG journey to enshrine sustainability across the entire E.U. asset management sector. The SFDR, which applies to all UCITS funds and Alternative Investment Funds (AIFs) sold in the EU, was adopted in 2019 as part of the European Union's Action Plan to mobilize investments to help meet the Paris Climate Accord's goals of reducing global warming. The SFDR Level 1 provisions themselves are challenging and require a massive revision of fund paperwork to be submitted to regulators in advance of the March 10th deadline. However, industry are agonizing over how the entity level and fund disclosures they make now will interact with pending detailed requirements in the Level 2 SFDR Regulatory Technical Standards (RTS) and the finalized E.U. Taxonomy, which have just become available as of last Thursday.
Importantly, the SFDR applies to all asset managers with E.U. regulated funds, even to those that don't offer specific ESG-focused funds. Even funds who don’t particular care for the concept of ESG too much must, at a minimum, acknowledge and disclose sustainability risks inherent in the investment process.
In addition to the requirements for fund disclosures, the SFDR requires fund managers to disclose the extent to which they integrate sustainability risks into the parent firm's investment decision-making process. This entity-level disclosure requirement has resulted in extra territorial impact to certain investment firms headquartered in New York and London, which are important players selling UCITS and AIFMD funds across the E.U. market. While their E.U. based offices and fund companies are obviously in scope, for many it was not abundantly clear if SFDR required the top-level management firm back in the home office to make sustainability disclosures. In many cases it does, and this level of transparency is something that has created an amount of disquiet with some.
The scope and application of the rule even at this final hour lacks a degree of clarity and certainty, so much so that it even moved E.U. regulators to write to the European Commission on January 7th seeking clarification on the scope of the disclosure requirements and some other ancillary questions.
For the funds themselves, managers need to determine which one of three distinct buckets each of their sub-funds fall into:
- Article 6, which requires disclosure of how sustainability risks are integrated into investment decisions and possible impact of those risks on returns
- Article 8, so-called "light green" funds that are said to promote certain sustainability characteristics
- Article 9, so-called "dark green" funds that have sustainability or reduction of carbon emissions as the fund's stated objective
Without an opportunity to assess the finer details of how to weigh and measure each classification, working off draft Level RTS, and the possibility of the European Commission throwing a spanner in the works in its response to the ESA’s letter, it is plain to see why there is an air of caution across the industry about over committing to these very time bound disclosures.
As important as regulatory compliance is, it is not the sole consideration asset managers have to make when classifying their funds. Because ESG funds are gaining such popularity with investors, placing a fund in an Article 6, 8 or 9 buckets could have an impact in existing or prospective investor appetite. Does the categorization as an Article 9 fund make it more or less attractive to investors? We do not know for sure, but what is sure is that such election for now remains primarily a qualitative assessment. However, when the SFDR Level 2 RTS becomes application it will be crucial to be able to back up the promises made with hard data or be accused of the worst of asset management sins in the current climate, “greenwashing”. For now, many of the key performance metrics are difficult to assess without access to the final E.U. Taxonomy, to properly assess the funds adherence to the six areas of environmental protection. While the E.U. Taxonomy and Level 2 of the SFDR is only likely to take effect on January 1, 2022, certain decisions must be made now.
Concerned that they still have insufficient rule certainty or indeed supporting data to underpin inclusion in Article 9 category funds, many fund managers are opting instead to include their ESG-focused funds under Article 6 or 8 for now, both of which enshrine a lower burden of proof on integration or promotion of ESG qualities.
The lack of prescription has lead industry stakeholders resorting to dubbing some funds Article 8.5, an unofficial designation to indicate that while they are not officially Article 9 funds, they will have strongly worded language and convictions to follow ESG principles or sustainability benchmarks. They will also screen out and divest non-ESG compliant stocks, and they will show active stewardship by voting proxies in support of sustainable corporate policies. It is claimed that while all Article funds are equal, some are more equal than others.
A similar dynamic might become evident in the Article 9 cohort of funds as well. Some funds will align investment policy with one or more of the six E.U. Taxonomy environmental objectives, whereas others may choose to pin themselves to other social or environmental targets beyond the Taxonomy. A third group of Article 9 funds are those who choose to align with a Paris Aligned Benchmark (PAB) or a Climate Transition Benchmark (CTB). However,
Article 9 funds may also deviate from these benchmarks and retain Article 9 status so long as they can prove that in doing so, the funds’ sustainable objectives continue to be met in full.
Once more, you will end up with multiple sub-sets of Article 9 funds without uniformity and without the ability to adequately compare funds under the SFDR classification system, things could get confusing fast. Lack of uniform standards may open the doors to instances of green washing.
The whole fund classification system was specifically designed to allow for a spectrum of ESG commitment across the E.U. fund universe, underpinned by data in order to remove greenwashing. However, with the inexact method of measurement it actually means there may be confusion about what is and what is not the more sustainably-focused fund.
The entity level website and pre-contractual document disclosure requirements on March 10th are the first steps in a much longer journey, a laudatory attempt to standardize disclosures at the entity and product level, which hasn't existed before.
The first step is relatively high level and qualitative, involving how firms view their investment process and broadly the degree to which they consider sustainability within their business model. But when Level 2 is implemented next year, it will shift from a qualitative assessment to a very quantitative and data hungry measurement process, requiring hard data to support the decisions they are making. Much of the data is currently unavailable or it is not easily accessible. The importance of ESG data providers as crucial components of the ESG ecosystem has become very evident recently with a call from ESMA to introduce rules that regulate ESG data providers. ESMA believe that if left unregulated and unsupervised, there is an increased risk of greenwashing, capital misallocation, and products mis-selling. They also suggest that there should be a common definition of ESG ratings.
The concern is that if managers are overly aggressive on the Level 1 disclosures this March, they are going to have to problems backing up those claims with the disclosure of the required data when the detailed provisions come into early next year. But many managers are also concerned that there is a data scarcity for a lot of different asset classes and geographies. So, something has to give.
The key takeaway here is: managers should be very attentive to how they position their funds now, because there are further, potentially slippery steps that lie ahead when the more detailed rules are rolled out next year.
