The climbing of Mount Everest is one of the most used metaphors for describing an achievement where a person overcomes seemingly insurmountable odds. Climbing Everest remains one of the most lauded feats of human endurance, planning and ambition. Almost 70 years after Sir Edmund Hillary and Sherpa Tenzing Norgay first scaled the summit, their story and the very concept of scaling the highest mountain continues to enthrall people the world over. However, fewer people ever granularly assess what scaling Everest involves. It is far from a single momentous event or journey. Rather, it is a multi-year iterative process of dedication, planning, perseverance, and significant financial commitment by prospective climbers. Anyone contemplating it must plan to get seriously physically fit, train to be highly competent in mountaineering, technical climbing, and navigational skills.
Just getting to the foot of the mountain entails a six to eight-day hike through Nepal’s wilderness. Upon arrival, ascending Everest involves a highly regimented acclimation process which attempts to prepare the human body for the high altitudes, thus avoiding the worst excesses of altitude sickness and pulmonary issues which often result of the shock to the system resulting from living at such extreme altitude. Making it to Everest base camp perched on the Khumbu Glacier more than 18,000 feet above sea level is a monumental achievement, but few people write books about their basecamp experience. The glory comes from the death-defying ascent to the giant Himalayan summit.
The Everest analogy sprung to mind strongly recently when, on March 10th, global managers operating in Europe had to comply with the first phase of the E.U.’s Sustainable Finance Disclosure Regulation (SFDR).
There was significant work and resource expended to adhere to the website and other documentation requirements for compliance with the level 1 provisions of the regulation. While March 10th focused minds within asset management on adherence to the E.U.’s ambitious and timebound ESG agenda, it very much represented the industry’s arrival at basecamp. Nobody should discount the significant efforts made by asset managers, and UCITS & AIFM management companies and their advisors, in the lead up to March 10th in terms of decisions about their disclosed approaches to sustainability risks, fund categorizations, and adjustments to remuneration processes to consider sustainability.
However, it’s true to suggest that the summit of the SFDR mountain remains some way off and with the recent arrival of the detailed SFDR regulatory technical standards and another consultation and proposed revision to the accompanying E.U. Taxonomy Regulation, it’s clear the journey towards sustainable investment integration and adherence to the exacting E.U. ESG standards will require a mammoth effort from industry. While not as perilous as an Everest expedition, it is an ascent fraught with challenges.
Here are the top three challenges remaining as the focus now turns to adherence to the detailed SFDR RTS and Taxonomy alignment:
1. No Straight Path
To extend the Everest comparison, there is a specific preferred route to the summit and climbers guided by their Sherpas must not deviate from this path or literally risk their lives. The final stretch near the top (above 26,000 feet) is known as the “death zone”. Climbers face extreme slipping hazards; oxygen levels are a third of the requirements normally needed to breathe. It takes 12 hours to travel the last mile to the summit. The very final section of climbing to the top includes walking up a series of steps made from rock and walking along a knife-edged ridge to a 40 foot wall called Hillary Step – get over that and you are at the top of the summit, which is highest point on earth at 29,029 feet. No deviation from the planned route is possible if you are to succeed. The certainty of the planned route is one of the few things that gives climbers confidence of taking it on.
As asset managers attempt to scale the SFDR data mountain, the path forward is not as well defined or certain, even as the first part of the regulation has already taken effect. The recent SFDR Level draft Regulatory Technical Standards (SFDR L2) contained some helpful revisions such as the significant reduction in the number of both mandatory and additional indicators required to frame mandatory principal adverse impact statements (PAIS). While there are some “wins” contained in the latest draft rules, there are also some new insertions.
The E.U.’s Taxonomy Regulation sits alongside SFDR and influences it regarding “taxonomy-related product disclosures”. The E.U. taxonomy is designed to be the world’s first science-based codification system for sustainable investing. Many of the SFDR periodic disclosures relate directly to alignment with the Taxonomy. As such, any changes to the Taxonomy mean knock on changes to SFDR disclosures. The Taxonomy requires asset managers to publish a statement stating the proportion of their investments considered sustainable according to the Taxonomy’s methodology. So, when the three European Supervisory Authorities (ESA) released another consultation paper which impacts the SFDR data set, it showed how dynamic and changeable the path to SFDR adherence remains.
The consultation aims to amend certain SFDR articles specific to areas relating to environmental targets contained in the Taxonomy. It serves to ensure consistency and reduce overlapping or duplicative requirements between the two intertwined regulations. It particularly impacts funds who have classified themselves as Article 8 or Article 9, who intend on investing in alignment with the Taxonomy.
Both Article 8 and Article 9 products under SFDR must disclose, by way of pre-contractual and periodic investor reporting, the Taxonomy objectives to which their underlying investments contribute to as well as to what extent they are invested in Taxonomy compliant activities. The Taxonomy proposal on how and to what extent activities funded by the product are taxonomy- aligned, consist of two primary elements:
- a graphical representation of the taxonomy-alignment of investments of the financial product and a key performance indicator calculation for that alignment; and
- a statement that the activities funded by the product that qualify as environmentally sustainable, are compliant with the detailed criteria of the Taxonomy Regulation.
The latest consultation paper also flared up yet another E.U. ESG controversy, since it proposes to broaden the classification system for sustainable assets to allow for the continued use of gas and nuclear power. Detractors suggest that framing to rules to allow for fossil fuel lock-ins goes against the entire idea of transitioning away from carbon-led economies. They accuse the energy lobbyists of forcing policymakers’ hands. The contrary view is that there simply is no way of moving from “brown” to “green” energy like a flick of a switch and a degree of pragmatism must play a role in a transitionary period which allows run off of carbon energy provision while at the same time ensuring the functioning of economies is maintained. The new proposal recognizes the use of gas and other liquid fossil fuels in cases where they replace higher emitting power sources (such as coal) and where such transition results in a material reduction in emissions.
The constant revisions to the ruleset make it increasingly difficult for in scope asset managers to frame their final data solutions in time for the effective date of the final regulations. Like the pathway to the Everest summit, a final route needs to be concluded and too many revisions to the itinerary along the way will leave many lost, confused and having to turn back.
2. Data Scarcity
Successful mountain ascents of very high peaks are often predicated on ensuring oxygen levels are enough as you reach the thin air at the summit. Successful adherence to the onerous SFDR and E.U. Taxonomy requirements is very much dependent on data provision. Much of this data is not readily available currently, while some will suggest that there are some very well-known ESG data providers in the market already providing ESG screening and scoring for thousands of securities and issuers. That much is true.
However, as of today it’s true to say that no provider has a full data set which incorporates every data point required under the still to be fully finalized SFDR Level 2 RTS and E.U. Taxonomy. Initial reaction to the prescriptive requirements of the detailed E.U. rules is that while much of the data is available, there are also large swatches of data which issuers will need to add to their current disclosures and sourcing will be particularly challenging for private market investments or for companies in developing markets, for example.
Consistent and accurate data provision for areas such as ozone depletion, high water stress, land degradation, and sustainable ocean, to name a few, are not as easy even for publicly listed holdings on large exchanges, so imagine what data coverage is going to look like for smaller private-market investments in less developed markets. Still, the level of vendor consensus is not always very high on many of the metrics used for SFDR indicators. This is because, as we stand, ESG data providers remain largely unregulated. There is not a great degree neither of standardization nor transparency to the methodologies used to derive the ESG scoring for the various elements that go to make up an assessment of a specific security. SFDR and the Taxonomy force a breakout of the various different elements that comprise the overall ESG scoring system. The critical importance of the ESG data providers to ensuring the successful implementation of SFDR is not lost on EU regulators either. Poor quality or inexact data from the ESG data providers could undermine the SFDR regulations in the eyes of regulators. As such, ESMA have already called for ESG data providers to be regulated in much the same manner as credit rating agencies or index providers already are. Such regulation would seek to ensure transparency and greater consistency of approach on the methodology used to apply ESG ratings to securities. Currently there are low levels of rating correlations because each ESG vendor uses their own calculation methodology to assess how ESG a security is.
Indeed, as the Taxonomy and SFDR drive further convergence, it’s fair to suggest that it could also mean proprietary models are needed less and less, and that a much higher convergence of methodologies will result in a greater degree of consensus on ESG parameters. Ultimately this is much better for investors and asset managers but might result in further consolidation in the ESG data provider space.
The other intention of SFDR is that it channels capital to more sustainable companies and enterprises and defunds those whose business models are relatively worse for the environment and society. As such, there is an underpinning of the regulation that will require companies looking for funding from E.U. institutions to start disclosing more data and to shift behaviors so that they remain an “investable asset”. Another string to the E.U.’s bow here is that bank funding is being regulated to be “greener” also. The European Banking Authority (EBA) is ramping up its green finance agenda with a consultation on the use of comparable disclosures and key performance indicators, in particular a Green Asset Ratio (GAR). So, wherever corporates look for funding in Europe – public listing, investment from investment funds, or traditional bank funding by way of loans or debt funding, they will be required to prove their own commitment to sustainability to source this funding. This will mean they need to gather data and disclose it to a degree they never have done before.
3. Competing Priorities
One of the longstanding debates around SFDR has been about the issue of “greenwashing”. There is now an intensifying focus on proving that firms saying they are committed to sustainability are delivering it through provision of transparent data regarding their actions and investments. It is imperative to back up statements and promises with hard data and visible actions. There is also an increasingly commercial imperative to meet the demands of an ever-growing cohort of investors who demand that asset managers have an ESG product offering that can do well by doing good. In the lead up to the March 10th, SFDR initial disclosure deadline, there was a healthy level of debate around the classification of funds and whether funds ought to plump for article 6, 8, or 9.
Many legal, risk, and compliance teams were in the conservative camp, suggesting that it was difficult without assessment of the final SFDR RTS and Taxonomy to truly assess whether or not a particular investment strategy promotes an environmental or social characteristic in the case of article 8 elections. Or indeed, Article 9 funds which purport to have an objective of positive impact on the environment or society. Sales and distribution teams on the other hand often see the world differently, and there was much feedback that classification of a fund as article 6 would result in certain investors divesting or believing that a firm lacked conviction in terms of their commitment to sustainability integration.
With such regulation-led elections, commercial imperatives were balanced against compliance assurances. What is true is that both investors and regulators will be watching closely to see which funds are elected into article 8 or 9 and ensuring when the requisite data disclosures are required, that these funds did not over promise and under deliver in terms of their funds classification when the portfolio composition is weighed by the SFDR & Taxonomy data for its “ESG-ness”. The level of article 8 fund classifications on March 8th, caused some to raise their eyebrows. Whether all those funds truly have the required level of integrated ESG processes and data to back up the initial high-level disclosures remains to be seen. Many will see the interim period between the initial March 10th elections and the likely first detailed principal adverse impact statements as plenty of time to fill in the data gaps I have highlighted above. It is likely that the detailed RTS won’t apply until next year, 2022. As such the likely first PAIS will hit the market in June 2023 covering the 2022 annual performance period. So, there is a little respite for those concerned about the ultra-aggressive regulatory deadlines.
Regardless of regulatory disclosures, I would expect institutional asset owners and allocators to be incorporating SFDR & Taxonomy aligned questions into their due diligence and RPI/RFI processes from later this year. Asset managers who have made the initial elections and feel they have time to get ready might be in for a rude awakening as they are asked questions well in advance of the mandatory disclosure deadlines. SFDR is as much a commercial issue as a regulatory issue.
Also, sales and distribution teams need to be conversant in a new type of language when describing products in the scope of SFDR, as institutional investors will be asking questions such as:
- How does the portfolio contribute substantially to the Taxonomy’s environmental objectives?
- How do you ensure the portfolio adheres to the “Do No Significant Harm” principle?
- What is your process to ensure compliance with minimum social safeguards?
You might need to bring along your ESG Sherpa to future sales meetings in Europe to ensure that you are traversing the SFDR slopes safely and bot free solo climbing.
While collectively industry sits at basecamp looking up at the monumental SFDR challenge ahead, some will be energized and excited by what’s to come, while others might feel an element of trepidation and as if they are currently hanging from a high ledge. Though there seems an Everest-like challenge ahead, similar challenges have been overcome before. So, traversing cautiously and meticulously as a collective, just like Hillary and Norgay in 1953, the asset management industry is very capable of reaching the SFDR summit together.