Sustainability is the future in Europe, and the SFDR brings the region’s financial sector directly within its ambit. While it would help establish a more rigorous and robust mechanism to check the ESG-ness of investment products, it also implies extensive data requirements for the financial sector players, as well as comprehending how to operationalise this. That can unlock significant opportunity for ESG consultancies to support the financial sector as they move ahead with SFDR adoption.
Following the EU Green Taxonomy, the Sustainable Finance Disclosure Regulation (SFDR) is yet another step towards greening the European financial sector. Part of the European Commission’s Action Plan to fund sustainable growth, SFDR requires all the sectoral players in the EU (regulated under MiFID, UCITS and AIFMD) to disclose on ESG parameters, including whether the investment products they offer comply with ESG or sustainability objectives.
February 2021 saw an update with the European Supervisory Authority’s report on its regulatory technical standards, following the consultation paper released previously. The technical standards involve indicators related to Principal Adverse Impact (PAI) of investment decisions, or the negative impact on sustainability factors arising from investment decisions. 18 of these indicators are mandatory, while the rest are voluntary depending on materiality. Narrative–based disclosure under Level 1 reporting are required on the PAI indicators. Financial players must explain how they take sustainability risks, the risk of depreciation in the asset value owing to such risks and the adverse impacts on sustainability using disclosures at the product-level and entity-level (for larger players). The reporting would be on quarterly-intervals across the year. Pre-contractual documents must indicate how they consider sustainability risks and how they integrate them into their investing decisions/advice. These policies must be published on the website. Products as per the regulation’s Article 8 and Article 9 (including products that are moderately sustainable and highly sustainable, respectively) that use a reference benchmark must disclose the indicators that justify the benchmark aligns with E&S objectives. They must include a comparison with the performance of a relevant sustainable index.
It is anticipated products who disclose they do not achieve any sustainability consideration may face limitations on distribution reach. An inability to pitch such products to clients who show preference for ESG products would further limit their marketability.
The moot idea to enhance the transparency on the degree of sustainability of financial products, set disclosure parameters to reduce the challenge of greenwashing, an issue ESG critics have brought up time and again with the way sustainable investing is done today, and reorient the clients’ capital towards more sustainable investments. In essence, it will create a more rigorous, robust and fool-proof mechanism to check the ESG-ness of the investment products, instead of depending on methods like exclusionary screening which often led to some ‘unsustainable’ companies making the list because they had a high ESG score in rating models. That obviously indicates the lack of 100% efficacy of the current rating models.
Where the SFDR aligns with the EU Green Taxonomy is on disclosing how the investments comply with ‘do no significant harm’, although the taxonomy is far more detailed and more environment-focused currently.
Of course, these disclosures imply players must possess the ESG data on these indicators as well as ESG technical expertise. They will have to collect data from various sources, ensure data quality checks and build a data model. That means cost and time. The adoption of a legislative proposal to create a Single Access Point for sustainability information can help on this front. Another challenge is that several EU players have indicated the European Securities and Markets Authority is yet to publish ESG standards. Financial players are currently also struggling to understand the acceptable levels for PAI indicators and the scope of items that imply ‘significant harm’, apart from issues around data availability, research on sustainability risks, drafting policies integrating sustainability risks with investing decision-making, tools and reporting capabilities. This is where ESG consultancies must work with the financial sector players to help the latter plan and prepare for the SFDR requirements.
While any additional compliance requirement will be viewed as a burden by the industry players, institutional and retail investor demand for ESG-oriented investment products has developed into a secular trend, perhaps most so in Europe. If that is an indicator of the future demand for investing products, compliance with the SFDR to highlight genuine ESG-compliant products might be a prudent business/commercial decision for the players to adopt, rather than viewing it from the lens of compliance. The commercial motive would extend even to asset managers outside the EU. Say if a UK-based fund markets into the EU or manages an EU-based fund, it will be an Alternative Investment Fund Manager and would be subject to the SFDR.
At the end, the SFDR is a part of Europe’s efforts to create an enabling framework for a sustainable economy and a sustainable future. While surveys like Morgan Stanley’s Sustainable Signals have indicated a growing preference towards sustainable investing, the COVID-19 pandemic helped scale up this a notch when several exchanges saw their benchmark ESG indices outperform the broader benchmarks. As Europe re-emerges from the pandemic-induced slowdown, the resultant competition for investor capital will imply players cannot ignore disclosure requirements like the SFDR if they aspire to remain relevant in the market.