From March, new EU regulations will require fund managers to disclose their environmental, social and governance policies and practices or risk facing difficult questions. Although the rules have been beset by controversy and delays, they represent a new compliance challenge and the beginning of enhanced scrutiny of funds’ ESG efforts.
The EU’s sustainable finance and climate change agenda comprises three pillars: the Taxonomy Regulation, which sets out a framework of definitions to help investors assess whether activities really are sustainable; the Sustainable Finance Disclosure Regulation; and the Low Carbon Benchmarks Regulation. The Taxonomy Regulation will now not apply until 2022 at the earliest, making the SFDR, which comes into force on 10 March 2021, the most pressing.
The SFDR requires all investment fund managers to disclose, for all the funds they manage, how sustainability risks are integrated into their investment decisions and the likely impact of sustainability risks on returns. There are additional requirements for funds that promote environmental or social characteristics, and for those that have a sustainable investment objective.
There have been delays to some of the SFDR’s mandated disclosures – the so-called Level 2 requirements – meaning not everything will come into force in March as originally intended.
“Firms are going to have to think about making sure they are making the necessary disclosures at firm level, product level, and for ESG-specific products,” says John Verwey, a partner in the private funds group at Proskauer. “On the basis that Level 2 will likely be delayed, that shouldn’t be as onerous a project as it could have been if it had all been coming into force in March. That being said, it is still something that needs to be done and be focused on.”
Two requirements that are going ahead as planned require disclosure of the integration of sustainability risks into investment decisions, and of how a firm’s remuneration policy is consistent with that process.
“Next, in relation to both of those initial tasks, you would need to be aware that you would be obliged to publish on your website the main features of your sustainability risks policy, or the whole policy if you wanted to be completely transparent voluntarily, and information showing consistency with your remuneration policy. You are not required to publish the revised remuneration policy.”William Yonge, a partner at Morgan Lewis, says: “In terms of formulating an internal checklist, you would first start with creating an internal policy describing how sustainability risks are considered in your investment decision processes. Then you would amend your remuneration policy to ensure consistency with the integration of sustainability risks.
“Firms are concerned that a lot of funds could fall in the scope of the disclosure requirements by promoting an environmental or social characteristic or as having a sustainable investment objective, even if they are not being promoted as green funds.”
The next step would be a requirement to look at the product range to see if any funds fall within the definition of promoting ESG goals.
Kirsten Lapham, partner at Proskauer, says: “Firms are concerned that a lot of funds could fall in the scope of the disclosure requirements by promoting an environmental or social characteristic or as having a sustainable investment objective, even if they are not being promoted as green funds. They may make some broad references to ESG or make negative statements about avoiding investments in tobacco or palm oil forestry, for example, and there are questions being raised as to whether these kind of references would mean that they are captured by the more wide-ranging disclosure rules.”
Probably the most contentious aspect of the new proposals is a requirement for funds to disclose the principal adverse impacts of their business on the world at large, which will be mandatory for certain large investment firms and optional for others. It was initially planned that this disclosure would need to be against more than 30 mandatory indicators, on a whole-firm basis across strategies, but while the headline requirement to disclose remains live, implementation on the underlying detail and the indicators has been pushed back while regulators digest feedback.
Yonge says: “The consultation on some of this has been very difficult, and there is a feeling that it is unrealistic to expect managers to make quantitative assessments of the impact of their investments on sustainability measures, because there is insufficient information available to them. The top regulation does allow for the making of qualitative assessments, which are regarded as much more realistic.”
It is unlikely we will see heavy-handed enforcement. “I don’t think the regulators are really going to go after fund and asset managers and enforce for lack of compliance from day one as the Level 1 Regulation is high-level and open to varying interpretations,” says Verwey. “The real penalty is that if firms don’t comply then investors are going to push back on why there is not a policy or ESG decision-making framework in place, so there will be a commercial impact. A lot of the rules are based on the principle of either ‘explain how you comply’ or, if not, ‘explain why you don’t comply’, rather than any prescriptive instructions. That makes it incumbent on a firm to either comply with all the ESG requirements or otherwise explain its reasons for not doing so.”
Impact of Brexit
Brexit presents an added complication. It has now been confirmed that the UK will not implement SFDR and will instead put forward a different set of recommendations. In November, UK chancellor Rishi Sunak announced plans to mandate climate disclosures by large companies and financial institutions by 2025.
The country’s Financial Conduct Authority intends to consult on its plans for ‘UK SFDR’ in early 2021, with director of strategy Richard Monks setting out the direction of travel in a recent speech. Nicola Higgs, regulatory partner at Latham & Watkins, says: “Monks’ speech makes clear that the FCA is considering whether it would be helpful to articulate a set of guiding principles to help firms with ESG product design and disclosure. These would overlap fairly significantly with the Level 1 rules of SFDR, covering topics such as sustainability policies, product disclosures and periodic reporting. This would suggest a comply or explain approach rather than mandatory disclosure standards, as in EU SFDR.
“However, pan-EU firms can take comfort that EU SFDR implementation plans are likely to comply with UK proposals for the most part, limiting the prospect of a double implementation burden.”
Michael Raymond, a partner at Travers Smith, says the ambiguity in the UK should not impact managers’ implementation of SFDR: “For most managers, this doesn’t mean they can ignore the EU rules as they will catch UK and international managers who, for example, offer private funds to EU investors. UK managers will therefore need to comply with a number of the new requirements on a lowest common denominator basis if they wish to access European capital.”
Paul Davies, partner and co-chair of the ESG taskforce at Latham, says: “International private equity houses may find themselves subject to EU regulatory requirements and/or other regulatory developments concerning ESG disclosure, including those that emerge in the UK. As such, the ability to obtain the necessary information and data from portfolio companies will be an important consideration.
“We can expect significant developments and innovation in technology, as the ESG data lake grows and resources are needed to enable a quick, simple and cost-effective means to analyse ESG performance and benchmark performance against peer companies.”