From March next year, new European regulations will require fund managers to disclose their ESG policies and practices or risk facing difficult questions. While the rules have been beset by controversy and delays, they create a new compliance challenge and represent just 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 (SFDR); 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, or have a sustainable investment objective.

There have been delays to some details 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 concerned that a lot of funds could fall in the scope of the disclosure requirements”

Kirsten Lapham

“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 of a project as it could have been if it had all been coming into force in March next year. 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.

William Yonge, a partner specialising in financial regulation 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.

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.“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.”

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.”

Adverse impacts

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.”

Michael Raymond, a partner at Travers Smith, adds: “It is arguably easier for a control position private equity investor to pull together that information from underlying companies, but for a credit investor it is likely to be much more difficult to get this data, whether from third-party service providers or from the borrower itself. Data gaps will be a huge issue generally.”

That is a view shared by Paul Davies, a partner at Latham & Watkins. “Debt funds active in the SME lending space are likely to be constrained by the lack of ESG data from portfolio companies,” he says. “Pricing a loan to a borrower typically involves performing a credit analysis and testing traditional financial metrics of the borrower. Testing sustainability risks as part of such credit analysis will require the borrower to provide ESG data. An SME borrower may not have achieved the size and scale required to measure or collect ESG data required for the debt fund manager to test sustainability risks and consequently provide purposeful disclosures.”

The good news is that it is possible for managers to decide that sustainability risks are not relevant for a particular product, and then simply say that in pre-contractual disclosure, thereby opting out of the rules.

It is also unlikely that 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,” Verwey says.

“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.”

Which way will the UK jump?

Brexit throws an added complication into the mix. “One of the big uncertainties is which way the UK will jump,” Michael Raymond of Travers Smith says. “As the new EU rules come into force after the end of the Brexit transitional period, the UK is not obliged to implement them and they have not automatically become part of UK law. Although the UK government is committed to the macro-level aspirations that drive these new rules, the policymakers have yet to confirm if they will follow them or implement a UK-specific version.”

Raymond says the ambiguity 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 or UCITS 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.”