The EU’s Regulation on sustainability-related financial disclosures (SFDR) came into effect on 10 March 2021, and has already had an important impact after its first year of application.
The SFDR set out the framework for a wide range of EU asset managers, and other providers of financial services and products, to disclose how they incorporate environmental, social and governance considerations in their investment decision making process. Much of the detail of the legislation is set out in underlying regulatory technical standards (RTS), a process that is finally reaching completion, with the technical standards due to apply in January 2022.
The SFDR set out a tier of disclosures, mainly depending on the scope of the asset manager’s ESG related ambitions. Disclosures – and ongoing reporting – will be made on the basis of detailed templates in the technical standards. While allowing investors to make side-by-side comparisons between manager’s approaches within a particular tier, this approach inevitably came with a degree of artificiality and at the risk of some confusion as to the scope of each tier.
At the bottom tier is the concept of “sustainability risk”, described in the SFDR as environmental, social or governance events or conditions that could cause a material negative impact on the value of an investment. Value-related sustainability risks are considered relevant to all – or almost all – managers.
The next tier – Article 4 of the SFDR – relates to the “principal adverse impacts of investment decisions on sustainability factors”. Larger managers (broadly, those with more than 500 employees) that cannot opt out of this tier of disclosure are required to assess, across their portfolios, a set list of “sustainability factors”, and describe the actions, if any, taken to address the impact of their investment decisions on those sustainability factors.
Given the breadth of this obligation, it is inevitable that firms in scope will, for a long period, have incomplete sets of data, and questions remain as to the efforts that firms should go to in order to collect the data and their reliance on estimated or proxy data.
The next tier – Article 8 of the SFDR – requires specific pre-contractual, and importantly, ongoing disclosure from those products that promote environmental or social characteristics, with particular focus on the manager identifying the type of sustainability related data collected and reporting that data on an ongoing basis to investors. All managers in scope of Article 8 are also expected to disclose their approach to ensuring “good governance” of their investments. It seems clear from the RTS that Article 8 products can, but do not need to, allocate a portion of their portfolio to making “sustainable investments”, which are investments whose business activity inherently contributes to a specific social or environmental objective and also respect the principle of “do no significant harm” to any other social or environmental objective.
The last tier – Article 9 of the SFDR – encompasses funds with sustainable investment as their objective. As for Article 8, the sponsor of the product must substantiate the investment’s focus on sustainable investments with detailed information on the type of investments targeted, and the degree to which those investments over the life of the fund contribute to their environmental or social objectives. Article 9 particularly encompasses
“Impact Funds”, funds that invest exclusively with a view to generating a social or environmental good.
Lastly, the SFDR incorporates various aspects of the separate EU Taxonomy Regulation, and in particular requires funds within scope of Article 8 or 9 of the SFDR to disclose the proportion of the fund that qualifies as aligned with the EU taxonomy technical screening criteria – currently in place for activities that contribute to climate change mitigation or adaptation.
How successful is the SFDR? At this stage, before sponsors are required to adopt the detailed disclosure and reporting templates, its success in improving disclosure, and improving manager’s overall approach to integrated environmental and social considerations, is hard to gauge. However, it is telling that ESMA in its recent “Sustainable Finance Roadmap” referred to the “heightened risk of greenwashing” arising from the SFDR and the “unequal understanding of the type of products which are subject to Articles 8 and 9 of the SFDR”. In particular, many commentators have pointed to Article 8 being a disclosure requirement (simply put, to substantiate how the sponsor will incorporate ESG in its investment decisions) but also carrying weight with investors as a “label” that indicates the product substantively considers ESG matters – with the benefit of this “label” putting the product at heightened risk of greenwashing, arguably contrary to the Commission’s original intentions. The UK’s proposal for Sustainability Disclosure Requirements – currently at discussion stage – noticeably distinguishes between a system of ESG disclosure and a separate product label.
Separately, while the SFDR puts forward reasonably concrete criteria for an investment to qualify as a “sustainable investment” (that the investment must contribute to an environmental or social objective, must show that it does not significantly harm any environmental or social objective and that the investment follows “good governance” considerations), there remains considerable doubt as to the process that a sponsor must put in place to for the purpose of these criteria. Most impact investors will already be following a version of these checks in their investment, while reserving broad judgement as to whether these criteria are met on an investment by investment basis.
Like much EU financial services regulation, the SFDR was largely without precedent in any other jurisdiction, was ambitious in scope and came with a degree of ambiguity that takes time – and potentially future amendment to the Regulation – to resolve. However, we can already see that it changes the ambitions of private fund sponsors, as the SFDR sets a high-level bar to qualifying under its labels.
The authors are Patricia Volhard, partner, and John Young, international counsel, of law firm Debevoise & Plimpton.