Credit funds that have spent the past year grappling with Sustainable Finance Disclosure Regulation compliance are now preparing for another wave of ESG regulations as the EU taxonomy rules come into force on 1 January, 2022.

While the SFDR aims to provide a harmonised approach around sustainability-related disclosures to investors, the taxonomy regulations seek to establish a framework for classifying environmentally sustainable economic activities using clear criteria. But with the regulatory technical standards that underpin both SFDR and the taxonomy significantly delayed and still in draft form, managers are facing uncertainty as they prepare for the next level of ESG disclosures.

SFDR, which came into force in March 2021, introduces separate disclosure requirements depending on whether a fund is Article 8, promoting positive environmental or social outcomes, or Article 9, specifically designed for sustainable investments.

“We have done a lot of work on ESG integration over the past year so that we could classify our current fund as Article 8,” says Coralie De Maesschalck, head of CSR and ESG at Kartesia. “We started to disclose more information on our website and in our quarterly reporting to investors in 2021. This was not mandatory yet, but we wanted to start early, to get familiar with all the requirements and to have time to adapt as the rules become clearer.”

New rules

The next step will be to get to grips with the taxonomy next year. “The taxonomy is even more complex to understand and interpret,” says De Maesschalck. “We are doing that work right now. It is really big for funds like ours, so managers have to start early and take a bottom-up approach.”

How SFDR classifies ESG funds

SFDR came into force on 10 March 2021, starting with a principles-based approach given the details were yet to be ironed out.

Managers must provide greater transparency about their sustainability policies on their website, in fundraising materials and in quarterly reporting to investors, with the precise requirements varying depending on whether a fund is Article 8, promoting positive environmental or social outcomes, or Article 9, specifically designed to make sustainable investments.

The principal challenge under the taxonomy is that managers must use it to determine the sustainability of their underlying investments and then report on which environmental objectives their investments seek to address. The taxonomy regulations set out six environmental objectives, including climate change mitigation and pollution prevention and control, and activities can qualify as environmentally sustainable if they substantially contribute to one of those six objectives.

The taxonomy rules build on the SFDR by putting additional disclosure obligations on Article 8 and Article 9 funds. Others must insert a disclaimer making clear to investors that they do not take the criteria for environmentally sustainable economic activities into account. Not only do the taxonomy regulations begin taking effect at the start of next year, so too do the regulatory technical standards of SFDR, putting meat on the bones of that legislation.

Paul Ellison, a funds regulatory partner with the law firm Clifford Chance, says: “Initially, SFDR was done on a principles-based basis, so firms could disclose in a way that was appropriate for their activities. Now we are moving towards regulatory templates for those disclosures, which are more prescriptive, particularly for Article 8 and Article 9 funds.

“Firms are really grappling with how to cope with the level of granularity now required. If you are a debt fund then you won’t always have the same information rights in relation to your investments that an equity investor might have. So, debt fund managers are looking closely at the information rights they have, and what they want to put into new debt agreements when they are doing primary origination to help them to comply with these new reporting obligations.”

“The EU has been a phenomenal leader in this area in our view, but it is almost struggling to keep up with itself”

Tim Lewis
Travers Smith

Managers that are investing in secondary debt, where terms are already in place, will have to make do with the existing information rights that may not be SFDR or even ESG sufficient. And those invested in listed debt instruments again won’t have direct control over the terms of the documents so will be looking to their information provision rights to see what can be done.

Ellison says: “In theory, funds could be in a position where they have to report information that they can’t get, but in practice they are finding ways to get that information and having conversations with borrowers. If you have an Article 8 or Article 9 product, then you need to be making disclosures at the product level, which requires quite a lot of granular information on what is in the portfolio. If you can’t get that, you might struggle to comply.”

Data challenge

De Maesschalck agrees that sourcing data is a big part of the challenge for credit managers: “Clearly getting the data is a significant issue. We are a debt fund, we don’t own equity, and so sometimes having access to management is a bit more difficult than it would be for private equity. We also invest in small, mid-cap companies, so sometimes they don’t even track this data internally. We started by sending a questionnaire to portfolio companies last year, because we expected them to take two or three years to set up the necessary reporting internally.”

“Firms are really grappling with how
to cope with the level of granularity now required”

Paul Ellison
Clifford Chance

She argues the best option for credit funds is to start work on this early, and also to consider the use of modelling in instances where, even with access to management, portfolio companies just do not have the information. In those situations models can be used to estimate and compensate for lack of data, coming up with a calculation for the carbon footprint of a company of a certain size in a certain sector, for example, based on data available from peers and other sources.

Despite the much more onerous obligations on funds that are categorised as either Article 8 or Article 9 under SFDR, evidence suggests managers have been keen to have their funds labelled as such. In April 2021, less than a month into the new rules, data from Morningstar suggested that €2.5 trillion in European fund assets already sat in Article 8 and Article 9 funds, with preliminary data from 30 asset managers indicating up to 21 percent of total European funds were included.

Tim Lewis, a partner with the law firm Travers Smith, says: “SFDR was never really designed as a labelling regime – it was meant to be an anti-greenwashing regime requiring fund managers selling green funds to provide disclosures to investors so they could see what exactly was being proposed and decide whether that was what they wanted to invest in.

“What’s ended up happening is institutional investors have chosen to treat the regime as a labelling regime, partly because it is a convenient way of understanding a fund’s approach depending on how the regime applies. There therefore seems to be more of a move from European investors to want to have Article 8 and Article 9 funds to invest in, and we expect that direction of travel to continue next year.”

Lewis says that at the moment only a small number of funds are trying to seek an Article 9 classification. There are several reasons, but one is the fact that Article 9 funds need to show they are investing in companies with environmental objectives, and the taxonomy is still unclear on how to prove that.

“If you are saying the objective of the fund is climate change mitigation or adaption, all of the investments have to comply under the technical screening criteria of the taxonomy in respect of those objectives,” says Lewis. “But those technical screening criteria haven’t been finalised yet, even though that’s all supposed to come into effect on 1 January. That’s a real problem because if the criteria aren’t formalised, how can a manager say with certainty to investors that it is going to meet them.”

Instead, it appears many managers have opted to go down the Article 8 route and minimise the risk that they will have to downgrade funds later. More Article 9 will likely come onto the market as the rules get clearer.

Lewis says: “The EU has been a phenomenal leader in this area in our view, but it is almost struggling to keep up with itself. The great thing is that this terminology of SFDR Article 8 and Article 9 has become quite commonplace already, though we have seen some teething trouble as the regime develops and managers seek certainty to know what is required.”

The good news is it is likely to be some time before regulators take any action against managers for non-compliance. “During the course of next year, the really hard regulatory technical standards and taxonomy obligations bite and firms will start to seek solutions to issues,” says Ellison. “Then we will see the regulatory reaction. There is a build-up phase, then an implementation phase, and then after a year to 18 months the regulators tend to come back and share their views on what they are seeing and what their expectations are. That will be a bit of an iterative process as this all comes in.”

What is already apparent is that investor appetite is driving managers to embrace the challenges of getting this right. De Maesschalck says: “Because we have integrated ESG at Kartesia from the beginning, we were able to classify our current fund as Article 8 and we are currently brainstorming on the potential for Article 9 funds. We want to take our time, because memos are still being issued on a regular basis and it takes time to set up a strategy, but we are working on it and want to start doing impact when we have all the cards in our hands.

“Despite the interpretation challenges and additional reporting requirements of SFDR and the taxonomy, we see this as something very positive for Kartesia and for the private debt market. We see a big impact across private debt thanks to SFDR – we have really caught up and are now moving at the same pace as other asset classes.”