Just about everyone in private markets will, by now, have heard about the EU’s Sustainable Finance Disclosure Regulation (SFDR) or the forthcoming Green Taxonomy. In surveys, many GPs say that these legal changes are affecting their firm’s approach to sustainability.
Those engaged in fundraising will report a preference from European investors for products they can describe as “ESG funds” (or “SFDR Article 8 products”, to use the technical term). Financial intermediaries in the EU will soon have to start asking their clients whether they prefer products that are classified under the SFDR, a development that is expected to drive demand even higher.
And it is still early days. The SFDR became effective in March this year – and then only at a high level because detailed rules are still being finalised. The Taxonomy is due to become effective in stages from the beginning of 2022.
It is good news that the rules are already having an impact, and EU policymakers will be delighted to hear it. These complex regulations – a centrepiece of the EU’s Sustainable Finance Strategy – have apparently hit their mark. They seem to be catalysing a shift to sustainable finance in the private markets, which have a major role to play in financing the transition to a more sustainable economy.
But hold on. Let’s not hang the bunting out quite yet. A growing number of people are pointing out that the complexity inherent in these rules, and the compromises that are still being made to get them through the EU’s multi-layered law-making process, are a problem. In particular, many different types of “ESG fund” can fall into the Article 8 category, while the very narrow approach to Article 9 – the category of products whose objective is “sustainable investment” – means that many positive impact funds will struggle to qualify for that categorisation.
That might not be such an issue if the regulations did what they said on the tin: if they only created a disclosure regime. Unfortunately, whether deliberately or not, these classifications are actually operating as ‘labels’, and of course firms are keen to attract the capital that comes with having the right label.
A label that is not designed to be a label is dangerous. Even more so if the borderline between the categories is not well-defined or clear to the end-users. That is clearly the case with the SFDR, and commentators are not the only ones to have noticed.
In a recent speech, Natasha Cazenave, an Executive Director at ESMA, the pan-EU regulator, accepted that Article 8 of the SFDR “is designed to capture a very broad and heterogeneous set of financial products, allowing a broad spectrum of sustainability strategies with differing levels of intensity within that category”. This, she said, could make it challenging for investors to understand or even “lead to greenwashing”.
ESMA’s own analysis reveals that, in some countries, 77 percent of new public funds launched have ESG characteristics or objectives according to EU classifications, while in others only 7 percent of fund launches are claiming that badge. This must be a cause for concern.
In the private funds world, many genuinely ESG-focused managers are fully embracing the spirit of the EU rules – and the rapidly evolving preferences of their investors – and significantly upskilling their teams and enhancing their procedures. They recognise that private markets, and private equity fund managers in particular, have powerful incentives and the right tools to respond to society’s demands for more responsible stewardship and more sustainable businesses. Many GPs are gathering and reporting more data on the external impacts of their portfolio companies, while others are launching dedicated positive impact strategies.
If their approach to ESG brings them into Article 8 or 9 of the SFDR, these firms will need to make disclosures according to templates that are not yet final, and – by the admission of the regulators that drafted them – sub-optimal, because of the one-size-fits-all approach of the EU rules. Those disclosures may not be what their investors want – in fact, LPs will usually have their own individual requirements when it comes to ESG reporting. Investors will have to pay for the template reports anyway, whether or not they find them decision useful.
That is not good – but it’s not a disaster. What would be much more problematic is if investors begin to choose a closed-ended, 10-year fund on the basis of its SFDR categorisation – treating that as if it were a label, when all it really delivers is ongoing standard form disclosure.
In that case, the apparent shift to ESG funds that we would observe could actually be a mirage, with the EU rules obfuscating – rather than catalysing – changes in investor behaviour. That would be a missed opportunity for regulations that have the potential to make a significant contribution to the transition.
The private funds industry, and all the people that work in it, have a vested interest in helping to make these well-intentioned rules work. It is certainly not too late for that: it requires an active dialogue with EU policymakers, and a sophisticated approach to the regime by investors.
Simon Witney is a senior consultant at law firm Travers Smith.