Sustainable Finance Disclosure Regulation (SFDR) is a great opportunity for investors to demonstrate how serious they are about sustainability and ESG.
In the first major move by a regulator to codify ESG disclosure rules, the EU introduced the Sustainable Finance Disclosure Regulation (SFDR) on 10 March, 2021. This represents a massive step change for asset managers and asset owners. Importantly, the changes will not just affect those inside the bloc, as SFDR also applies to non-EU managers that market to EU investors.
Designed to strengthen protection for end-investors, SFDR improves disclosures on the principal adverse impacts – in other words, the negative externalities – of investment decisions and on the sustainability features of financial products.
One of the main objectives of SFDR is to crack down on so-called “greenwashing” and achieve comparability between end products, while placing sustainability risks and factors at the centre of their operations and investment approach. It requires asset managers to be clear on how and to what extent they integrate sustainability risks into their decision-making process, how they reflect this in their risk management process, and how they can assess the impact of this risk on their product performance.
Before SFDR, it was relatively simple to create ESG funds, which have attracted significant investor inflows in recent years, but financial market participants now face additional hurdles when creating them.
What are the new requirements of SFDR?
Asset managers must demonstrate their ESG ambitions and engagement and show how far they go in creating, promoting and reporting on sustainability metrics. They need to collect and report ESG data, and then implement policies and disclose how they integrate sustainability risks into investment decisions.
Asset managers (including alternatives) and asset owners (including pension funds and insurers) – with over 500 employees – must also disclose whether they take the main adverse effects of investment decisions on sustainability factors into account. Under a ‘comply or explain’ approach, smaller entities with fewer than 500 employees have the option not to consider the impact of sustainable factors on investment decisions – but they must justify it accurately and precisely.
SFDR requires market participants to publish their sustainable investment strategies and policies on their websites.
Investment funds also must be categorised into three levels of sustainability – grey (Article 6), light green (Article 8) and dark green (Article 9) – and documentation, marketing material and reporting must be amended accordingly.
Many asset managers and some asset owners have already disclosed how they embed sustainability in their investment portfolios, and published statistics to which ‘green level’ their funds fall under. This is because they want to demonstrate their level of engagement with sustainability and give comfort to investors who want to act and align their sustainable strategies.
Before investing in a company, asset managers must put in place an ESG policy to understand and assess all the risks. This is a significant exercise because of the sheer amount of raw data from companies’ Corporate Sustainability Reports (CSR) and engagement strategies that will need to be collected and parsed, as well as taking into account controversies.
A major issue is the lack of consistent ESG data in the investment universe. To tackle the problem, the EU is now proposing to have a single data access point for listed equities and bonds. However, this will not solve the issue that it is difficult to obtain data on other types of companies. Small and medium sized entities (SMEs) do not provide as much ESG data as listed entities, and it is even more challenging to obtain data from private capital firms.
While some data providers are developing expertise in these areas, more disclosure is needed from these companies, and this can be helped by more collaboration between companies and institutional investors. In this respect, it is important to note that on 21 April 2021, the EU Commission proposed a Corporate Sustainability Reporting Directive (CSRD), which, if implemented, will extend the scope of reporting requirements to all large companies, whether they are listed or not. It would also remove an existing 500-employee threshold.
This year, as SFDR gets underway, we will start to see how asset managers and asset owners position themselves under the regulation. Clients that have categorised their funds as Article 6 or 8 may have ambitions to ‘go greener’ and classify as dark green under Article 9 in order to put themselves at the forefront of the sustainable finance shift.
In any event, ensuring compliance will be time-consuming, and so another challenge for asset owners and asset managers is to absorb the cost of complying with SFDR.
What is next for SFDR?
The Level 2 Regulatory Technical Standards (RTS) are set to come into force in 2022. They will introduce more detailed requirements to provide market participants with a holistic picture of the ESG legislation and how it is intended to apply. They will lay down additional rules for the financial products defined in Article 8 and 9 of SFDR.
While non-EU managers that have EU investors and are currently closed to new investors do not need to report under SFDR, they will be potentially required to comply if they plan to raise funds from EU investors in the future.
At BNP Paribas, we believe the EU’s SFDR could steer the sustainable finance shift globally and potentially influence non-EU countries. Some regulators in other regions such as the Asia Pacific and North America could introduce similar rules in the future. Thus, the US Securities and Exchange Commission (SEC) and several other regulators have created task forces to enable standardisation of ESG reporting frameworks.
Even non-EU asset managers that do not have to comply with SFDR should take the opportunity to get ahead of the game and ensure they can collect and analyse ESG data before similar regulation is inevitably introduced in their domestic markets.
More to come
Asset managers and asset owners will have to stay ahead as SFDR evolves over time.
In parallel, clients will also be impacted by many other regulations that will soon be upgraded. For example, asset managers in Europe will have to upgrade their risk management procedures to reflect the integration of systemic risks. Distribution rules under MiFID will also be upgraded to reflect some ESG components to make sure that products meet their stated objectives, and that end-investors are fully aware of the ESG characteristics or objectives at the time of sale.
The European Insurance and Occupational Pensions Authority (EIOPA) has issued an opinion setting out expectations for insurers integrating climate change risk scenarios in their Own Risk and Solvency Assessment (ORSA). In the ORSA, insurers should conduct an assessment of material climate change risk exposures.
At BNP Paribas Securities Services, we believe there is still a huge amount of work to be done to ensure ESG or sustainable investments are accessible and comparable for everyone, and some asset managers will need to expedite plans to integrate these into their strategic roadmap if they want to keep pace with the market.
Asset service providers such as BNP Paribas Securities Services are an important part of the value chain. We proactively engage with our clients – whether they are investors or manufacturers – to aid their understanding of new regulatory obligations, and create solutions to help them comply.
The paradigm is clearly shifting on ESG, and we believe SFDR is a great opportunity for our asset owner and asset manager clients to demonstrate how serious they are about sustainable investing.
To help our clients better understand and respond to these new requirements, we have developed a step-by-step guide to SFDR, laying out the specific disclosure obligations that need to be applied at entity and product level. Click here to download a free copy.