With SFDR phase 2, are your investment compliance capabilities ready?

​Outsourced investment screening solutions can help firms to ensure that they can adapt successfully to the new phase of SFDR

Outsourced investment screening solutions can help firms to ensure that they have an ESG compliance process that is up to date, can grow with their monitoring needs and help them to adapt successfully to the new phase of SFDR.

The exponential growth of ESG and sustainable investing shows no sign of slowing down. Almost half the world’s assets under management are now committed to a net zero emissions target, with Bloomberg predicting this may surpass USD 53 trillion by 2025 According to the Sustainability Institute’s 2022 Trends Report more than $3 trillion in combined assets have been raised over the last decade by private capital funds that integrate ESG principles.

It is, however, not easy for firms to accurately assess the true ESG credentials of different funds – a process made harder by the inconsistency of ESG labelling practices.

Across Europe, individual member states offer their own flavours, with EU funds able to choose from at least nine ESG style labels. The criteria underlying the labels combine objective standards (usually in the form of sector exclusions or limitations) with subjective criteria including ESG practices, internal controls and guidance on exercising voting rights. The use of these subjective criteria, which relies on individual asset managers’ interpretations, has led to some concern in the industry about consistency of labelling and the potential for managers to make misleading claims.

To reduce this risk of greenwashing and create a more level playing field, legislators and regulators across the world are introducing tough disclosure, screening and reporting measures.

Direct access to SFDR insights: “SFDR: a piece of the puzzle to prevent greenwashing”

The evolving role of outsourced investment compliance

Increasingly, both asset owners and managers have to screen their portfolios to confirm they adhere to the relevant sustainability or ESG criteria. But while negative screening has been an established ESG methodology for many years, ESG scoring for disclosure purposes is in its infancy. This is where investment compliance monitoring solutions can help.

Fund classification and credentials

How can managers prove that a product should be classified under article 8 or 9 of the SFDR? An outsourced investment compliance solution can provide independent confirmation of the fund’s classification and credentials to the asset owner, regulator and investors.

Whether a fund seeks to confirm adherence to SFDR or the ESG-related fund labels already issued by some EU member states, the monitoring process can be enriched with new rules to monitor the additional ESG criteria. For instance, carbon footprint metrics can be monitored at asset and portfolio level to validate the fund meets its objectives as well as the monitoring of a portfolio’s alignment to the EU taxonomy. Rule cards can be developed to monitor the unique criteria applicable to labels and confirm a fund’s adherence to its benchmark.

Independent assurance

It is vital that the investment compliance rules which underpin ESG labels are appropriate and regularly monitored. Institutional investors need independent assurance to confirm that the criteria that support the labels are met, for example, sector exclusions and exclusion of companies involved in prohibited activities.

Most asset managers are developing their own ESG scoring based on huge amounts of raw data. Asset owners want to make sure the manager will do what it says, and may require much stricter controls in their ESG portfolios. By relying on third-party independent checks and data sources, they can make sure their ESG-related investment guidelines are strictly adhered to and mitigate the risk of greenwashing.

Independent third-party validation of non-financial processes, controls and data outputs can also help managers to build trust with investors and differentiate their products from other managers whose products use in-house, or limited, screening processes.

Scalability and expertise

The regulatory technical standards under Level 2 of SFDR have applied from 1 January 2023. Market participants should already be considering the principal adverse impacts of investment decisions on sustainability factors and be publishing information on these impacts by 30 June 2023. Furthermore, the first reference period for reporting were from 1 January 2022 to 31 December 2022. This means that firms must already have appropriate screening methodologies, provide the relevant disclosures, and ensure adherence to the correct categorisation and labels.

However, many firms may not have in-house teams with the necessary, specialist expertise required to incorporate sophisticated ESG criteria into their compliance monitoring processes. Screening and monitoring ESG criteria requires look-through capabilities, data and the technical expertise to conduct portfolio, fund and company level assessments to examine the underlying assets’ exposure. An outsourced investment compliance provider can offer large teams of compliance specialists and other ESG experts, as well as the technological capabilities and systems to integrate complex ESG factors into monitoring workflows.

Beyond compliance: from reactive to proactive

Investment compliance has traditionally been a reactive service, informing managers of breaches once portfolio criteria has been contravened and recommending corrective actions. Responding to the increasing demands of the SFDR and investors, the service is now evolving to play a more proactive role. We  partner with firms to reduce the rate of breaches through an ‘early warning’ system. For example, if a firm has a 5% limit of assets with carbon exposure, our solution can put in a warning at 4% to give clients time to change their investment choices and avoid triggering a breach.

Building the ESG compliance capabilities of the future

Investor interest in ESG funds is only set to grow, and with it, the accompanying regulatory measures to ensure a level playing field and to protect investors from potential mis-selling.  Increasingly, investment compliance providers are vital partners in helping the investment industry to build trust with investors and ensure ESG funds are constructed in accordance with regulations.

About our ESG and investment compliance solutions

The Securities Services business of BNP Paribas performs investment compliance in 17 locations for over EUR 2.3 trillion of client assets1 , using a specialist proprietary system that supports monitoring processes across a wide variety of fund types including UCITS, AIFs, ‘40 Act funds and mandates.

SFDR: a piece of the puzzle to prevent greenwashing

The European Supervisory Authorities have taken a particularly strict line on greenwashing. Their recent Call for Evidence which closed on 16 January 2023 evidences this trend.

The SFDR, first introduced in March 2021, aims to bring consistency and comparability to the EU fund industry’s sustainability-related labelling, and provide greater transparency on financial products’ sustainability.

It aims at improving:

  • Sustainability-related disclosures
  • Comparability of the disclosures for end investors
  • Reducing the occurrence of adverse sustainability impacts and greenwashing.

Under the “Level 1” requirements, asset managers are already subject to entity-level disclosures regarding the integration of sustainability risks into investment decisions and have to classify their funds into three groups:

  • “Dark green” funds (Article 9) have sustainable investment as their objective.
  • “Light green” funds (Article 8) promote environmental and/or social characteristics.
  • “Grey” funds (Article 6) have no sustainability commitments in the investment process and no exclusions in the portfolio.

SFDR, not a labelling regime

SFDR is not a labelling regime as expressly stated in the explanatory memorandum accompanying the final version of the “Level 2” disclosure requirements. It needs to be considered together with transparency on methodologies, ESG scoring, data sources, etc. Therefore, an element of caution is needed and the introduction of independent oversight may induce a degree of comfort for asset managers that their chosen ESG strategy does not risk being considered “greenwashing”.

“Sustainable investment” definition at the centre of SFDR Article 9 financial products

The definition of sustainable investment at the center of the Article 9 funds’ definition still proves to be extremely challenging for financial market participants given the continuing absence of a regulatory definition and a lack of harmonisation across the European Union with respect to the interpretation of this concept, alongside comparable ESG data.

In summer 2021, the EU Commission attempted to introduce a level of clarity when it specified that funds making Article 9 disclosures may only invest in sustainable investments based on the definition provided by Article 2 (17) of the SFDR, with the exception of cash and assets used for hedging purposes.

This lack of certainty as to the meaning of sustainable investment, ahead of the introduction of Level 2 SFDR requirements, is acknowledged as being a key driver behind the recent reclassification by asset managers of ESG funds from Article 9 (most stringent compliance with ESG criteria) to Article 8 (less stringent).

New technical standards live since January 2023

As from 1 January 2023, the “Level 2”requirements set out the regulatory technical standards to be used by financial market participants apply, including:

  • The entity-level Principal Adverse Impact (PAI) reporting template and indicators (a minimum of 20 indicators: 18 (mandatory) + 2 (optional))  ( Annex1)  
  • The mandatory pre-contractual / periodic templates (including the EU Taxonomy-related disclosures) for Article 8 and 9 products (Annex 2Annex 3Annex 4 and Annex 5).

The enhanced disclosure requirements for “light green” and “dark green” funds significantly raise the bar for investment firms’ ESG scoring.

Sustainable Finance Disclosure Regulation (SFDR) – regulation memo

[1] Internal figures, Securities Services, 2022

Article initially published in 2021 and reviewed in March 2023

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