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

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.

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 has been raised by private capital funds that integrate ESG principles over the last decade.

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 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.

SFDR: hanging the greenwashers out to dry

The EU has taken a particularly tough line on greenwashing. 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. Under the new regulation’s “Level 1” requirements, asset managers are already subject to entity-level disclosures regarding the integration of sustainability risks into investment decisions. The more detailed “Level 2” requirements, setting out the regulatory technical standards to be used by financial market participants, were published on 25 July 2022 in the Official Journal of the EU and will apply from 1 January 2023.

Under the SFDR, asset managers need to classify their funds into three groups:

  • “Dark green” (Article 9) funds have sustainable investment as their objective.
  • “Light green” (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.

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

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. In our Global ESG Survey, more than 70% of firms said they had only introduced ESG scoring in the past two years. 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

Although the regulatory technical standards under Level 2 of SFDR apply from 1 January 2023, market participants must consider the principal adverse impacts of investment decisions on sustainability factors by 31 December 2022 and publish information on these impacts by 30 June 2023. Furthermore, the first reference period for reporting will be 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 of BNP Paribas performs investment compliance in 17 locations for over EUR 2.2 trillion of client assets[1], using a specialist proprietary system that supports monitoring processes across a wide variety of fund types including UCITS, AIFs, ‘40 Act funds and mandates.
  • Sustainable finance is a core part of BNP Paribas’ strategy and the bank has set ambitious decarbonisation and sustainable investment targets to be met by 2025. In 2022 we were named by the Euromoney Awards for Excellence as the Best Bank for Sustainable Finance and the Best Bank for ESG Data and Technology.

[1] Internal figures, 2021

Related solutions

Depositary bank & Trustee services

Regulatory change – and principally the desire to ensure the fund industry continues to provide products in which investors have confidence – has focused attention on the Trustee and Depositary function.