Arun Srivastava, Regulatory and Fintech Partner at Paul Hastings, places SFDR’s impact in context of wider regulatory developments.
Over the last few years, society has become increasingly aware of the importance of health, environmental issues and social justice, and 2020 saw this accelerate even further. These societal changes are reflected in new EU rules, the Sustainable Finance Disclosure Regulations (SFDR), which came into force on 10 March, with the aim channelling capital flows towards sustainable investments.
In line with these new rules, managers and advisers will need to take a more holistic approach towards their investment processes. While financial data and performance will remain key, it will need to be supplemented by information on a range of non-financial matters too. This will provide a view on how investee companies approach environmental, social and governance (ESG) considerations and, therefore, reflect on the quality of the investee’s governance, in addition to quantitative matters relating to financial performance.
Impact on companies’ sustainability strategies
It is important to clarify that sustainable investing will not become mandatory from 10 March. Firms can still produce products which are not sustainability compliant, provided that the products are not promoted in this way. However, new ‘comply or explain’ disclosure standards, and expectations from investors for managers to produce greener investment products will create pressure on firms to incorporate sustainability in their investment processes and advice. This is the clear direction of travel.
The rules contained in the SFDR will, therefore, result in change across the entire investment sector. Although the rules apply directly to investment managers and advisors, they are equally important for investee businesses. In order to attract investment, investee companies will increasingly need to implement ESG strategies and be prepared to work closely with investors’ sustainability teams. They will also need to publish and have information available that will enable investors to assess their own ESG compliance.
While there have previously been concerns raised around the perceived dichotomy between sustainable investing and profitable investing, this is false. Sustainable investing, which focuses on quality of governance and requires investment firms to take into account a wider range of information as part of their due diligence processes, can also be profitable. In fact, firms who have lower levels of employee satisfaction, and have poor compliance and governance standards are likely to be riskier investments.
Legal duties of companies operating in the EU
Over recent years, investment committees have been increasingly assessing non-financial data when making investment decisions. SFDR will standardise this approach, with firms having to explain how sustainability risks are considered in both investment decision making and advisory processes. Simply having in place restricted or negative exclusion lists, such as ‘sin sectors’, from eligibility for investment will no longer be sufficient for products held out as sustainable.
For funds promoted as sustainable, or which have sustainability as an investment objective, managers will now need to assess a broad range of information in relation to their investee companies or other underlying investments. A diverse range of data will need to be collated, including in relation to matters such as an investee company’s carbon emissions, use of renewable energy, labour relations and compliance records.
The SFDR will work alongside, and complement, other regulations that focus within a similar area. For example, the Non-Financial Reporting Directive, which was introduced in 2014, already requires listed companies to include a non-financial statement in their annual report covering environmental, social and employee matters, respect for human rights, anti-corruption and bribery matters.
Further, with a specific focus on environmental issues, the Taxonomy Regulation, which will apply in the EU from January 2022, creates a harmonised system for the classification of environmentally sustainable activities in the EU. It will require large entities to include additional information in their non-financial statement on how and to what extent their activities are associated with environmentally sustainable economic activities. This will include matters such as the proportion of their turnover derived from products or services associated with economic activities that qualify as environmentally sustainable.
The SFDR is also complementary to the disclosure requirements introduced by the second Shareholder Rights Directive (SRD II), which imposes new obligations on assets managers. Under these rules, managers are required to develop a policy on shareholder engagement, make that policy available on their website and annually disclose how they have implemented the policy and how they have cast votes at general meetings. One of the reasons for amending the original SRD was to obtain greater shareholder engagement in corporate governance, since it is one of the levers that can help improve the financial and non-financial performance of companies.
Harmonising regulation sustainable investing standards
Until now, the EU lacked a harmonised approach to sustainable investing standards. The SFDR will impose new discipline around how investments are promoted and create transparency around investment processes and objectives, where products are held out as ‘green’. This is a wider reflection of investors’ attitudes over recent years, so formalising these expectations is helpful.
In terms of the wider picture, the new rules are part of the EU’s objective to move towards a sustainable economy, and alongside other regulations, should work towards building a financial system that promotes sustainable growth. It’s therefore encouraging that steps are being taken to improve the current system and will hopefully benefit the economy moving forwards.