SFDR Level 1 is just one step toward quantifying ESG investments and currently offers much room for interpretation.
The EU’s Sustainable Finance Disclosure Regulation (SFDR) Level 1, which came into effect on March 10, asks asset managers to sort their ESG funds and other investment products into three progressively greener categories, as outlined in the regulation’s Articles 6 (pale green, at best), 8 (light green) and 9 (dark green). All client-facing documentation, including marketing materials and website information, must clearly reflect these distinctions.
The main goal of the legislation is to give greater assurance to investors that they are investing in products matching their own sustainability priorities, without the risk of succumbing to greenwashing.
This process might sound simple, but it has been far from straightforward for asset managers to handle the terminology and the amount of detail required. There is also the ever-present headache caused by insufficient ESG-related data.
The new regulation is “a double-edged sword”, says Hari Bhambra, Global Head of Compliance Solutions for financial services provider Apex Group, claiming compliance requirements may discourage investment managers from creating sustainable products.
“That would ultimately drive capital flows in the opposite direction from where the world needs them to flow – away from sustainable products rather than towards them,” she says.
SFDR is just one part of the EU’s Sustainable Finance Action Plan, which aims to reorient capital flows into sustainable investments, incorporate sustainability into financial risk management and better foster transparency and long-termism in finance.
“We are as much excited about SFDR as we are disappointed about it,” says Michael Sieg, CEO of specialist infrastructure investment firm ThomasLloyd. “There’s still a long way to go until the end-investor really understands what this all means, which will hopefully come when Level 2 requirements are introduced next year.”
Level 2 of SFDR will ask asset managers to provide more detail on the contents and methodologies to support the categorisation of their green-labelled funds. The European Supervisory Authorities (ESAs) published the final draft of the regulatory technical standards (RTSs) last month, which outline the additional requirements. It’s expected that the European Commission (EC) will endorse the RTSs and implement them from January 1 2022, but delays will make it harder for asset managers to get things right.
Spot the difference
Many asset managers have struggled to understand when funds should be labelled as Article 8 and when they can slot into 9, a problem area the ESAs flagged in an open letter to the EC.
Article 9 refers to ESG-labelled funds that have a sustainable objective. If a fund has an overarching goal, i.e. reforestation, and all of its holdings reflect this target, then that is considered ‘dark green’ and qualifies as Article 9.
For example, Franklin Templeton’s Franklin S&P 500 Paris Aligned Climate UCITS ETF has been labelled as Article 9 because its core objective is to hold US large capitalisation securities that are aligned to the low carbon transition.
Article 8 is much broader. Theoretically, any fund with some proven sustainable holdings or characteristics can be included, even if it also includes some assets that aren’t considered sustainable. Currently, there is no common consensus as to the minimum requirements for a fund to claim it has an environmental or social characteristic.
But any claims asset managers may make about the ESG characteristics of their Article 8 funds must be explained through disclosure. “While we should seek to apply transparency requirements to a broad range of funds, disclosures have to be commensurate with the characteristics of the funds,” says Giorgio Botta, Regulatory Policy Advisor of Sustainable Finance and Stewardship for the European Fund and Asset Management Association (EFAMA),
So, if a fund has holdings in renewable energy, and the asset manager can prove that’s the case, then it can be marketed as an Article 8 fund. But that doesn’t account for its other holdings, which could potentially include more carbon-intensive companies, firms that have not outlined credible transition targets, or Big Tech companies that have a number of social-related issues.
“If regulation leaves space for a very broad interpretation, there is a risk that products falling under the scope of Article 8 won’t actually have sufficient characteristics to qualify as such,” Botta acknowledges.
An EU-backed green label thus could lead to unwarranted assurance on the part of investors.
“The problem is that people buy the label. They don’t have the time – or they don’t always have the understanding – to look at what’s inside the package,” Sieg says.
Sorting wheat from chaff
Asset managers will need to provide detail beyond the label when SFDR Level 2 is enforced, which should do much to sort the wheat from the chaff. In the meantime, funds are being classified as Article 8 when this is not strictly justified.
Conversely, some asset managers err too much on the side of caution in order to avoid being penalised for mis-selling, says Dewi John, Head of UK and Ireland Research at Refinitiv Lipper. “A number of fund managers have chosen to be classified as ‘other’ products, or to fall under Article 8 when they should be Article 9 [for that very reason],” John says.
But we can’t expect all funds to be dark green straightaway, which is why Article 8 is an important label for asset managers. Non-sustainable sectors, such as oil and gas, or hard-to-abate industrial sectors such as steel, still provide investors with strong financial returns and include firms with ambitious and detailed transition plans. Article 8 allows asset managers some middle ground.
That’s not to say that asset managers can be too lax with the kinds of funds they market as compliant with Article 8. Under SFDR, when an asset manager says a fund qualifies as Article 8 in a pre-contractual or periodic document, even in its product name or broader marketing communication, it needs to provide a short description as to the proportion of investments included in the fund to attain an environmental or social characteristic the manager considers sufficient enough to qualify.
Without clearer guidelines as to how asset managers should be promoting Article 8 funds, and to what extent they are allowed to market them as sustainable, asset managers are left with too much room for interpretation, says Rob Sanders, Co-Founder of due diligence platform Door Funds.
“Asset managers are interpreting SFDR Level 1 differently, from very conservative to more liberal approaches, particularly around Article 8 funds,” Sanders says. These inconsistencies therefore make it more difficult for investors to understand how funds stack up against each other, he explains.
In the short to medium term, Sieg predicts that at least 80%-90% of all market products will end up falling into Article 6, with 5-10% in Article 8 and the small remainder in Article 9. That means a very small percentage of the market actually offers funds the EU considers worthy of an ESG label.
Therefore, for asset managers looking to market themselves as ESG-conscious, it’s Article 6 they need to avoid.
If a fund doesn’t have a sustainable characteristic or objective, it’s a non-sustainable product and will be tagged with the Article 6 label. These funds will likely face considerable marketing difficulties in the longer term as investors look to transition to a greener economy.
The increased transparency through labelling could encourage asset managers with funds in Article 6 to better align all of their funds with Article 8 or 9 criteria, Botta says.
Nonetheless, while more clarity is welcome, fulfilling SFDR requirements shouldn’t become a “box-ticking exercise”, Botta warns.
Although the necessary detail expected from the eagerly anticipated implementation of Level 2 rules should make things clearer, presently asset managers simply don’t have as much impetus to provide detailed justifications for their green-labelling.
“Now is the time to get those processes and systems properly in place, rather than trying to scramble to do it […] in six months’ time. [Asset managers shouldn’t] become complacent and get left behind at the first hurdle,” Bhambra says.
Full and rounded disclosure
The decision to delay the application date of the RTSs until January 2022 was a pragmatic one, even if it has generated short-term uncertainty for asset managers, who are using the draft RTSs as guidance in the interim.
“Without a delay, it simply wasn’t possible for asset managers to comply with the more prescriptive requirements, or for national authorities to supervise effectively,” Botta says, adding that EFAMA is maintaining a dialogue with its members and the EC in order to resolve any outstanding issues. He encourages all national supervisory authorities to take a “consistent approach to supervision”.
The delay gives asset managers time to gather enough data to fulfil the principal adverse impact (PAI) requirements, which fall under Article 4 of SFDR, and will come into force as part of Level 2.
Article 4 states that managers must publish a PAI Statement on their websites concerning the impact of their investment decisions on a range of sustainability factors on a quarterly basis. Initially, SFDR Level 2 specified that asset managers should be reporting on 34 PAIs, but this has been reduced to 18 mandatory indicators.
“However, most managers will need to report on more than the core PAIs, considered from a materiality perspective, if they are to provide a full and rounded disclosure, and create a holistic picture of their ESG profile,” said Charles Sincock, ESG Lead at Capco.
At the very least, asset managers must also disclose against one additional indictor related to climate or other environmental impacts and at least one additional indicator relating to social impacts, such as human rights, anti-corruption or anti-bribery.
Reporting against the PAIs requires a steady and reliable inflow of ESG-related data.
Considering the industry-wide concerns and ongoing issues surrounding the consistency, comparability and applicability of ESG data, it’s no wonder asset managers largely welcomed the delay, points out Clare Vincent-Silk, Partner at global consulting firm Sionic.
“There are still difficulties around trying to aggregate data so it can be analysed in an apples-to-apples comparison,” she explains.
Ultimately, the demands of SFDR compound the fact that “ESG must be a digital revolution as well as one for sustainable finance”, wrote Paul Elflain, Head of Asset Management at Linedata.
One piece of the puzzle
The handling of ESG data is a critical priority for asset managers and their clients with the EU Taxonomy and updated Non-Financial Reporting Directive (NFRD) looming on the horizon. The NFRD update is expected in April and the Taxonomy from 2022.
The EC is looking beyond this trifecta of changes, too, having recently requested that the European Financial Reporting Advisory Group (EFRAG) and EFRAG’s Project Task Force map out how future standards for sustainability reporting will align with its sustainable finance agenda.
Asset managers can’t afford to be short-sighted, focusing solely on SFDR Levels 1 and 2, Bhambra argues. “The requirements are only going to increase as ESG legislation develops,” she points out.
These legislative changes won’t be without teething problems either.
Over 225 scientists, financial institutions and NGOs recently sounded the alarm following the EC’s leaked proposal to classify new fossil gas projects as environmentally sustainable under the EU Taxonomy.
The SFDR’s RTSs will be aligned with the Taxonomy’s technical screening criteria, environmental objectives and disclosure obligations, meaning asset managers will derive much of the detail they need for Level 2 disclosures from the Taxonomy’s delegated acts.
If anything, this is a reminder that the investment industry is still on a journey towards sustainability and a green economy – we can’t expect perfection overnight.
But the puzzle pieces are beginning to fit together, Botta says.
“It’s a process that only just started on March 10, and it’s important to remember that it will continue to evolve as disclosures become more detailed and accurate, as methodologies adopted to assess sustainability risks improve and ESG data flows from investee companies,” he adds.
“Undoubtedly, the SFDR is a game-changing piece of regulation, but Level 1 disclosures are general and largely qualitative. This is the start of the ESG disclosure journey for financial services, not the finish line,” Bhambra agrees.