Sustainable investing regulation is intended to encourage investment in sustainable activities, while the disclosure regime aims to increase transparency. But how will this influential element be a solution to the climate crisis and drive better outcomes?
- The growing shift towards sustainable investment has seen regulation higher on investors’ minds, amid increased regulation, in the move towards greater transparency.
- Sustainable Financial Disclosure Regulation (SFDR) introduced in March 2021 requires mandatory Environmental, Social and Governance (ESG) disclosure standards for the financial sector which takes sustainability into account in investment decisions.
- But what are the long-term implications of enhanced regulation, and will it encourage even greater investment in sustainable activities, increase transparency and give investors the ability to compare products and sustainability outcomes?
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What are the SFDR article classifications and current requirements for asset managers?
Every Article has its own reporting and disclosure requirements, which is intended to combat greenwashing and help investors identify those funds that best suit their needs.
Defining “sustainable investment” under article 9:
- an environmental objective, as covered by the EU Taxonomy
- an environmental objective that falls outside the Taxonomy, where asset managers can define the environmental objective as they see fit
- or a social objective, defined as the asset managers see fit, given a social Taxonomy is not yet finalised.
SFDR will increase the transparency regarding the implemented ESG-criteria and the resulting environmental and/or social performance of the respective funds.
What are the immediate and likely long-term implications of SFDR regulations on EU and non-EU fund managers?
The EU’s Sustainable Finance Disclosure Regulation (SFDR) will have multiple implications for asset managers and corporations inside and outside the EU, as every fund management company that wants to distribute their products to EU investors needs to be compliant with the regulation.
Flows in ESG-related Funds between 1 January and 30 June 2022 (bn EUR)
This also includes the respective reporting duties. As a result, companies outside the EU that wish to attract capital (via mutual funds or ETFs) from EU investors will have to report the respective data and key performance indicators to the fund management companies, as SFDR also applies to investments outside the EU.
In addition, fund management companies will have to review the whole lifecycle of products, from the initial product development and marketing, through to monitoring and reporting, updating policies and processes accordingly.
To fulfil the assessment and reporting requirements of the respective SFDR articles, fund management companies will need to develop processes to gather and store relevant data and other information.
Finally, there is a need to implement a risk management policy and framework that covers ESG and SFDR within the business, ensuring that this is updated to reflect ever-evolving sustainability reporting requirements, and that risk metrics are reviewed regularly at the fund and investment level.
SFDR will therefore increase the transparency of investment products with regard to the incorporation of ESG criteria and the resulting impact.
Why do SFDR labelled funds vary significantly across Europe and what problems can this pose for both asset managers and investors?
The fund market in the EU is not a single market and local regulators can add additional regulatory requirements (for ESG disclosures and other topics) for funds and asset managers domiciled in the respective country.
The EU regulations do only set the minimum standards which can’t be lowered by local regulators.
The increased regulatory requirements are often seen as competitive disadvantage by local asset managers since products domiciled in countries with minimum regulatory requirements can still be sold in countries with higher regulatory requirements under the so-called UCITS fund passport.
From my point of view, this so-called regulatory arbitrage was one of the reasons why the German regulator BaFin pulled back on the attempt to implement higher ESG standards because of the inclusion of nuclear power as “green technology” within the EU taxonomy. This kind of regulation would have been a disadvantage for funds domiciled in Germany, compared to other EU fund domiciles.
Do you think the lack of clarity around what constitutes an Article 8 fund could potentially increase greenwashing?
Greenwashing could potentially happen under Article 8 and 9.
I assume that we will see several reclassifications from 8 to 6 and 9 to 8 once the funds need to fulfil the reporting duties, since the reporting will show which fund will fulfil the demand from the regulation and investors.
As some fund managers may play around with the classifications, I believe regulators will look closely at funds classified by Article 8 or 9 and penalise those using misleading terms or do greenwashing.
I also feel that EU regulators will review SFDR and may add additional duties to determine what a fund must fulfil to be classified as Article 8 or 9.
Flows in ESG-related funds by asset type between 1 January and 30 June 2022 (bn EUR)
Will SFDR give greater ESG clarity for investors?
The reporting duties for funds under Article 8 or 9 should help investors identify funds that best suit their needs. Therefore, I strongly believe that SFDR will increase the transparency regarding the implemented ESG-criteria and the resulting environmental and/or social performance of the respective funds.
