The EU’s Sustainable Finance Disclosure Regulation (SFDR) and its related Regulatory Technical Standards (RTS), which are intended to promote environmentally and socially conscious investment in companies, were set to take effect on March 10, 2021. With guidelines to be implemented by financial market participants by June 2021, financial firms need to complete their operational SFDR framework to conform to these regulations.
Due to concerns that have surfaced since the comment period on SFDR closed in September, and continued confusion and debate about SFDR’s principles and how they can be implemented, it appears to be headed for more postponements, or at least a grace period that could extend into 2022 or 2023.
While John Berrigan, deputy director general of the European Commission, in an October 20 letter to European Securities Authority officials, acknowledged that the Covid pandemic crisis may also contribute to SFDR delays, he stated that compliance to the Level 1 provisions in the regulation should be possible by the set deadlines, even if not to provisions in other levels. Berrigan also acknowledged that market participants will need more time to implement the RTS (or Level 2) part of the regulation.
RTS includes a methodology for Principal Adverse Impact Statements, which are the means by which firms will disclose decisions relevant to meeting Environmental, Social and Governance (ESG) criteria in investments. There will be standard templates for disclosures that can be incorporated into a firm’s SFDR framework, but along with the required metrics and additional content for pre-contractual and periodic reporting, investment firms will need to make changes to their operations. SFDR overall names 32 principal adverse impacts. Some firms, on their own, may be using Adverse Sustainability Impact Statements as plans for how to meet ESG criteria. Generally, firms will be expected to report on sustainability risks and factors that will be affected by their business decisions, as detailed in an informational paper by global international law firm Simmons & Simmons.
Where to start
Collecting and analyzing data, and creating relevant reports, is a significant undertaking and requires firms to develop an SFDR framework to operationalize the processes. Executives of ShareAction, a London-based non-governmental organization, say there is a “straightforward answer” for a lack of data on ESG impacts, and that is to start collecting and reporting such data as soon as possible. Aside from financially material information, this also includes double materiality, which means responsibility for social and environmental factors, as well as adverse impacts of their own decisions on people, society and the environment.
This stance on the 32 named impacts, which include carbon use, deforestation, waste water and forced labor, runs counter to a position set out by the Principles of Responsible Investment (PRI), a United Nations-supported group of investors with its own set of principles for ESG compliance. PRI points to an overall ambiguity in the criteria and takes the position that non-zero values in the 32 categories named in SFDR could still be acceptable as long they are reasonably small numbers of instances or incidents.
Setting up your SFDR Framework
Whatever the threshold for compliance with SFDR principles is, financial firms will have to apply an SFDR framework to sort through the fragmented strengths of different available ESG enterprise data feeds. A major bank that wishes to provide ESG scores and research might have to cobble together as many as 20 data providers to get a complete picture of ESG standards compliance in the market, because each provider may have certain strengths depending on the asset classes or regions they cover. As with fund managers preparing for disclosure reporting, it may prove easier for such a firm to adopt the SFDR framework within a dedicated data management platform, potentially provided as service. This would standardize all that data from different sources, and all the necessary processes and controls, into a coherent and consistent whole.
The later phases of what the EU and European Supervisory Authorities (ESAs) intend to implement from SFDR are still subject to change, but investment firms and banks should be prepared to collect, compare, evaluate and manage ESG data, regardless of what threshold the regulators set for compliance with ESG principles. The SFDR framework for Principal Adverse Impact Statements in the RTS part of SFDR will be valid even if specific thresholds or provisions end up being changed.