The EU’s Sustainable Finance Disclosure Regulation (SFDR) consultation paper has a comment period that closed on September 1, and its guidelines are supposed to be implemented by firms starting in June 2021, but its taxonomy and reporting standards have already reaped criticism as being vague, inaccurate or off-target. These issues will have to be clarified or dealt with before investment firms can begin to get an idea of how much new data they will have to manage and evaluate as a result of the new rules.
The guidance is intended to set standards for ESG investment products
Three European Supervisory Authorities (ESAs) put forward SFDR to better protect end investors and improve disclosure to end investors concerning investments that meet Environmental, Social and Governance (ESG) criteria. Another rationale for SFDR is to prevent the practice of “greenwashing,” which means portraying investments or companies as environmentally sustainable when they are not. Greenwashing has been a problem in the US, and the EU intends to prevent the practice in its member countries through the SFDR regulation. However, SFDR will also apply for any firm from any global region that transacts business within the EU, so US and firms from other geographies will still be affected.
Among the biggest global firms, some on both the buy and sell sides support sustainable finance policies like SFDR, while others are lobbying to weaken such policies.
Along with this mixed bag of compliance commitments, awareness of SFDR itself appears to be low. A survey of European energy, utilities, infrastructure and transportation fund managers published in July by Linklaters found that 53% knew about SFDR, 34% did not and 13% were not sure.
What is SFDR?
So what is actually in SFDR? It enables supervisory authorities to set Regulatory Technical Standards (RTS) for how ESG investment information must be presented and what is fair to claim as an investment that is conscious of ESG principles. The SFDR RTS cover the content, methodology and presentation for ESG disclosures at the entity and product levels. Both financial markets participants and financial advisors will be obliged to comply with SFDR when making disclosures to end-investors. According to an interpretation by Dechert LLP, the RTS include:
- Setting indicators for adverse ESG impacts so that information presented with an ESG investment does not run afoul of those indicators.
- Requiring firms and funds to publish a due diligence policy on their website that describes how investment decisions can impact ESG principles negatively.
- Pre-contractual information for investment products showing how they meet ESG characteristics or how a product with a sustainable investment objective aligns with a designated index measuring compliance with that objective.
- Requiring firms to publish what the ESG characteristics are for a product designated as compliant with ESG principles.
- Requiring firms to publish periodic reports on how well products continue to meet ESG principles or sustainable investment objectives – or to conform with designated indexes that measure compliance with ESG objectives, when that product has been previously aligned with such an index.
While SFDR, in Dechert’s view, is very clear and prescribed, leaving little doubt about what needs to be included in firms’ efforts to comply, other industry interests point out a lot of issues with the guidance. At the start of September, the Asset Management and Investors Council (AMIC), working with ICMA, an association of capital markets firms, issued a 10-page point-by-point critique of SFDR elements. Generally, the ICMA-AMIC critique says several metrics set in the RTS are wrong or misleading, in part because quant disclosures can give an inaccurate picture of ESG-adverse impacts of investments. The standards do not consider what is really material to their intent and cannot be evaluated against the KPIs being set, according to the ICMA and AMIC. The organizations add that retail investors should not be overloaded with all the information being required in SFDR, and that availability and maturity of data should be considered.
Data concerns for SFDR
In a related concern, particularly for determining what data demands SFDR will create, it appears to leave asset managers with no idea how much additional data will be generated that they will have to manage or report, whether through self-reporting on their own websites, or in product contracts. And with sources of ESG data ranging from pre-calculated ratings to vendor feeds of hundreds of data elements from which scores can be modeled in-house, establishing the bias-free nature and fitness for purpose of ESG classifications used in disclosures will be challenging for some time to come.
Under a heading “Volume of data,” guidance from Bloomberg Professional Services states that the quantity and quality of ESG data that needs to be processed is clear to all, and specifies certain qualities that should be present in this data, but offers nothing about what the volume of data may be.
In addition, this unknown is compounded by another possible flaw in the design of SFDR — it only applies to firms with 500 employees or more, rather than firms that have more than a certain level of assets under management. Hypothetically, a firm could have 501 employees and $100 million AUM and be subject to all its disclosure requirements, while another firm with 499 employees but $100 billion AUM would not be subject to any obligations.
Even for those who believe SFDR is a noble and essential effort, the uncertainties that appear to abound in its definitions and details make it likely that the ESAs will have to postpone its compliance dates, revise its guidance and answer all these questions.