The European Union’s new Sustainable Finance Disclosure Regulation (SFDR) – also known as the Disclosure Regulation – comes into effect in March 2021. SFDR imposes new transparency obligations and periodic reporting requirements on investment management firms at both a product and manager level.
For the largest firms, this will mean extremely onerous new ESG disclosure requirements. However, some degree of additional disclosure will be required from all firms that market funds into the EU, while firms that incorporate ESG considerations into their investment process will be required to make detailed product level ESG disclosures.
The form and content of the disclosures will be highly prescriptive, including the use of PRIIPs-like standardised templates.
Financial advisors are also subject to the European ESG transparency regime. However, this article focuses on asset managers.
Background to SFDR and the ESG regime
The EU’s Capital Markets Union project includes a package of reforms on sustainable finance intended to define a harmonised ESG framework for European financial services firms in order to prevent ‘greenwashing’ – marketing products as having an ESG component when in fact ESG considerations are not substantively taken into account in the investment process. We looked at the background to the development of ESG regulation for financial services in our article: ESG – changing more than the climate.
The core parts of the regime are:
- Sustainable Finance Disclosure Regulation (SFDR) – Imposes transparency and disclosure requirements on firms and products
- Taxonomy Regulation – Establishes criteria for determining whether an economic activity is environmentally sustainable and includes additional product-level reporting requirements for products that promote environmental characteristics
- Low Carbon Benchmarks Regulation – Introduces a new framework for climate related benchmarks
- Amendments to AIFMD, UCITS and MiFID – Requires AIFMs and UCITS ManCos to integrate sustainability risks into their risk management processes, and requires sustainability factors to be taken into account in the product governance and suitability processes of firms subject to MiFID.
SFDR and the Taxonomy Regulation
Scope of SFDR
SFDR applies product and manager level disclosure requirements to “Financial Market Participants” (FMPs). The definition of an FMP is incredibly broad and includes managers of alternative investment and UCITS funds, discretionary account managers, pension providers and insurance-based investment product manufacturers. We expect most European investment management firms to meet the definition of an FMP.
Moreover, the disclosure regime appears to be intended to apply to all products marketed into Europe, including those managed by non-EU firms.
There are three categories of product under SFDR:
- Products that have sustainable investment as their objective (article 9 products) – These are products that have sustainable investment as their objective and use a specific index as a reference benchmark. Products in this category may have a specific ESG objective, such as mitigating the risk of climate change, or it may have a broader exposure to ESG themes.
- Products that promote an environmental or social characteristic (article 8 products) – These are products that do not have sustainable investment as their objective, but take ESG criteria into account in the investment process as one factor among many.
- Out of scope products – products that do not purport to promote any kind of ESG objective.
All product providers will be subject to additional disclosure requirements as a result of SFDR to some degree, even if they only manufacture out of scope products, though the burden will be less for these firms. However, it should be noted that the definition of article 8 products is potentially, exceptionally wide ranging. Investors increasingly expect managers to have something to say on ESG in their marketing materials and as a result a very large number of products purport to take ESG into account to some degree in the investment process.
Firm level disclosures
The most onerous of the disclosure requirements is reserved for firms with more than 500 employees. These firms must disclose their “principal adverse impacts” – deleterious effects of investment decisions on environmental and social criteria – on their websites, alongside summaries of engagement policies. The items to be disclosed and the methodology, set out in a mandatory template in accompanying Regulatory Technical Standards, are highly prescriptive and will require extensive information to be sought from investee companies. By way of example, among the 32 mandatory items that must be reported on is the “share of investments in investee companies with operational sites owned, leased, managed in, or adjacent to, protected areas and areas of high biodiversity value outside protected areas”.
Firms with fewer than 500 employees may include a statement explaining why they do not do this. Firms should consider the reputational impact of taking this approach, though we expect that the vast majority of firms will wish to avail themselves of this exemption if they possibly can.
All firms – including those that do not purport to make sustainable investments – must include on their websites a description of their policies with respect to how sustainability risks are integrated into the investment process and remuneration practices. Here, “sustainability risk” means an environmental, social or governance event or condition – for example, widespread flooding across parts of the UK or high workforce turnover as a result of poor employment practices– that could cause a material negative impact on the value of an investment.
Product level disclosures
All products, including products that do not purport to promote any ESG factors, must be accompanied with a pre-contractual disclosure that sets out the manner in which sustainability risks are integrated into investment decisions and the likely impacts of sustainability risks, such as environmental events, on the returns of the product. Even where sustainability risks have been deemed to be irrelevant, a brief explanation of the reasoning must be provided.
Firms with over 500 employees must additionally disclose how the financial product considers principal adverse impacts on the sustainability of the product, or for smaller firms that have opted out, an explanation of the reasons why they do not consider the adverse impacts of investment decisions on sustainability factors. This requirement applies from December 2022.
Products that promote ESG characteristics or have a clear ESG objective (article 8 and article 9 products), must make a pre-contractual disclosure in the form of a yet to be developed mandatory template, to include:
- The product’s ESG objective and a breakdown of the different categories of investment
- The investment strategy
- An explanation of how indicators for adverse impacts are taken into account and how investments that cause significant harm to sustainable objectives are screened out
- A list of sustainability indicators
- Information on how the use of derivatives is consistent with the ESG aims of the product
The template must include a link to a more detailed product specific website disclosure, including information on monitoring, due diligence and engagement around ESG factors.
Periodic reports for article 8 and 9 products must also include a description of the extent to which the sustainability objectives of the products have been met. A mandatory template for inclusion for these disclosures is expected, but yet to be published.
Article 8 and article 9 products that promote environmental objectives are subjected to additional pre-contractual disclosure and periodic reporting requirements. These disclosures must break down the underlying sustainable investments into more granular categories set out in the Taxonomy Regulation and set out whether the investment makes a “substantial contribution” to these environmental objectives. The form and content of the additional reporting is to be set out in further regulatory technical standards.
Definition of sustainable investment and the ‘do no significant harm’ principle
A key feature of the new EU ESG framework, within SFDR and the Taxonomy Regulation, is that it provides a definition of sustainable investment. In other words, it lays down criteria that investee companies must meet in order to qualify as sustainable investments.
There are two elements to this definition. Firstly, the investment must promote an environmental or social characteristic and meet minimum standards of governance. Secondly, the investment must ‘do no significant harm’ to any other area of environmental or social concern. Environmentally sustainable investments in particular are defined in further detail in the Taxonomy Regulation, as is the substance of the ‘do no significant harm’ principle in relation to environmental factors.
Further Regulatory Technical Standards are expected to include an even more prescriptive specification of the environmental objectives that an investment must meet in order to qualify as a sustainable investment in the form of “technical screening criteria” and further clarify the substance of the ‘do no significant harm’ principle.
AIFMD, UCITS and MIFID amendments
In June 2020, the European Commission published draft legislation to incorporate ESG considerations into the UCITS Directive, AIFMD and MiFID.
Under the amended regulations, fund managers must incorporate sustainability considerations into their risk management processes, including due diligence on prospective investee companies, and ensure that they retain the necessary resources and expertise to do this.
Investment managers that are subject to MiFID, must ensure that the sustainability factors are included into their product approval and suitability processes at a sufficiently granular level to distinguish between different ESG objectives and characteristics.
Mercifully, in contrast to the SFDR and Taxonomy Regulation, ESMA has not taken a prescriptive approach in its amendments to AIFMD, UCITS and MiFID.
Impact of Brexit
The disclosure requirements set out in SFDR and the Taxonomy regulation do not enter force until after the end of the Brexit implementation period. As a result, they will not form part of retained EU law. However, as indicated above, the intention of the European authorities appears to be that products marketed into Europe by non-EU firms should be subject to the relevant disclosures. This means that, in practice, many UK and other non-EU fund managers will have to comply with the rules.
Furthermore, it is likely that that the UK will introduce its own measures around green washing and ESG disclosures. It is likely that these will conform to the EU regime to a large degree. While the EU’s ESG disclosure regime may be overly prescriptive and unduly onerous – one bad regime may be less onerous than two completely different systems and would improve the prospects of equivalence determinations in the future. Although, we would expect a domestic regime to incorporate additional proportionality to some degree.
How can Bovill help?
The EU’s sustainable investment package is complex and wide-ranging. It cuts across a number of existing regimes such as AIFMD and MiFID as well as introducing a completely new transparency and reporting regime. Bovill can help you navigate this complex area by assisting with:
- Scoping – we can help you identify which parts of the ESG disclosure regime apply to you and your products
- Gap analysis – we can help you identify the actions you need to take in order to bring your ESG framework into compliance with the new regulations
- Policies and procedures – a substantial amount of work will be required to amend existing policies and procedures as well as drafting new documentation
- The investment process – we can help you improve the governance around your investment process and advise on how best to include ESG factors at key points