There are less than five months to the first sustainable finance disclosure regulation (SFDR) deadline, and the next is just eight months away. Stéphane Badey, a partner with Arendt & Medernach speaking at the recent LuxFlag Sustainable Investment Week on 14 October, highlighted some of the key concepts.
The 10 March 2021 deadline is looming. That’s when fund entities need to start disclosing sustainability risks and potential adverse impact at an entity level. This date was maintained even though the European Commission decided on 7 October to lighten the load by postponing some required declarations. Then on 30 June 2021 there will be a requirement to ‘comply or explain’ the sustainable investment approach of investment products produced by large financial market participants (i.e. those with more than 500 employees). Taxonomy alignment and disclosure is scheduled to start on 1 January 2022 with full taxonomy alignment from 2023.
The March deadline
For the 10 March deadline on entity level disclosure, the AIFM/ManCo/asset manager has the choice of responding by posting one of two types of information on their website. For those managers and their surrogates seeking to be sustainability compliant, they should explain how sustainability risk is being integrated into their investment decision-making and the advice they give. Otherwise, there are two ways to opt-out. A statement can be issued on the expected size, nature and scale of the ‘principal adverse impact’ of investment decisions on sustainability factors. Alternatively, clear reasons can be given for why these adverse impacts are not being considered by the entity.
The June deadline
As regards the ‘comply or explain’ stage, which is set to begin in July next year, Badey (pictured) pointed to SFDR making a distinction between three types of funds that need to be processed in different ways. So-called ‘article 6’ funds make no particular attempt to be aligned with sustainability goals, while ‘article 8’ and ‘article 9’ funds have explicit, but different sustainability strategies. All this communication must be made explicitly to the investor on a pre-contractual disclosure basis. Incidentally, SFDR seeks to address environmental and social questions, with the governance aspect that makes up the ESG trinity being seen as particularly difficult to measure.
For the standard article 6 funds, the fund manager has two main ways under SFDR to signal their policy of not having an explicit environmental and social investment strategy. It can either report on how sustainability risks are integrated into investment decisions, and the likely impact of sustainability risks on financial returns. Alternatively, if sustainability risks are not deemed to be relevant, this decision can be explained, ‘in a clear, concise manner’.
Environmental or social?
Article 8 products are those which promote environmental or social characteristics. Reporting will have to detail how these are met, including background on which metrics and methodology is used. In other words, explanation is required how an investment strategy that calls itself sustainable differs from standard approaches.
Article 9 funds are somewhat different, in that these products should have an objective of sustainable investment. There needs to be an explanation of how this objective is to be achieved, along with explanations of the metrics and methodology, plus specific data on carbon emission exposure, if relevant.
As well, fund players will need to become acquainted with EU definitions. As well as environmental and/or social objectives, funds must ‘do no significant harm’, which has spawned its own acronym: DNSH. Badey explained this last concept with an example: ‘if you have a wind farm that negatively impacts indigenous people’s land rights then this would not meet the criteria.’
‘There was a lot of debate during the ESMA consultation period, where many fund associations have complained about the lack of clarity in the definitions,’ Badey noted. ‘Market consensus was that most products will fall under article 8 and very few under article 9.’ There is a thought that the Commission and ESMA may see article 9 funds as ‘impact funds’ which explicitly seek to change sustainability outcomes. The article 8 and 9 definitions are currently being reviewed.
Delay
The other major concern is the delay in publication of the regulatory technical standards (RTS) which will provide many of the definitions needed for 10 March. These are currently under review following consultation with the industry, with Badey not expecting them to be published much before the end of this year: just over two months until the deadline. The production of the definitive regulatory templates is also in the works.
This process is welcomed, however, as the early drafts of the text raised a range of concerns for practitioners. For example, regarding the 32 criteria for calculating ‘adverse impact’, a study backed by several fund associations found that of more than 100 UCITS funds there was reliable relevant data for only six.
The delay to the publication of technical standards is one of the reasons industry groups, such as Efama and Alfi, have asked for a delay to the SFDR deadline.
So what should fund businesses be doing to adapt to these new ways of thinking? Antoine Portelange, an associate with Arendt & Medernach, highlighted three steps. ‘The first is to raise awareness to understand the ESG universe through training and hiring specialists,’ he said. ‘Secondly, and most importantly, conduct a gap analysis on fund level exposure on the current status of SFDR compliance.’ Then strategic assessments can be made, either categorising existing products or seeking to move in a different, more sustainable direction.