8 minute read 9 Dec 2020
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EU Action Plan – Deep dive on Disclosure Regulation (SFDR)

By Stephan Geiger

ESG Lead Financial Services | Switzerland

Responsible for building the Sustainable Finance team in Switzerland. Trusted advisor in regulatory transformation and governance projects.

8 minute read 9 Dec 2020

SFDR is the first set of a regulatory wave aiming to reorient capital flows towards a more sustainable economy.

Recommended Action

  • Review your marketing materials, pre-contractual (e.g., prospectus) and website disclosures in light of the EU’s SFDR requirements
  • Integrate sustainability risk in all investment and research processes
  • Prepare your position on principal adverse impacts, considering your organization’s size, stakeholder expectations and long-term strategy

The ultimate aims of the EU Action Plan on sustainable finance are to reorient capital flows towards a more sustainable economy, foster long-termism and manage the increasing importance of sustainability risks. The measures stemming from the EU Action Plan are, to date, the broadest and most comprehensive regulatory initiatives developed in sustainable finance. The EU Action Plan lays out a roadmap for future work. As certain key provisions of the EU Regulation on sustainability related disclosures in the financial services sector (Disclosure Regulation or SFDR) must be implemented by 10 March 2021, these should be tackled first in any current EU Action Plan projects.

While the legal initiatives of the EU Action Plan relate directly to entities in the EU, they also have an (in)direct impact on entities outside of the EU, especially those wishing to manufacture or sell financial products to EU clients. From a Compliance point of view, various activity triggers apply. Swiss asset managers should be careful when promoting ESG under the new strict marketing regime in Europe.

Regardless of the direct applicability of these measures, asset managers and asset owners must consider positioning themselves and their product range regarding ESG from a strategic point of view.

Background and developments

The SFDR entered into force in December 2019 and certain key provisions must already be implemented by 10 March 2021. SFDR is supplemented with further details in regulatory technical standards (draft RTS) that have been developed by the three European Supervisory Authorities (ESAs), i.e. the EBA, EIOPA and ESMA. In April 2020, the ESAs issued a consultation regarding their proposed draft RTS about content, methodologies and presentation of disclosures.

In its recent letter to the European Supervisory Authorities, the EU Commission has made clear that it will not accept delays on the general application deadlines of the SFDR (Level 1). Nevertheless, certain technical aspects of the draft RTS (Level 2) have been delayed. This leaves the industry with the challenge to implement the first piece of legislation of the EU Action Plan as of 10 March 2021 based on principles that may have to be revisited a few months later.

Main requirements

The SFDR contains ESG-specific transparency requirements to be disclosed to (potential) investors via various channels, i.e. website, pre-contractual documents (e.g. prospectus), periodic reports. The transparency requirements contain disclosure obligations on an entity and product level and apply to entities manufacturing financial products (Financial Market Participants) or providing investment or insurance advice (Financial Advisors). Financial Market Participants include fund managers, insurance-based investment product providers, pension product providers and institutions providing portfolio management (discretionary mandates) so, broadly speaking, any type of asset manager.

The disclosures to be made require a strategic positioning of all asset managers regarding their sustainable finance approaches as they will be required to be transparent about the following three topics: i) Sustainability risks, ii) Principle adverse impacts (PAI), and iii) ESG approach positioning.

Sustainability risks – financially material impacts

In order to act in the best interests of their clients, Financial Market Participants and Financial Advisors should assess the likely impacts of sustainability risks on the financial return of financial products in a systematic way (i.e. integrate it in their due diligence and research processes on a mandatory basis).

The EU regulator expects asset managers to assess sustainability risks continuously and apply this on a best effort basis to all asset classes. The proper management of sustainability risks becomes even more important with the increasing risks related to climate change. Therefore, over time sustainability risk integration can be expected to become the new normal in the EEA asset management market.

The SFDR provides for the option to explain why sustainability risks are not relevant and thus do not need to be considered (comply or explain). However, in most cases this would not be a prudent approach and may be considered a breach of fiduciary duties of asset managers. Not considering risks related to climate change, for example, does not seem to be an option given the effects of climate change that we are already experiencing. Therefore, integrating sustainability risks in the investment decision process will become the new baseline expectation from both regulators and investors.

Principal adverse impacts (PAI) – footprint / active ownership and engagement

The SFDR also requires asset managers to disclose their policies regarding the consideration of principal adverse impacts (PAI) of investment decisions on sustainability factors on a “comply or explain” basis. In a PAI statement, they should describe their due diligence policies regarding PAI, provide summaries of their engagement policies and how they discharge their stewardship responsibilities regarding the negative impact or footprint of their investments. Qualitative (narrative) disclosures should also include references to compliance with business conduct rules and international standards, e.g. Task Force on Climate-related Financial Disclosures (TCFD), Principles for Responsible Investment (PRI) and OECD due diligence guidance.

The draft RTS proposes a very granular template-based description of the PAI based on up to 50 quantitative key performance indicators (KPIs). Of these, 32 are mandatory and the remainder are optional. Asset managers face real challenges in obtaining all relevant ESG data across all financial products. It remains to be seen in Q1 2021 whether the pushback from the asset management industry to this draft RTS proposal will have an effect and whether full transparency will nevertheless need to be provided.

At this point in time it is assumed, due to the generally increased ESG data need and political pressure on delivering the EU Green Deal, that a large part of the quantitative KPIs will remain, especially those related to environmental data as well as the general aim to link PAI to measurable KPIs.

Asset managers with more than 500 employees as a parent of a group will have to start considering PAI on an entity level as of 30 June 2021. Others below this threshold may choose not to comply. This non-compliance must be made transparent on the website and should include a statement that the entity does not consider PAI (their investment footprint) along with a clear explanation why it does not do so. It will be a strategic decision whether asset managers choose to opt in on an entity level or to issue such a statement, with key decisive factors being the sustainability ambition of an entity and / or pressure from their various stakeholders. By 30 December 2022, this decision will have to be made on a product level as well.

The 10 key action points of the EU Action Plan ultimately aim to reorient capital flows towards a more sustainable economy, foster long-termism and manage the increasing importance of sustainability risks. Given the quick-paced EU developments, Swiss ESG market players cannot assume that leading today will necessarily mean leading tomorrow

ESG approach positioning – positive impact (if any)

The ESG market includes a broad variety of ESG approaches (e.g. exclusions, norms-based screening, best-in-class, ESG integration, thematic and impact related approaches). While not all of them necessarily lead to a positive ESG contribution or exclude unsustainable companies, the main rationale for providing transparency about the underlying ESG approaches is to prevent misleading the investor and, therefore, also reduce the prevalence of “greenwashing”. This aligns with the new strict marketing regime of the EU Action Plan where promotion of ESG will only come at the price of transparency (and underlying internal ESG governance and processes).

The concrete disclosures required, as well as their form, channel and periodicity, depend on the type of product and some special features (e.g. use of an index or carbon emission reduction objective). It is, therefore, crucially important to classify the different types of products (product by product). Currently, debate about the exact lines to be drawn between the different product categories has not yet been concluded. Considering the tight deadlines in March 2021, the finalization of the draft RTS due in Q1 2021 will hardly leave enough time for implementation if entities are not prepared.

The SFDR makes a clear distinction between financial products that have sustainable investments as their objective (SFDR Art. 9 products) and financial products that promote, among other characteristics, environmental or social characteristics (SFDR Art. 8 products). The ESAs draft RTS diluted this concept somewhat with the introduction of a mixed type of SFDR Art. 8 product where only part of the investment is sustainable. In addition, the ESAs proposed that any sustainable investment must satisfy the Do No Significant Harm (DNSH) test by referring to the adverse impact indicators developed in the draft RTS.

There is also no clear line drawn between the two ESG products (SFDR Art. 8 and 9 products) and other financial products. The ESAs suggest in their draft RTS that the promotion of ESG should be limited in some way and that the industry should not “over disclose” on ESG. For this reason, they have come up with a vague concept that only products with underlying assets based on “binding” selection criteria should be promotable as ESG products (e.g. SFDR Art. 8 or 9 products). The French regulator AMF has taken a slightly different and stricter approach and asks for percentage limitations of the investment universe and a minimum percentage of assets to be screened according to the methodology if ESG is made a key part of communication (e.g. in the KIID or marketing material). The outcome of this debate will be highly relevant to position the financial products accordingly. Even if SFDR Art. 8 should end up being a catch-all category (also including pure sustainability risk integration approaches), ESG should still be used more cautiously as a marketing factor since the reputational risk of greenwashing exists independent of the concrete underlying regulation.

Strict marketing regime

In accordance with the new regime introduced by the SFDR, asset managers must review their marketing materials, pre-contractual (e.g., prospectus) and website disclosures in respect of the three topics summarized above that will be applicable after 10 March 2021. In addition, they will also need to implement product and marketing approval and maintenance processes to continuously monitor compliance with these disclosure requirements.

Summary

Financial market participants should closely observe changes across international and local sustainable finance legislation in order to offer leading – and fully compliant – products and services in the short-, medium- and long- term future. Given the quick-paced EU developments, ESG market players cannot assume that leading today will necessarily mean leading tomorrow. The first implementation timelines of the EU Action Plan are quickly approaching with several sets of regulatory waves to follow. It is time to start paddling.

About this article

By Stephan Geiger

ESG Lead Financial Services | Switzerland

Responsible for building the Sustainable Finance team in Switzerland. Trusted advisor in regulatory transformation and governance projects.