Sustainable finance: are you keeping pace?

The foot has hit the accelerator when it comes to sustainable finance regulation in the past six months. Are you on track with the latest developments?

Background

According to a recent survey1, 85% of asset managers consider environmental, social and governance (ESG) to be a high priority and it is expected that 57% of portfolios will incorporate ESG elements within five years. If sustainable investment quickly becomes a strategic priority, it comes with significant compliance challenges as the regulatory agenda is filled with developments impacting the whole asset management value chain.

Policymakers and supervisory authorities have been very active during the past few months to clarify legal requirements and close loopholes in the sustainable finance framework. The aim is not only to bring certainty for market players but also to strengthen investor confidence in financial products promoting environment and social values. Timing is of the essence since detailed disclosure templates must be used from 1 January 2023, as recently reminded by the Commission de Surveillance du Secteur Financier (CSSF), for both pre-contractual and periodic disclosures of ESG investment products as required by the sustainable finance disclosure regulation (SFDR).

Recent regulatory developments

Taxonomy

• Taxonomy-alignment of gas and nuclear activities

On 31 October 2022, the European Commission adopted amendments to the SFDR Level 2 Delegated Regulation to integrate nuclear and gas related disclosures in the pre-contractual and periodic reporting templates for Art. 8 and Art. 9 products. This Delegated Regulation adds a section in the periodic report template providing for the disclosure of the exposure of financial products to investments in fossil gas and nuclear energy activities. The question aims at identifying whether the financial product intends to invest in such activities and in what proportion.

In the meantime, a governmental amendment to the Luxembourg 2023 Budget Law is expected to exclude assets deriving a taxonomy-alignment from gas and nuclear related activities from the investments eligible for a reduced subscription tax rate under the Law of 17 December 2010. The rationale for this proposal is to align the current legislation with the overall Luxembourg position at the EU level that denies a classification of gas and nuclear related activities as sustainable activities.

• Taxonomy-alignment data and estimates
  

At the moment, sourcing taxonomy-alignment data remains a major challenge for financial institutions. As a result of phasing-in of taxonomy disclosures applicable to undertakings in scope of the non-financial reporting directive (NFRD), taxonomy-alignment key performance indicators (KPIs) will only start to be available from 1 January 2023 onwards and only for non-financial undertakings. Financial undertakings in-scope of NFRD will start to report from 1 January 2024. The availability of taxonomy-alignment data is set to increase in the following years with the entry into force of the Corporate Sustainability Reporting Directive (CSRD), which has been approved by the Council on 28 November 2022. It will bring in scope all large EU companies2, all companies listed on EU regulated markets3 and all foreign companies with substantial activity in the EU4.

In the meantime, in a Q&A (“ESAs’ Q&A”) published on 17 November 2022, European Supervisory Authorities (ESAs) have reminded financial market participants (FMPs) that assessments and estimates should only compensate for limited and specific parts of the desired data elements and produce a prudent outcome. Financial market participants (FMPs) should clearly explain the basis for their conclusions as well as the reasons for having to make such complementary assessments and estimates for the purposes of disclosure to end investors. 

• Taxonomy-alignment disclosures

In a Q&A (“EC’s Q&A”) published in May 2022, the European Commission had already extended the burden of taxonomy-alignment monitoring and disclosures to certain types of products which were not previously foreseen as being in scope, i.e., Art. 8 products promoting environmental characteristics which did not commit to make sustainable investments and Art. 9 products with a sustainable investment objective targeting a social impact. In both cases, FMPs are expected to assess reliable data to determine whether taxonomy-aligned investments are included in their portfolios and should be disclosed. While the diagrams included in SFDR regulatory technical standard templates present taxonomy-aligned investments as a subset of sustainable investments which are themselves not subject to disclosure for above-mentioned Art. 8 products, there is no need to disclose a proportion of sustainable investments but only the percentage of taxonomy-aligned investments. Where data is not available, zero taxonomy-alignment should still be disclosed. Any additional narratives should neither leave room for ambiguity about the alignment of the investments of the financial product, nor should they include negative justifications, such as explaining a lack of the alignment by a lack of data.

In the calculation, all investments should be understood as investments resulting from collective and individual portfolio management. Calculation should be based on market value, and not net asset value, in order to avoid over-estimating the alignment. With regards to green bonds, calculation is expected to be based on the use of proceeds (financed activities) and not the issuer. The ESA’s Q&A also clarified that taxonomy-aligned investments must be owned by the fund and their performance should not be swapped. 

• Definition and monitoring of sustainable investments 
  

Sustainable investments are legally defined in SFDR as investments which contribute to a measurable environmental or social objective provided that they do not significantly harm (DNSH) any other objective and follow good governance practices. This definition presents significant similarities with the definition of sustainable activities in the Article 3 of the Taxonomy but it has a much broader scope and provides FMPs the flexibility to demonstrate a positive impact on environmental and social factors beyond the sole climate objectives currently covered by fully standardized technical screening criteria.

This definition must be adapted to the product specific investment objectives and accompanied by relevant indicators to become operable. The ESAs confirmed it is possible for FMPs to create their own framework for their products as long as they adhere to the letter of the legal definition and its different elements. Their interpretation should also be consistent across their product range.

However, there are certain limits to this apparent flexibility. Until 31 December 2022, it is not possible for a tracker of a Climate Transition Benchmark to rely on requirements applicable to such index to qualify the product as a sustainable investment. While it is possible to use estimates to assess the DNSH, approaches solely based on environmental controversies are not considered as a suitable proxy, since they lack metric-based thresholds and process-based requirements. It should also be kept in mind that taxonomy-alignment, which is determined at the activity level, is not sufficient to cover DNSH requirements for sustainable investments. To a certain extent, it is expected that principal adverse impact (PAI) indicators should be used to substantiate this assessment and the ESAs clarified that best practice would be that reference values used to compare investment PAIs and demonstrate that sustainable investments do not significantly harm any environmental objectives should be aligned with the technical screening criteria.

• Principal adverse impacts
  

Similarly to taxonomy-alignment KPIs, PAI indicators are standardized metrics which support the fundamental policy objectives of comparability of data/information with science-based targets for sustainable development, reliability and comprehensiveness of impacts. Where relevant and possible, their use should be maximized in the evaluation frameworks in order to reduce the risk of disclosing misleading/incomplete information and make an efficient usage of data. The Commission confirmed that it is possible to consider PAIs at the product level when the manager opted out at the entity level. Moreover, consideration of PAIs is expected from Art. 9 funds on the grounds that they should only be invested in sustainable investments. The ESAs also explicitly recognized the different possible uses of PAIs and in particular as sustainability metrics to measure the attainment of environmental and social characteristics/sustainable investment objectives. 

With regard to PAI indicator disclosures, good practice would be to indicate the share which is estimated and the share which is based on data provided by investee companies. It must also be noted that delegation of portfolio management should have no impact on PAI disclosure granularity and the investment fund manager’s (IFM) responsibility for compliance with SFDR.

By default, funds of funds and funds investing in holding companies or special purpose vehicles should look through to the individual underlying investments. Where such information is not available, they should be able to demonstrate that they deployed sufficient efforts to source the information either directly from investee companies, or by carrying out additional research, cooperating with third-party data providers or external experts or making reasonable assumptions.

The PAI calculation methodology should be based on four data points, using most recent data for each investment, to reflect portfolio composition variation. In line with the definition applicable to taxonomy KPI calculations, all investments should be understood as all investments resulting from collective and individual portfolio management. The ESA’s Q&A also contains various clarifications on the assessment of PAIs and the calculation of individual indicators. Moreover, if investment funds should not be in scope of the upcoming Corporate Sustainability Due Diligence Directive (CSDD), the ESAs have indicated that FMPs may consult the Annex to this Directive to seek guidance on how to approach social violations that investee countries may be in violation of. It should be at Member State discretion to decide whether CSDD will apply to financial services entities, including IFMs or not.

More specifically, PAIs of green bonds should primarily reflect impacts of the project financed by the bond and not those of the entire undertaking. However, ESAs acknowledged that some PAI indicators, such as the unadjusted gender pay gap, could still be applied at the company level.

It is possible (additional PAI indicator) to voluntarily report the share of investments in companies without a policy to address deforestation. However, asset managers will finally not be required to screen their investments for deforestation risks and ultimately be unable to provide financing to companies that contribute to the degradation of the world's forests since the final agreement reached on the Commission proposal for a Regulation on deforestation-free products excluded them from the personal scope of the text. This position might be reconsidered when this Regulation will be reviewed two years after its entry into force.

• Actual and forward-looking considerations for product design and investment policies
  

In this area, most discussions and challenges revolve around product classification and commitments made in prospectuses, notably with respect to minimum percentages of taxonomy-aligned assets and/or sustainable investments. These thresholds are binding commitments of the investment strategy and not targets or achieved results. Therefore, breaches are subject to sanctions under sectoral legislation such as public statements, temporary prohibition to exercise managerial function or administrative fines up to EUR 250,000. As a result, Art. 9 products, as well as Art. 8 products committing to make sustainable investments should monitor at all times that their sustainable investments comply with legal and contractual requirements. 

In an FAQ issued on 2 December 2022, the CSSF reminded that (i) figures such as minimum committed percentages, (ii) the binding elements of the investment strategy and/or (iii) benchmark are considered as material information. As a consequence, any change to such information must be submitted for approval. With regards to benchmarks, ESAs clarified that the index designated to measure the sustainable performance of the product cannot itself be a broad market index.

When setting up their investment policy, IFMs of Art. 8 funds implementing only an exclusion strategy must be able to explain in detail to investors how the fund’s environmental and/or social characteristics will  be met. However, an exclusion strategy only will not be sufficient for an Art. 9 fund. The CSSF confirmed that an inclusion strategy setting out a positive investment selection process is mandatory and must be disclosed in pre-contractual information in order to demonstrate how all underlying investments meet the conditions of the sustainable investment definition in SFDR. Therefore, it can be extrapolated that an Art. 8 fund committing to make a sustainable investment should not rely exclusively on an exclusion strategy. 

However, an exclusion strategy, which would be in line with the investment strategy and the binding positive investment selection process of the fund, can still be used on top of the positive selection process.

It should also be considered from the design phase of the investment fund life cycle that an Art. 8 fund or an Art. 9 fund must be able to demonstrate that all underlying investments follow good governance practices.

While work on an EU Ecolabel for investment funds has been at a standstill for some time, another recent development must already be considered by product managers. A European Securities and Markets Authority (ESMA) Consultation launched on 18 November 2022 seeks stakeholder feedback regarding draft guidelines on the use in funds’ names of ESG or sustainability-related terms which contain more specific guidance compared to the supervisory briefing issued in May 2022. These draft guidelines specify criteria, in terms of quantitative thresholds, to assess whether the name of a fund containing terms suggesting that the fund focuses on investments that have, or investments whose issuers have, ESG or sustainability features, are fair, clear and not misleading. The approach adds a layer of complexity since it does not set thresholds by (SFDR) category of product but on the basis of certain key words used in the product name:

I. An investment fund which has any ESG-, or impact-related words in its name, would be expected to commit to a minimum proportion of 80% of its investments to be used to meet the environmental or social characteristics or sustainable investment objectives in accordance with the binding elements of the investment strategy

II. Where an investment fund has the word “sustainable” or any other term derived from the word “sustainable” it should allocate, within the 80% of investments to “meet the environmental or social characteristics or sustainable investment objectives”, at least 50% of minimum proportion of sustainable investments

III. Minimum safeguards including exclusion criteria as defined in the Benchmark Delegated Regulation are recommended for all investment funds using an ESG- or sustainability-related term in their name

IV. Further recommendations are also provided for specific types of funds:

• Funds designating an index as a reference benchmark could use ESG- and sustainability-related words in their name only if criteria (I) and (II) are fulfilled by the fund
• The use of the word “impact” or “impact investing” or any other impact-related term should be used only by funds meeting the quantitative thresholds set out in (I) and (II), and additionally whose investments under the minimum proportions mentioned in those paragraphs are made with the intention to generate positive, measurable social or environmental impact alongside a financial return

ESMA will look to finalize its guidelines and publish the final report by Q2/Q3 2023.

When assessing evaluation tools and metrics which will be used to measure and report how they attain the environmental/social characteristics promoted by their products, asset and fund managers should adopt an analytical and critical approach to ESG ratings versus their practical needs and regulatory requirements as such ratings do not systematically encapsulate the different dimensions of sustainable investing. The lack of harmonization and transparency of such ratings is one of the primary reasons why policymakers and supervisory authorities push for the wide use of harmonized taxonomy data and PAI indicators which should therefore be prioritized by the industry in their evaluation and monitoring framework. Following a Consultation launched in April 2022 and the impact assessment which is currently being conducted, a legislative proposal could be put forward to ensure all relevant ESG factors are incorporated in ESG ratings. In the future, the European Single Access Point should also provide a one-stop shop to retrieve sustainability-related information directly reported  by EU investee companies in a machine-readable and extractable manner. However, first sets of data are not expected to be available before 2027.

• Distribution aspects
  

On 23 September 2022, ESMA published its final Guidelines on certain aspects of MiFID II suitability requirements clarifying the following sustainability requirements: collection of information from clients on sustainability preferences, assessment of sustainability preferences, and organizational requirements. While distributors have made significant progress on the collection of sustainability preferences, efforts are needed to ensure front-office staff is properly trained to explain to their clients to which extent and in which manner the range of investment products incorporate sustainability in order to avoid any misunderstanding and reputational risks. The CSSF reminded investment firms that MiFID II sustainability-related amendments regarding the integration of sustainability factors and preferences into product governance obligations such as, inter alia, the distribution strategy by the product manufacturer, the target market assessment by the distributor and the distribution strategy by the distributor, and the product review by the manufacturer or the distributor, will apply as from 22 November 2022. Ultimately, matching of sufficiently granular client sustainability preferences with products according to their target market may be facilitated by through the use of the European ESG Template developed by FinDatEx.

Why  dedicated focus on sustainability regulation is a necessity

The response of the asset management industry to these intricate requirements, guidance and potential upcoming developments will be critical. Greenwashing is a concern now more than ever with the growing demand for sustainability-related products, the complex regulatory requirements and the difficult delineation of sustainable investments. In that context, the ESAs launched a call for evidence, on 15 November, to collect views on greenwashing practices and drivers to complement their own findings. ESMA will share progress on this exercise in May 2023 and is expected to publish a final report in May 2024 which could potentially trigger further legal developments. For an outlook on upcoming regulatory topics, refer to the timeline below.