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Europe’s SFDR: Shades of Green Cause Ops Headache

By August 12, 2021July 27th, 2022No Comments

Non-green, light green and dark green.

Investment, compliance, and legal managers at fund management shops who must classify their funds in one of those three categories under Europe’s Sustainable Finance Disclosure Regulation (SFDR) are finding the road to explaining how their investments are helping or harming the environment and society paved with good intentions but filled with plenty of obstacles given the scarcity of some data and unclear interpretation of the technical rules for implementation. Grey funds will require the least amount of administrative work, while dark green funds dedicated to sustainable investments will need the most.

Sustainable and ESG investing are considered the fastest growing investment strategies across the world. particularly in the European Union. Research firm Morningstar estimates the value of assets falling under the light green and dark green categories could rise from 34 percent to 50 percent of the value of all European fund assets over the next 12 months. Unfortunately, there is still plenty of confusion as to how much information to disclose and when even after the European Commission’s recent responses to questions posed by the three European Supervisory Authorities seeking clarifications to some of the SFDR’s provisions. The three European Supervisory Authorities are the European Securities and Markets Authority, the European Banking Authority, and the European Insurance and Occupational Pensions Authority.

Compliance with SFDR will be more difficult than simply following its disclosure rules, because the SFDR overlaps with Europe’s ESG Taxonomy Regulation requiring fund managers to follow taxonomy-related disclosure for sustainable investing. The three European supervisory authorities recently released another consultation paper on the Taxonomy Regulation to amend SFDR’s articles specific to areas relating to environmental targets contained in the taxonomy regulation to reduce discrepancies between the two measures. “The consistent revision to the [taxonomy’s] ruleset makes it increasingly difficult for an in-scope asset manager to frame their final data calculations in time for the effective date of the final regulations,” writes Adrian Whelan, executive vice president of regulatory intelligence for custodian bank Brown Brothers Harriman in Dublin in a recent blog in which he compares the task of following SFDR to the tortuous journey of climbing Mount Everest.

So far, only Europe has mandated buy-side firms report on sustainability or ESG factors, but the US might eventually follow suit depending on what the Securities and Exchange Commission’s new leadership under the Biden administration decides. SEC Chairman Gary Gensler has asked his staff to create ESG-related disclosure rules by the end of this year after the ESG subcommittee of the SEC’s asset management advisory committee recommended that issuers– corporations, closed-end funds, and mutual funds — incorporate ESG disclosures in a way that allows investors to make better decisions.

Current SEC guidelines suggest climate change risk may need to be disclosed in federal filings, but they do not specify the information required to be revealed, leaving companies to decide what to say about such risks. “US fund managers need to prepare for more robust climate-risk disclosures in the US as they consider their solutions for compliance with the SFDR’s rules,” cautions Jeffrey Zoller, director of US mutual fund services at BNP Paribas Securities Services in Denver. SEC examiners are also looking into the ESG-related investment practices of fund managers. In a recent blog Gwen Williamson, a partner at the law firm of Perkins Coie in Washington, D.C. notes that the SEC’s staff is asking for data on internal definitions of ESG and socially responsible investing (SRI), the ESG/SRI strategies, the criteria considered including internal and third-party scoring systems, written policies and procedures, and marketing materials.

The goal of SFDR is two-fold: to help investors understand how to make investment decisions based on companies’ sustainable footprints and to ensure that fund managers don’t greenwash or incorrectly categorize funds as being focused on improving the environment and society, such as reducing carbon emissions.” European-based UCITS fund managers, alternative investment fund managers (including some non-EU fund managers, and asset owners, such as pension plans and insurance companies, will fall under the SFDR’s mandate,” says Eve Ellis, a partner in the asset management group of the law firm of Ropes & Gray in London. “US fund managers must comply with the SFDR if they market alternative funds to European investors under national private placement rules. US advisers acting as submanagers to European-based investment firms may also be subject to the SFDR indirectly.”

In its recent question-and-answer analysis on how the SFDR is to be implemented, the EC suggests that non-EU fund managers fulfilling the SFDR’s requirements need to do so at an entity-wide as well as the fund level. However, the EC’s text is unclear to some legal experts. European and non-European fund managers with under 500 employees will likely only have to comply with the SFDR on an entity- fund-wide basis, rather than on an individual fund basis and might not have to discuss the principal adverse impacts (PAIs) of their investment decisions. The 500-employee litmus test is based on employees working for the same parent fund management firm inside and outside of Europe. UK fund managers will not have to comply with the SFDR, but the UK could eventually decide to implement its own similar disclosure regime.

Although the buck in fulfilling the SFDR’s disclosure requirements will stop at a fund management firm’s compliance department, it will take plenty of teamwork from the front-office to get all the work accomplished. “The investment management team will need to provide the compliance department with all the data for the overall firm and for each fund’s sustainability factors,” says Trysha Daskam, head of ESG strategy for Silver, a New York-based regulatory compliance and ESG advisory firm. Other data management experts believe the most time-consuming element of complying with SFDR for fund management firms will be researching public records and asking companies in which they have invested for information on how their policies have affected the environment and society. “Fund management firms may already be able to report 60 percent of the data, but 40 percent will be missing,” says Mark Davies, a partner at Element-22, a London-based data management and governance consulting firm. “It will initially become a data gathering and management challenge.”

Reporting ESG-related data isn’t mandatory and there is no common reporting framework even for voluntary disclosures. Different data points may be reported across companies in the same industry sector while the same company might report different data points from one year to the next. “We have seen investment managers relying on ESG data vendors to an extent, which can play a helpful role in assisting with carbon emissions modeling,” says Caitlyn McErlane, a partner in the financial services and regulatory group at the law firm of Baker McKenzie in London. There are over 100 ESG dta vendors, such as Bloomberg, FTSE, MSCI and Sustainalytics, yet they aren’t always the entire solution. “ESG vendors use proprietary and often opaque methodologies to rate the same companies, resulting in fundamentally different results,” explains Davies. In addition, there are still gaps in data when it comes to venture capital and private equity investments, so fund managers must rely on contacting the investee companies themselves. The investment contracts signed by the fund management firms with privately held companies may not always require disclosure of sustainability factors.

As of March 10, 2021 — the deadline for meeting the SFDR’s Level 1 requirements– a fund manager must have integrated “sustainability risks” into its decision-making process and explained how an ESG event or condition may have a material impact on the value of its investment and how the risk is addressed. The disclosure is required at the fund-level in a fund’s offering statement and at the entity-level on the fund manager’s website. Until the EC’s recent response to questions posed by the EU’s three supervisory regulators, many non-EU fund managers have applied only the fund level disclosures, Based on an interpretation of the ambiguous language of the EC’s new attempted clarifications of the SFDR’s requirements, non-EU fund managers might be required to publish on their websites on whether harmful effects on sustainability factors– PAIs– are considered along with the due diligence policies used to identify the PAIs. The term PAIs refers to the negative effect of an investment decision on sustainability factors, such as poor water quality and toxic waste.

For disclosure purposes, fund managers must categorize funds in one of three buckets– non-green or “gray” funds, light green funds, or dark green funds. Non-green, otherwise known as “gray” funds are designated as Article 6 funds — a broad category of products that do not promote environmental or social causes; they could even invest in tobacco companies. Light green funds, which fall under the category of Article 8 funds, promote environmental or social causes. However, that is not their main objective. Article 9, or dark green funds, are those specifically designed with sustainable objectives. That means the companies in which investments are made ensure sustainable outcomes. Under the Level 1 requirements of SFDR for funds classified as Article 8 and Article 9 funds, fund managers must disclose in their offering documents how environmental and social characteristics are promoted or the sustainable investment is made by each fund. Referenced benchmarks must also be discussed.

As of July 1, 2022 the SFDR’s Level 2 requirements kick in requiring more granular disclosures on Article 8 and Article 9 funds, particularly when it comes to discussing the use of benchmarks or other quantitative metrics. The disclosures must include an explanation of how the investment strategy achieved the desired environmental and social characteristics or sustainable investment objective and what asset allocation– percentage of companies in the fund– the fund used to promote environmental or social characteristics or the sustainable investment objective. The fund must also indicate whether a specific index or indices was used to meet its sustainability objectives. “The disclosure rules for Article 9 funds are a step above Article 8 and are likely to be more resource-intensive,” explains Baker McKenzie’s McErlane.

In an Article 9 fund if the index used by the fund is designated as a reference benchmark, the fund manager must explain how the designated index is aligned with the fund’s sustainable investment objective. If there is no designated index used as a reference benchmark, the fund manager must explain how the sustainable investment objective can be achieved. If the goal of the fund is to reduce carbon emissions, then the benchmark used by the fund must be an EU Climate Transition Benchmark or an EU Paris-aligned benchmark and the fund manager must explain where the benchmark’s methodology is available. If the EU Climate Transition Benchmark or the EU Paris-aligned benchmark is not used the fund manager must then explain how reducing carbon emissions will happen based on the Paris Climate Agreement.

Compliance managers at several US fund management firms contacted by FinOps Report say they are uncertain about what benchmarks they will use to determine how a fund addresses sustainability factors. They are also confused about how much information to disclose about PAIs and when. Some believe they don’t have to worry about PAIs until July 2022 and are uncertain if disclosure of PAIs at the fund level is required for non-EU fund managers. Based on the most recent explanations on PAIs, there are a total of 60 indicators of which 14 are mandatory and 46 are voluntary. “So far, all of the information that must be disclosed about PAIs is at the manager, rather than the fund level, and fund managers are waiting for more clarity on the Level 2 requirements when it comes to PAIs and taxonomy disclosures,” says Ellis from Ropes & Gray’s London office.

None of the US compliance managers who spoke with FinOps Report understood how to relate the SFDR’s disclosure requirements with the EU’s Taxonomy Regulation, which requires fund managers of Article 8 and Article 9 funds to explain which taxonomy objectives they are following and to what extent they are invested in taxonomy-compliant activities. The explanations, effective as of January 1, 2022 and January 1, 2023, must be made graphically and through quantitative metrics based on the taxonomy’s methodology. “Fund managers still don’t clearly know where Article 8 funds fall in needing to meet the meeting the taxonomy’s requirements as that has not been finalized,” says Silver’s Daskam.

Although the financial penalties regulators can impose on firms which do not comply with SFDR have yet to be revealed, fund managers aren’t taking any chances. Their biggest concern appears to be classifying funds correctly; the wrong classification will result in the wrong disclosure. “Fund managers classifying a fund as an Article 9 fund when it is an Article 8 fund will generate regulatory attention,” says Camilla Bossi, the Milan-based business development manager for ESG solutions at Confluence, a global technology solutions provider focused on solving investment data challenges. “Therefore, it is likely that fund management firms will err on the side of caution and classify more funds as Article 8 compliant.” Regulatory penalties are not the only bad outcome for a bad classification. “Fund managers are also incentivized to make the right classification by investors,” says Daskam. “Investors won’t invest if the fund isn’t aligned with the right ESG risk.” As a rule of thumb, once a fund is classified as an Article 9 fund it will be harder to justify a downward change in classification, according to Ropes & Gray’s Ellis. An Article 8 fund could always be upgraded to an Article 9 fund down the road if the fund’s investment objectives change.

As is the case with regulatory requirements, fund managers can choose to do the work entirely in-house, rely on consultancies such as Confluence and Silver to help out, or turn to their custodian banks. Custodians are also quickly adding Big Data analytics, artificial intelligence, and machine-learning tools to their ESG reporting capabilities to provide the necessary information for fund managers to incorporate in their disclosures. “The decision on whether to rely on external help and how much help depends on the maturity of the fund manager,” says Chantal Mantovani, Confluence’s RegTech and Fixed Income Analytics product manager in Milan. “Some fund managers have been gathering ESG-related data for years, while others are just starting and will require more assistance.”

BNP Paribas Securities Services has partnered with sustainability data providers Clarity AI, Fintech Util and Moody’s owned V.E. to give fund manager users of the bank’s Manaos platform access to sustainability data and modeling tools. Util’s machine-learning models quantify the extent to which listed companies positively impact the 17 United Nations Sustainable Development goals and their 169 targets. MUFG Investor Services, the global asset servicing arm of Mitsubishi UFJ Financial Group, has launched an ESG transparency reporting service based on data from ESG data service company RepRisk, which relies on AI and machine-learning technologies to identify ESG risks. Citi says it has incorporated ESG scores into its securities services data platform Citi Velocity Clarity to enable clients to analyze the sustainability of their holdings at a portfolio and security level. The update includes new visualization and algorithmic tools supplied by global data provider Arabesque S-Ray to help analyze multiple sustainability measures daily.

Although there remains some confusion on the exact quantitative disclosure requirements of SFDR at the fund level, fund managers should be on their way to being prepared. In an April alert to clients, Angela Korek and Matthew Dunlap, partners in the law firm of Morrison & Foerster in London recommended that fund managers develop internal reports assessing sustainability risks with quantitative and qualitative measures; analyze the PAIs of Article 8 and Article 9 funds, including what actions were taken to reduce PAIs; and define the sustainability targets for their own economic activities But first thing’s first. “Fund managers need to establish a process for who will collect the data, which sources will be used, and who will ask underlying investee companies for information,” says Element22’s Davies. “Collection and management of ESG data for SFDR could and should be a BAU process. Provided that fund managers have robust data management processes in place there is no reason ESG data needs to be processed differently.”

Davies recommends that fund managers clearly identify the reporting requirements; the data points needed to service these requirements; the preferred data sources; and how to best collect, validate and deliver the data to those who need it– the marketing, compliance, investment, and portfolio teams. BNP Paribas’ Zoller also suggests that once firms address the data gathering process, they think about the next step–data integration. “Funds must report on the extent to which they met their sustainability objectives, and this process should occur alongside analytics and risk considerations,” he says.

Fund managers relying on third-party ESG vendors need to ask for full transparency into the methodology they use, according to Davies. “If vendors have included estimates in their data set, they should be identified as such,” he says. “The methodology behind any derived values should be clearly understood as fund managers may have to explain and justify the methodology to regulators and/or clients.” The decision on whether to outsource the data collection and analysis work to a custodian bank will likely depend on a portfolio’s complexity. Funds could depend on custodian banks for help with listed companies which already do some reporting on ESG factors with the custodians sourcing data once and sharing costs across multiple parties. “Portfolios that contain private company or real estate investees may find it harder to source data and with few economies of scale it may be left to the fund managers to handle themselves,” says Davies.

Fund management firms which think they have sufficient time to prepare for SFDR’s disclosures even if a deadline is months away, had better think again. “Asset managers who have made initial elections and feel they have time to get ready might be in for a rude awakening as they are asked questions well in advance of the mandatory disclosure guidelines,” writes BBH’s Whelan in his recent blog. Sales and distribution managers at fund management firms, he believes, can expect to be questioned on how their portfolios contribute substantially to the EU taxonomy’s environmental objectives; how their funds adhere to the “Do No Significant Harm Principle”; and what process is used by fund manager to ensure compliance with minimum social safeguards. The EU Taxonomy Regulation’s “Do No Significant Harm Principle” requires fund managers to not violate the six environmental change objectives of the Taxonomy Regulation, including climate change mitigation, climate change adaptation, as well as sustainable use and protection of water.

While technically intended to promote greater disclosure on ESG factors, the SFDR could also ultimately have a behavioral impact on fund managers and corporations. Fund management firms may decide to offer more ESG-dedicated funds to attract investor interest as they face an uphill battle marketing Article 6 funds. They have to answer why they don’t consider sustainability rules or PAIs. In addition, under amendments to the MiFID II legislation Article 6 funds won’t be recommended to investors expressing an interest in ESG. Companies will also need to respond to the increasing ESG-related disclosure requirements if they want better access to capital. “Companies should consider assessing their own sustainability impacts, their alignment with the major ESG standards, and the benchmarks applicable to their operations,” says the law firm of Vinson & Elkins in a recent client alert.