The Sustainable Finance Disclosure Regulation (SFDR) will bring a binding transparency framework for European sustainable investment products and a certain harmonization on the definition of what constitutes such products. Even if many Swiss financial institutions may not be directly in the scope of the requirements, they will feel the push towards more transparency from their clients and should learn from the struggles of their European peers.
The Sustainable Finance Disclosure Regulation (SFDR) is the first of many regulatory initiatives originating from the EU’s 2018 Action Plan for Financing Sustainable Growth. It aims at clarifying the duties of financial institutions regarding the integration of sustainability considerations into their investment decisions, while also promoting transparency.
The broad range of both entity and product-level requirements coupled with very ambitious deadlines make the SFDR implementation one of the top priorities for companies concerned. What is important to note is that SFDR does not mandate specific approaches to sustainable investing. However, it does raise the bar for money managers who are looking to market their products explicitly as “sustainable” or as “impact investing” products. Our chart provides an overview of the disclosure requirements for different types of products.
The SFDR applies to financial market participants and financial advisers in the EU. The former includes Alternative Investment Fund managers, UCITS Management Companies or investment firms managing portfolios on behalf of clients (MiFID II). The SFDR requirements may also be relevant to third country firms (such as Swiss Managers of EU-domiciled investment funds). As such, careful consideration of the SFDR is important not only for Swiss financial institutions with EU-subsidiaries.
The degree of legal uncertainty regarding the scope of application of the requirements to non-EU firms (namely non-EU managers of funds marketed or domiciled in the EU) remains substantial. It has even moved the European Securities Authorities (ESAs) to write a letter to the European Commission on 7 January this year seeking clarification on the scope of the disclosure requirements and some other ancillary questions. However, in practice, Swiss money managers may find that the strict legal context doesn’t matter so much.
For example, where an EU Management Company (ManCo) or Alternative Investment Fund Manager (AIFM) has delegated portfolio management to a Swiss fund manager, the disclosure obligations may formally lie with the ManCo or AIFM, but the delegated manager will likely need to contribute substantially in order to source all the data.
Finally, any Swiss fund manager or manager of segregated portfolios with EU investors is likely to receive requests to deliver the relevant data under SFDR for their portfolios, in particular where such EU investors are in scope of SFDR themselves, such as pension funds or insurance companies. The investors will require such data to prepare their own disclosures.
Leaving aside the strict legal or contractual context, there is a strong case for Swiss asset managers to at least take some inspiration from the SFDR requirements. While there is currently no equivalent Swiss regulation, it is becoming ever more apparent where the journey is headed – both in terms of the regulatory and societal (including investor) expectations.
First and foremost, there is growing demand for transparency on non-financial matters. The indirect counterproposal to the Responsible Business Initiative (RBI) requires firms (including all regulated financial institutions) to prepare non-financial disclosures, covering environmental concerns, in particular CO2 targets, social and labor issues, human rights and the fight against corruption. See our blog on the RBI here.
In January 2021 Switzerland became an official supporter of the Task Force on Climate-related Financial Disclosures (TCFD). The Federal Council formally recommends companies across sectors to voluntarily implement this reporting standard and is deliberating on making this recommendation binding. The recent FINMA consultation concerning the disclosure of climate-related financial risks by systemically important banks and large insurance companies is a further step on the path to increased climate-related transparency. Find out more about TCFD in our recent blog.
Another core concern of the regulator is the risk of “greenwashing”, stemming from the rising tide of products marketed as sustainable. The State Secretariat for International Finance (SIF) is expected to present a proposal to the Federal Council by fall 2021 on legislation to prevent greenwashing. At present the topic of ESG-integrated advisory services is still largely dealt with in the self-regulatory realm by players such as the Swiss Banking Association and the Asset Management Association. We have highlighted the 2021 regulatory trends in our recent blog.
For the financial services sector the SFDR constitutes a robust framework to address both transparency issues surrounding environmental and social considerations as well as greenwashing.
The SFDR is an intricate mesh of duties, whose implementation requires careful orchestration. The implementation work for the regulation will go on during the year 2021 as the ESA’s final Level II requirements were published only on 2 February 2021 (“draft RTS”), and will likely enter into force by 1 January 2022.
One of the cornerstones – and key challenges – of the implementation process is the classification of financial instruments (including managed portfolios), on which the determination of the nature and scope of the disclosures hinges. “ESG products” in the sense of the SFDR are only those which meet the requirements of Art. 8 and/or Art. 9 SFDR, i.e. products promoting environmental or social characteristics (Art. 8) and those that pursue a sustainable investment objective (Art. 9). While these products are attractive for promotion, the regulatory hurdles are quite high, as many players have discovered. For those products that do not meet the respective conditions, it must be ensured that no “E” or “S” strategy or sustainability impact is implied, as this would constitute mis-selling. Indeed, experience so far has shown that the most commonly observed product type are Art. 6 funds (which consider sustainability risks) which will be considered as “mainstream” products. In contrast, the highest category – Art. 9 funds – is encountered only on very rare occasions, due to the very high standards set by the regulation.
Beyond being a technical exercise, the product classification may necessitate a re-examination of the overall sustainability-related strategy and communication. All the more so as the pending amendments to the MiFID II regime link up with the SFDR classification for the determination of clients’ ESG preferences. Those who want to position themselves as “green” must ensure they have a product palette to match the claim.
Another focus is the disclosure of principal adverse impacts of investment decisions on sustainability factors (“PASI”), which is mandatory for firms with more than 500 employees. For many, the gathering of the necessary data from internal and external providers must be prioritized in order to adhere to the website and periodic reporting duties. This may involve negotiating new contracts or sourcing additional data or IT providers. Internally, the corresponding reporting structures must be established and methods to take the PASI into account as part of the investment decision process.
Due to the variety of different workstreams which are necessarily involved in the SFDR implementation, coordination and consistency is vital: A range of policies and procedures must be assessed and adapted in order to guarantee an adequate internal framework. Policies on the integration of sustainability risk into the investment decision-making process must be evaluated, along with the remuneration policies and how these are consistent with the integration of sustainability risks. Where PASI are considered, information on the respective due diligence policies must be published. Implications for the broader policy framework must also be addressed in order to avoid inconsistencies and to embed the provisions in the existing control and reporting framework. Coordination with IT will be key to secure a timely “go live”. Client contracts form a further workstream to be aligned with the remaining preparations.
Many have barely made it past the finish line for 10 March but it is important to bear in mind that this is just the beginning. Due to the complexity and breadth of the covered topics, a successful SFDR implementation must have the big picture in mind – both from a regulatory as well as a strategic and business-minded perspective.