This blog was written before the level 2 rules were issued by the European Commission and whilst the rules have offered a degree of additional clarity, these uncertainties still largely remain. It will be interesting to see to what extent the publication of the level 2 rules has altered the approach towards product classification and the balance between Article 6 and Article 8 product categories ahead of 10 March.
Whilst appetite amongst investors for integrating environmental, social and governance (ESG) considerations in their investment portfolios continues to gain momentum, developments in funds and disclosures are mixed. Exclusionary screening is no longer enough to meet investor expectations. There is greater demand for funds with tangible ESG objectives and measurable impacts, as well as a growing recognition that ESG factors can offer a competitive advantage in the market.
Across Europe, the industry is grappling with swathes of new regulations and updates to existing obligations. These require significant changes across the operating model and increased operational burdens. Rules around disclosures, definitions and new taxonomies are difficult to interpret. To add, there is further confusion due to a plethora of ‘soft’ regulation and the decision of the UK to not adopt EU rules.
The imminent implementation of the EU Sustainable Finance Disclosure Regulation (SFDR), the first deadline of which is 10 March 2021, has forced managers to adapt to market developments faster. SFDR requires disclosures at both company and individual fund or portfolio level, whether ESG factors are considered or not. Firms are grappling with many uncertainties and are waiting for the detailed “Level 2” rules to be adopted by the European Commission, in order to have a better understanding of the requirements. But whilst they wait, several factors are influencing the shape of their eventual implementation; namely:
1. Many UK asset managers are applying SFDR to their UK companies and funds
Despite no onshoring of the EU SFDR rules by the UK Government, most UK managers will make disclosures about their UK companies and funds in line with the EU rules, until such time as any similar rules are introduced in the UK. In part, this is in order to provide consistent information about their investment process and products, but it is also due to pressure from UK investors requesting ESG strategies and information.
2. Cautious approach in the UK to categorising funds
SFDR requires fund managers to categorise their funds between Article 6 (not having a specific ESG investment objective), Article 8 ('light green') and Article 9 ('dark green'). Article 8 can be viewed as a spectrum, ranging from the barest of green products with minimal screening of the underlying investments, to products that perhaps select only the highest ESG-scoring assets. UK fund managers appear to be steering clear of the beginning of the spectrum and are categorising funds as Article 8 only if they fall firmly in the top half. The main reason for this is potential reputational risk. Before the Level 2 rules are finalised and extra guidance is given by regulators, firms are unwilling to put themselves in the position whereby products labelled Article 8 must now be downgraded subsequently to the lesser Article 6.
3. Data quality and availability challenges are prevalent
Firms are struggling to access ESG credentials of relevant portfolio companies especially at the level of granularity needed to meet the EU requirements. This issue is especially problematic when attempting to disclose the principle adverse impacts (PAIs) of investment decisions on sustainability factors, given the breadth of data needed about the underlying assets. Firms will need to rely upon data from multiple data providers and their own engagement efforts, which will be costly and time consuming. ESG reporting is central to regulatory expectations, stakeholder credibility, client demands and the ability to effectively embed ESG considerations across the business. However, knowing 'what good looks like' from a reporting perspective is often unclear and is made even harder by the absence of quality data and aligned industry standards.