SFDR – The end of the beginning

The EU Sustainable Finance package has finally started to make itself felt with the implementation of the Sustainable Finance Disclosure Regulation (SFDR) level 1 regulation as of the 10th of March which mandates financial market participants (with over 500 employees) to disclose the ESG performance of the companies/assets underlying their investments.

A few weeks after the regulation entered into force Morningstar estimated the current European ESG and sustainable fund market, based on SFDR definitions, could be worth as much as €2.5trn and this trend is only set to continue.

Despite this, the regulation has raised some serious questions and concerns from asset managers, with some struggling to precisely identify which of their ESG and sustainable funds are eligible as article 8 or 9 products under the new requirements. The complications increase when we begin to consider the cross-border element of regulatory expectations asset managers might have to satisfy when operating across multiple different jurisdictions.

One size fits all?

Asset management companies required to comply with SFDR must determine whether some of the funds they market qualify as either article eight or an article 9 products – the former only includes funds that ‘promote’ environmental or social characteristics, while the latter must have an explicitly sustainable investment strategy.

Once the correct classification has been applied, asset managers must then provide investors with comprehensive disclosures on their ESG performance according to a new template for the Article 8 and Article 9 products they market. In addition, they must explain how the product measures and meets its stated sustainability objectives.

However, problems arise when we begin to consider the categorisations behind article 8 and 9 products. For many firms who have been engaging in ESG and responsible investment for years, it might be difficult to attempt to apply what they do into the framework set by the EU. They may find that what they regard or define as ESG or responsible investment does not qualify as such under the SFDR.

These issues only get more complicated when the level 2 requirements come into effect in January 2022 which will require asset managements to report against 14 principal adverse impact (PAI) indicators on which disclosure will be mandatory, with 46 optional adverse impact indicators that can be included voluntarily.

Transparency vs sales – a trade off

The purpose behind the SFDR is to increase transparency in relation to the ESG impact of investments. However, the labelling system has led to concerns around the regulation being used as a marketing tool. A number of fund selectors and distributors are specifically seeking out article 9 products given its appeal which could lead many asset managers to fast track their article 9 classifications in pursuit of inflows.

Investors have already begun to assume article 9 products are ‘better’ than article 8 which is often not the case. While article 9 funds should continue to be encouraged, the rush to label a fund article 9 is problematic and companies risk failing to meet the stringent regulatory standards which could lead to downgrades later.

Opportunities for asset managers

The different national obligations pose another problem for SFDR as national regulators could begin to diverge, leading to different types of reporting in different jurisdictions. The SFDR is a positive change and a step in the right direction but these complications need to be overcome if the regulation is to have its intended affect. With the level 2 requirements around the corner however, things will only get more complicated.

Asset managers struggling to communicate their ESG and sustainability considering the new framework need to ensure all marketing, sales and external communications material makes sense across different jurisdictions to present a global ESG story as opposed to one fragmented by different markets and criteria.

This requires communication expertise, coupled with engagement with the appropriate political and regulatory stakeholders across different jurisdictions to promote harmonisation in standards across the globe.

 With a presence across the UK, Europe, Asia, and North America, Hume Brophy is uniquely positioned to support you in your engagement with policymakers, customers, and other industry participants across key markets. Please contact ukteam@humebrophy.com to start the conversation.