About a-team Marketing Services
The knowledge platform for the financial technology industry
The knowledge platform for the financial technology industry

A-Team Insight Blogs

SFDR: Dilemma of Shakespearean Proportions Looms Amid Scope Three Preparations

Subscribe to our newsletter

Financial institutions putting compliance processes in place for the European Union’s Sustainable Finance Disclosure Regulations may be reminded of Claudius’ dilemma in Hamlet.

“When sorrows come, they come not single spies, but in battalions,” the usurper king bemoans as he contemplates an avalanche of challenges to his authority.

As Shakespeare’s antagonist watched events piling relentlessly upon him, so asset managers, insurers and lenders in Europe are facing a torrent of new ESG reporting requirements.

SFDR is the EU’s long-gestated regulation to get companies to make declarations on their ESG impact. It’s being phased in, with the focus initially on gauging firms’ environmental impacts before it’s expanded to encompassing their social and governance records.

Financial institutions have had since March to get to grips with making disclosure reports on their own environmental impacts. Those must be made with reference to Principle Adverse Impact (PAI) indicators, which detail dozens of potential ways a firm’s activities are affecting the environment. From January they must begin issuing those reports in earnest. With no time to rest, 12 months later they’ll face the far tougher prospect of preparing to disclose so-called Scope Three impacts – those generated by the companies they work with and in which they invest.

As the biggest step yet in SFDR’s implementation looms, financial institutions are having to work harder to keep up with events. And at the heart of the problem is data; or, more accurately, the lack of it.

The Other Way Around

Scope Three reporting will require market participants to disclose the greenhouse gas emissions of the value chains of the companies in their portfolios. Making that a challenge is the fact that those companies are under no obligation yet to make such disclosures themselves; that will come with the implementation of the Corporate Sustainability Reporting Directive (CSRD).

To some, the timing appears convoluted.

It looks like “the regulators have actually approached it the other way around” says Inna Amesheva, ESG Research and Regulatory Solutions Head at Germany-based financial data provider Arabesque.

“They’re asking investors to disclose on their holdings the disclosures that those companies are actually not required by law to disclose,” Amesheva tells ESG Insight. “It’s like they’re asking the market to first request the data before it is enshrined into legislation.”

Wheels Within Wheels

For investee companies to report their Scope Three disclosures they will need to calculate the emissions of their entire value chains. Large companies, like a car manufacturer, could find that a daunting task, requiring information from potentially thousands of suppliers.

But it doesn’t end there; like matryoshka dolls, that data will necessarily have to include the emissions records of their suppliers’ suppliers… and their suppliers too.

Mohamed Hoteit, Business Analyst Manager at Adenza, formerly AxiomSL, says that’s troubling asset managers.

“These are areas that they cannot control fully,” he says. “They need to figure out how much they contribute to total carbon emissions at each stage of the supply chain – it requires a lot of communication with suppliers. It’s a lot of work.”

Companies that fall under reporting regulations are expected to make every effort to comply, despite the effort required. But with the best will in the world, few are likely to be able to fully do so until they’ve worked out how to obtain the necessary data, argues Denis Noonan, Vice President of Depositary Services and Custody Oversight at wealth manager Northern Trust Luxembourg.

“From a regulatory perspective, as well as from a corporate governance perspective – as well as a stewardship perspective – we’re all kind of punching off the back foot because we don’t have that underlying data; it simply doesn’t exist,” says Noonan, who is also non-executive director of Greenomy, a maker of sustainability data management software.

Data Gaps

With the EU’s reporting technical standards (RTS) yet to be encoded, companies remain uncertain about how or what they should disclose. Its most recent iteration, unveiled last month, has also raised questions about how the regulation would apply to market participants’ holdings of exotic assets such as derivatives and swaps.

But even once a unified set of standards is adopted, it’s more than likely that huge gaps would remain in the data record, which currently can be filled only with estimates and modelled proxies.

That raises another headache: the SFDR demands that only real data be reported. What, then, is to happen to the asset managers that have tried to comply but been hampered by the unavailability of the information they need to do so?

Experts appear divided. The EU’s regulators have pledged they will not take action as long as financial institutions show they have tried all they can to comply.  Arabesque’s Amesheva believes that from past experience, there will be no wriggle room. But others feel the overseers will have no alternative but to show early lenience.

“From a regulatory perspective, they understand that’s not going to happen overnight, especially considering that the data itself is not there,” says Adenza’s Hoteit. “And we’re not just talking about SFDR here – that will apply to all other ESG regulations.”

Hoteit echoes others when he suggests SFDR’s Scope Three implementation is probably designed initially to get the ball rolling on better reporting. There is growing awareness that the deepening climate crisis and societal divisions can be helped with the careful allocation of private capital. Therefore SFDR, say some observers, can be a galvanising force to encourage asset managers and companies to think about how they can make more effective disclosures and help ease global crises.

“I am fully on board with what I heard is the European Commission’s position, which is that ESG in general and the climate in particular are too important to wait until we come up with a perfect solution or a perfect framework,” says Tom Raptis, Principal Consultant at FinTech consultancy firm Reformis. “We have to start now.”

Data Delay

So what of the data that’s proving so difficult to obtain, but which is nonetheless going to be needed for companies to fully comply with SFDR? When will it be available?

Raptis believes data vendors – who are dependent on companies actually providing the information in the first place – won’t be able to offer their clients anywhere near what they need for at least four or five years after Scope Three implementation. Hoteit thinks it could be double that and Noonan argues vendors will never have enough data because the reporting framework will always need changing as the nature of business and commerce evolves.

“It’s going to be gradual, and it’s going to be continuous,” he says.

There is a broad consensus, however, that as the regulation beds in, global reporting standards and vendor methodologies will converge, making it easier for companies to comply. That will also encourage the standardisation of regulations around the world.

One theme that comes through is the likelihood that more asset managers will create proprietary data gathering and management capabilities to ensure they have the exact information they need. That’s likely to see the evolution of software and services that enable financial institutions to obtain data directly only from the companies in which they invest, according to some observers who spoke to ESG Insight.

Others expect more financial institutions to integrate feeds from ever more vendors to ensure they have covered all bases. At Bloomberg’s OneData Day conference recently, panelists heard that it was not uncommon for asset managers to have ESG data feeds from as many as 15 individual vendors.

Arabesque’s Amesheva is confident the regulation in general and Scope Three reporting in particular will succeed because, she says, it has a precedent.

“We’ll get there because if you make the comparison with the way the financial system was working before the introduction of IFRS and commonly agreed financial data reporting standards, we’re currently in the same place,” she says. “So we will get there, eventually, but until then it will be a challenge.”

Subscribe to our newsletter

Related content

WEBINAR

Recorded Webinar: Progress and challenges in taxonomy and standards setting for ESG

Volumes of investment in ESG products continue to rise, regulators around the world are putting rules in place, and the EU has, perhaps, first mover advantage with both ESG regulation and a taxonomy in place. This is significant progress in a relatively uncharted market, yet significant challenges remain for financial market participants keen to make...

BLOG

Natural Capital Asset Manager CAM Takes Data Sourcing In-House

The notion that the natural world has a capital value beyond that provided by the economic activity it supports has gained ground among investors. Consequently, a number of asset managers have emerged to service growing demand to support a natural capital and biodiversity market that’s estimated to grow 2,000 per cent in value to US$93...

EVENT

RegTech Summit New York

Now in its 6th year, the RegTech Summit in New York will bring together the regtech ecosystem to explore how the North American capital markets financial industry can leverage technology to drive innovation, cut costs and support regulatory change.

GUIDE

ESG Data Handbook 2022

The ESG landscape is changing faster than anyone could have imagined even five years ago. With tens of trillions of dollars expected to have been committed to sustainable assets by the end of the decade, it’s never been more important for financial institutions of all sizes to stay abreast of changes in the ESG data...