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SFDR Ready to Take the Fizz Out of New Year For ESG Compliance Teams

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New Year celebrations are unlikely to last long for Europe’s fund and asset managers; at the stroke of midnight when party poppers are pulled and prosecco corks are popped, regulations that force funds to disclose the ESG performance of their investments will suddenly become tougher.

The European Union’s Sustainable Finance Disclosure Regulation (SFDR) will step up a gear on January 1 when so-called Level 2 rules come into play. Six months later another great slab of regulation will descend, when reporting of data covering SFDR’s Principle Adverse Impact (PAI) indicators – essentially, metrics to show how funds’ investments are affecting the environment – will be required.

The headaches from those can be expected to last far longer than those brought about by too much fizz at the previous night’s party.

Bad Movie

If SFDR was a Hollywood film franchise, the 2023 sequel would come with a poster strapline that reads “this time, things get real”.

SFDR was introduced in 2021 amid huge fanfare that had built up since 2018 when it was initiated by the EU. Since then fund and asset managers have been mainly expected to gather data, get their technology in place and voluntarily publish surface-level data on the environmental impact of their investments. As such, Europe’s regulators have taken a softly-softly approach to SFDR so far.

Like many an overhyped movie, SFDR’s debut promised much but ultimately had little impact.

But what was intended as a dry run in the regulation – with the EU allowing companies to comply with its initial rulings on a best-effort basis – will come to a jarring halt.

“Now we are talking about the real stuff,” Neoxam ESG and data management, R&D director Thierry Duchamp told ESG Insight.

Data Demands

From New Year’s Day, SFDR’s Regulatory Technical Standards (RTS) come into force. They prescribe the actions that must be taken to comply with Level 2. Financial institutions will be expected not only to report more information to regulators on their EU or UK holdings, they will also have to buy in more data and technology.

They’ll need that to make a “pre-contractual” report on whether their funds can be classified as light green or dark green – or as SFDR describes them, Article 8 or 9 compliant; funds that, respectively, have a sustainable element to their mandates or are entirely mandated as sustainable.

Having established the ESG targets of their funds, managers will also have to demonstrate through data published in regular reports how they are achieving those goals, or how they are failing to achieve them.

As well, they must communicate all of this to the public on their websites.

A key data issue of SFDR Level 2 is that it must apply to the financial instruments themselves. Under Level 1, the regulation has required disclosures on the entities that issue the assets.

With huge holes in the ESG data record and the challenges associated with handling the multiple formats, both structured and unstructured, in which it’s generated, companies will have a tough data management task in mapping information sent by issuers to the instruments they issued.

“It’s a huge amount of data that they’re going to have to collect, and which, for the most part, they weren’t collecting previously,” Afzal Amijee, commercial director at Broadridge, told ESG Insight. “It’s a much more onerous task than anything they’ve had to do previously.”

Information Sheet

To make things theoretically easier and more streamlined, the EU has endorsed a reporting document called the European ESG Template (EET), which can be used to transfer all the information to regulators. Just how easy and streamlined it will be is up for debate – EETs have 580 data fields that need to be completed.

The data challenge has partly been the reason why many managers have reclassified their funds as light green from an initial dark green declaration. As public awareness and scrutiny of greenwashing intensified over 2022, managers grew wary of overstating their intentions, especially when the data they’ll need to accurately substantiate the claims probably won’t be at their disposal for many more years.

In what’s been called the “great reclassification”, the world’s biggest asset managers have downgraded many of their funds, Amundi, BlackRock, Axa, Invesco, NN Investment Partners, Pimco, Neuberger Berman, Robeco and Deka among them. More are expected.

They’ve realised that under the prescriptive language of Level 2, the absence of data could lead firms into inadvertent greenwashing, as Neoxam’s Duchamp describes it.

“Many datasets are missing and the only thing asset managers can do is to fill the gap” with scores and estimates, he said. “You can fill those gaps in two ways, by being very pessimistic or very optimistic.”

Being too optimistic will attract accusations of greenwashing, he said, adding that it wouldn’t be the problem of the asset manager, necessarily, but a problem of “having uncontrolled process, uncontrolled data”.

Vague Definitions

The challenges associated with SFDR’s most intractable problem – its failure to define closely what constitutes a “sustainable investment” – will become magnified with Level 2 implementation. The vagueness of the wording in the RTS was criticised before it was even published – after much delay – earlier this year. It’s another reason why so many funds were downgraded by their managers.

The problem with ill-defined concepts is that they are open to interpretation, which opens companies to accusations of greenwashing.

For that reason, Institutional Shareholder Services has urged firms to have their classifications ready as early as possible.

“Due to the definition of ‘sustainable investments’ within SFDR leaving room for interpretation and the qualitative nature of the precontractual and periodic reporting templates, financial market participants would benefit from starting the process to define and quantify the sustainable investments of their Article 8 and 9 products at the earliest opportunity, as well as filling out the templates,” said Till Jung, Global Head of ESG Products at ISS ESG.

Regulatory Deluge

The next 12 months are going to be exacting for ESG compliance teams, following a 2022 that saw the introduction of new consultation rules under Markets in Financial Instruments Directive (MiFID II) and the Insurance Distribution Directive (IDD), as well as other non-ESG regulations.

For large and small fund managers, getting to grips with the data challenges that SFDR Level 2 will bring– including how to incorporate it into data management structures – will be a “massive task”, said Broadridge’s Amijee.

“You can’t pick and choose what you want, but you’ve got to be very careful as to as to what you get,” he said. “It will all come down to the data.”

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