Investment Managers are scrambling to finalise processes ahead of the EU’s Sustainable Finance Disclosure Regulation (SFDR) product-level or “level 2” disclosure requirements taking effect at the end of this year. At the same time, they are keeping an eye on two sets of proposals in other jurisdictions.
Firstly, the Sustainability Disclosure Requirements (SDR) proposed by the UK’s Financial Conduct Authority (FCA) in a Discussion Paper issued in November last year. Secondly, in the US, two ESG-related proposals from the Securities and Exchange Commission (SEC) in May 2022, which contemplate changes to the “Names Rule” and to a range of disclosure requirements.
Investment Managers have been preparing for SFDR over the past three years, particularly since the entry into force of the entity-level or “level 1” disclosure requirements in March. The challenge for funds marketing in more than one of the EU, UK and US will be to ensure that their ESG and impact strategies remain true to their objectives and comply with, but not be determined by, regulatory intervention. This challenge will be most acute where there are inconsistencies between regimes.
Interestingly each of the regimes has been clear that it does not dictate the application of any particular ESG strategy, acknowledging that there are a range of approaches to sustainable investing. The regulators seem to be at pains to stress that the intention is to intervene only so far as necessary to address “information asymmetries” (SFDR), to ensure consumers are “able to effectively navigate the market for sustainable financial products” (FCA) and to provide investors with “decision-useful information” (SEC).
How Are Regulators Approaching Labeling
European authorities have been adamant that SFDR is “not a labelling regime,” with the European Commission going so far to include an express statement to that effect in the explanatory memorandum accompanying the final version of the “level 2” disclosure requirements. SFDR establishes differentiated disclosure pathways based on whether a product pursues the objective of “sustainable investments” or “promote environmental or social characteristics” without necessarily making “sustainable investments”.
There is however a potential threat in Europe that supervisors in individual member states seek to develop individual minimum standards, as has already started to arise, including in France, and with proposals in Germany and Spain. More than 30 regulatory bodies and standard setters in 12 markets have undertaken some sort of official consultation on ESG.
The UK regulator has been much more express about its approach to labelling. Its SDR Discussion Paper included separate chapters on labelling and disclosure.
The FCA asserted that the distinction between Articles 8 and 9 of SFDR “has become a de facto classification and labelling system for sustainability-related investment products.” In contrast, SDR proposes a classification and labelling system consisting of five labels.
In the US, rather than prescribe labels, the SEC has proposed a more principles-based approach. It notes the proliferation of labels including “socially responsible investing, sustainable, green, ethical, impact and good governance” all of which it considers encompassed by the term “ESG.” The SEC’s proposed approach to reshaping the Names Rule focuses on three key elements; ESG factors have potential to be determinative, ESG focus must be fundamental policy and apply to at least 80% of value of assets and ESG focus must reflect plain English or industry usage. The SEC’s disclosure proposal also differentiates between “Integration Funds, ESG-Focused Funds and Impact Funds”.
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Similarities Between the Three Proposals
SFDR contemplates entity-level and product-level disclosures with entity-level or “level 1” disclosures focused on the policies and practices of applicable “financial market participants” and “financial advisors”. Product-level or “level 2” disclosures setting out, both pre-contractually and periodically, relevant attributes of applicable products.
Like SFDR, SDR contemplates both entity-level and product-level disclosures. In both cases, the FCA contemplates building on existing requirements on climate-related reporting at each level to include “other sustainability factors.” But unlike SFDR, SDR contemplates two layers of disclosure, the first targeting consumers and the second aimed at institutional investors and other stakeholders. SDR expressly contemplates a set of labels, which ultimately sit over the top of the disclosure layers.
The SEC Proposals similarly contemplate amendments to existing disclosures required to be made by advisers and in registrations for open-ended and closed-end funds, effectively also adopting the entity/product level distinction shared by SFDR and SDR.
What Disclosures Could Be Required
The form of detailed product-level disclosures Investment Managers will need to provide at launch and periodically under SFDR are set out in prescribed forms that require, among other things, details of:
- the environmental and/or social characteristics promoted by the product (Article 8) or the sustainable investment objective of the product (Article 9);
- whether or not the product takes into account “principal adverse impacts,” a set of specified indicators;
- the binding elements of the investment strategy used to attain the environmental and/or social characteristics (Article 8) or sustainable investment objective (Article 9);
- the extent to which investments will be allocated to “sustainable investments”; (Article 8 only); and
- the extent to which investments will be aligned with the EU Taxonomy (both Article 8 and 9).
The SDR Discussion Paper gives less detail about the content of product-level disclosures. It will draw on a range of inputs, including the UK TCFD Implementation (eg in the FCA’s ESG Sourcebook), IOSCO’s Recommendations on Sustainability-Related Practices, Policies, Procedures and Disclosure in Asset Management, the FCA Guiding Principles and the standards published by the ISSB. The delay of the ISSB standards has been cited as a reason for delaying further consultation about SDR.
The SEC Proposals contemplate product-level disclosures, including in prospectuses and annual reports, which include details (for ESG-Focused Funds, including Impact Funds) of:
- the fund’s ESG strategy, providing a series of check-boxes, including “tracks an index,” “applies an inclusionary screen,” “applies an exclusionary screen,” “seeks to achieve a specific impact,” “proxy voting,” “engagement with issuers” and others;
- how the fund incorporates ESG factors in its investment decisions; and
- how the fund votes proxies and/or engages with companies about ESG issues.
Details of applicable methodology and data sources are required, although the SEC Proposals are less prescriptive than SFDR.
How the Proposals Differ
SFDR, SDR and the SEC Proposals are not fundamentally inconsistent. But there are clear differences in approach between each that appear to mean that Investment Managers marketing products into each of the jurisdictions will be set down a path of differentiated, rather than harmonised, disclosure. ESG strategies must remain true to identified objectives, and not be overly calibrated to the regulatory requirements of any one jurisdiction, or they may find themselves unable to comply with the requirements of other jurisdictions.
Materiality is a particularly hot topic in the ESG data reporting space. This refers to the effectiveness and financial significance of a specific measure as part of a company’s overall ESG analysis. Companies and governments must determine what ESG issues are significant for their organisation and how those impact the business. There is also the question of the outside-in perspective versus the inside-out perspective, also referred to as single and double materiality. This issue essentially asks whether it is a case of reporting how changes in the environment will affect certain companies or how certain companies affect changes in the environment, the US is focusing more on double materiality.
There is also a huge variety in what ESG comprises. Some regulation concentrates on the E side, others look at the S and G elements. Even just considering the E side, there is disagreement over whether this should include climate mitigation or prevention of climate risk, and whether other factors such as biodiversity should be included.
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