The Sustainable Finance Disclosure Regulation (SFDR) has already been one of the most wide-ranging regulations in terms of its impact on the funds industry, and one of the most challenging to comply with. And further changes will come into effect on 1 January 2023.
When the SFDR was published at the end of 2019, it was not intended to be a classification system for investment funds, but, as the name suggests, it was a set of rules about the disclosures required by funds, fund management companies and financial advisers, depending on the claims they make about sustainability. However, it quickly became a way of classifying funds as “Article 6” (traditional), “Article 8” (light green) and “Article 9” (dark green or impact), because that was a shorthand way of satisfying the automated searches of the large distributors.
This has resulted in a lot of work on product governance, as fund groups set out to promote the ESG credentials of their funds.
Some funds whose investment strategy takes sustainability risks into account (as an Article 6 fund could do) were “upgraded” to promote their environmental or social characteristics, so they could satisfy the criteria of an Article 8 fund. And funds that described themselves as “impact” were classified as Article 9.
These categories became more relevant on 2 August this year, when the changes to MiFID II and the Insurance Distribution Directive (IDD) took effect, as distributors might use the fund classification as the starting point when considering a client’s sustainability preferences in the suitability assessment. In more detail, the criteria to determine whether a fund satisfies a client’s sustainability preferences are:
- The minimum percentage of the fund in environmentally sustainable investments, as defined in the Taxonomy Regulation,
- The minimum percentage of the fund in sustainable investments, as defined in the SFDR, or
- The fund considers principal adverse impacts on sustainability factors
The regulators have been very strict, saying that, unless it can be shown that a fund meets those criteria, it should not be recommended to a client with sustainability preferences, so the challenge has been to express preferences in that way, even though it is unlikely to be the way clients consider sustainability characteristics.
When the SFDR came into force on 10 March 2021, it was unusual, in that it had no technical standards setting out the details of the disclosures required. The templates to be used for pre-contractual and periodic disclosures, the table to be used for the statement on the consideration of principal adverse impacts, and even the contents and order of website disclosures about funds’ sustainability-related information were adopted in April this year, a year after SFDR started, and only take effect from 1 January 2023.
At the time of writing, the picture has become very uncertain around what will happen on 1 January 2023, as the disclosure templates have been updated to include natural gas and nuclear power disclosures, with these having been added to the taxonomy at a late stage.
The European Commission endorsed the new templates at the end of October and the Parliament and Council have three months in which to raise any objections before they are published in the Official Journal, which will take until at least the end of January. So we are now waiting for clarity around whether funds will need to disclose their exposure to gas and nuclear from the start of 2023 or not until shortly afterwards.
During 2022, product providers (described in the SFDR as “financial market participants”) have needed to consider the principal adverse impacts (PAIs) on sustainability factors at an entity level. For funds investing in equities, the regulators have made a list of 14 mandatory PAIs, including such metrics as greenhouse gas emissions, non-renewable energy consumption, gender pay gap and board gender diversity. They will need to publish their first reports on this by the end of June 2023.
From 1 January 2023, providers will also need to start considering the PAIs on sustainability factors at a product level, so each fund will need its own set of PAIs. This is particularly important where they differ materially from those that the company considers as a whole. This is likely to be the case for sustainable funds within the stable of generalist management groups.
While almost everyone agrees about the importance of disclosing as many metrics as possible as soon as possible, so that both professional and retail investors can see how much progress funds – and the companies they invest in – are making towards a net zero target and a sustainable future, the size of the challenge has in many cases proved too great, as the implementation deadlines are under constant threat.
The Taxonomy Regulation listed six environmental objectives against which economic activities would be measured to determine whether they are deemed to be sustainable. The first two – climate change mitigation and climate change adaptation – have been fleshed out and have applied from the start of 2022.
The plan was for details of the economic activities that satisfy the other four – protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection of biodiversity and ecosystems – would be published during 2022 and apply from the start of 2023. However, as the annexes for the first two objectives ran to 500 pages, the other four seem to be taking longer than expected.
While time is of the essence, it seems to be the case that once everything has settled down, real progress can be made, but don’t expect everything to run smoothly and all the information to be available from the beginning of next year.
A German version of this article was already published in Das Investment on 29 November 2022.
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