As the entry into force of the SFDR Regulatory Technical Standards (RTS) looms just two months away, asset managers are still grappling with fundamental components of the regulation, as well as other related rules such as the EU Taxonomy and Sustainability Preferences under MiFID II.
Alpha is currently supporting several asset managers with their SFDR programmes, and recently ran a roundtable for peers to discuss the common challenges remaining in interpreting, solving for, and delivering the work needed to ensure compliance.
Below are some of the top themes we see asset managers facing over the next two months and beyond:
1. Sustainable Investments: Definitions Continue to Diverge
The definition of a sustainable investment is perhaps the most frequently asked open question around SFDR.
While the concept of a ‘positive contribution’ to an environmental or social objective is clear at a high-level, the standards applied by managers to measure such contribution continue to vary. This means the commitments made to sustainable investments on a pre-contractual basis, and the ongoing reporting of such, are entirely driven by how strict a manager’s framework is. It will therefore be difficult for end investors to compare products and managers on the basis of sustainable investments, if definitions and methodologies are not communicated clearly enough.
Similarly, the level of rigour applied to the Do No Significant Harm (DNSH) and Good Governance tests also vary, and further guidance on how the Principal Adverse Impact (PAI) indicators should be used – further explored below – continues to be sought.
The fact that such a foundational feature of the regulation remains so loosely defined is a cause of concern for managers, though we hope the industry will be able to converge around more common approaches as standards emerge next year.
2. Product-Level PAI Consideration: A Mixed Bag
Integrating the PAI indicators at product-level is another major point of contention. While the EU Commission (EC) has not officially confirmed as such, it seems clear that what it means to ‘take into account’ the PAIs must be a proactive effort from managers – simply monitoring and reporting the data is not enough.
What this means in reality remains to be seen, but we expect leading practice to include incorporating the PAI indicators into pre-trade screens, flagging instances of potential ‘harm’, and articulating clear action to avoid or mitigate such harm, both as part of the research process and through ongoing ownership.
It will also become important to demonstrate improved PAI indicators over time – given the lack of guidance as to what constitutes harm and the subjectivity involved in setting PAI thresholds, the ability for investors to see harmful indicators trending down over time would arguably be the most transparent way of communicating these datapoints.
For this to work, investment teams must be equipped with the data, tools, and knowledge necessary to attest that these new indicators fall under their remit, and will come under regular internal scrutiny as part of ongoing product oversight and governance checks.
3. ‘Sustainable’ Article 8: The New Standard?
The EC has made it clear that Article 9 products must ‘only’ make sustainable investments. The clarity of this guidance was well-received, even if sustainable investment definitions continue to diverge, as described above.
Article 8, however, continues to present a wide spectrum of approaches. There are early signs that intermediaries in some regions are asking for Article 8 products to include minimum percentages of sustainable investments and disclose this in the European ESG Template (EET). This will be challenging for those Article 8 products that justify the ‘promotion’ of environmental or social characteristics, but for which including an additional commitment to sustainable investments may represent a material change to the investment strategy.
While the regulator has been clear in signalling that SFDR is not a product labelling regime, the commercial demand for sustainable investments will only increase. Given the narrowing of the Article 9 category, the need for Article 8 products to include sustainable investment commitments may become more prevalent in order for them to retain distribution in certain channels.
Asset managers will need to carefully balance the commercial imperative of meeting distributors’ and clients’ preferences, with ensuring their framework for sustainable investments allow for these commitments to be made credibly. Such commitments should be approached with sufficient time, diligence and governance.
4. January 2023 Onwards: The Work Continues
Despite the entry into force of the RTS, the work will not stop there. Asset managers’ ESG regulatory programmes will continue, and possibly expand further, throughout 2023, with new priorities emerging.
Focus will turn to completing the periodic reporting templates due in fund annual reports published from 1st January 2023 onwards. In practice, this means starting work on these templates as soon as the pre-contractual disclosures are finalised in Q4 2022. There is a timing challenge here on the data that managers will use as their reference period, given that the commitments reported in the pre-contractual templates will have only just gone live.
In addition, the entity-level PAI reporting due on 30th June 2023 for in-scope entities represents a significant data undertaking, with the need to source, integrate, interpret and report new PAI datapoints for the 2022 calendar year, as well as prepare narrative disclosures on how such PAIs are identified, prioritised and mitigated.
While ESG Reporting, Data and Technology teams are likely already involved in these efforts, the reliance on these teams is likely to increase further in 2023, as work shifts from interpretation and planning to ongoing delivery.
Given the challenges described above, it remains to be seen how long after the 1st January it will be before the regulator’s objectives of improved transparency and comparability of products can be observed. Thematic reviews from the regulator, iterations on practical guidance by supervisory authorities, and collaboration among industry participants will all be key in ensuring the regulation meets its original objectives. In the meantime, managers should continue to focus on pragmatic, credible solutions that can be clearly communicated but also robustly demonstrated, given the scrutiny on greenwashing that is only expected to increase.
If any of these challenges resonate, or to discuss any aspect of your ESG regulatory programme, please get in touch with our team.