Regulation – 101 SFDR Implications – Brace for BIG change in the asset management sector

Here we are, some weeks to go to align with the SFDR Level 1 requirements. The date to respect is 10 March 2021.

SFDR Level 1 is to a large extent focusing on integrating sustainability risks and adverse impacts plus classifying funds according to how sustainable they are. To simplify a little. The text in itself is not long but demanding and with few details to help implement. You can find it here: https://eur-lex.europa.eu/eli/reg/2019/2088/oj

SFDR RTS Level 2 will give more details on how to implement but will come into play on 1 January 2022 at the earliest.

A lot has been written about this already.

• EY’s Stephan Geiger wrote this piece in December: https://www.ey.com/en_ch/sustainability-financial-services/eu-action-plan-deep-dive-on-disclosure-regulation-sfdr
• KPMG’s Gry Evensen Skallerud and Matthew Smith have co-written recently this piece (in Norwegian):https://home.kpmg/no/nb/home/nyheter-og-innsikt/2021/02/esg-utfyllende-regler-til-offentliggjoringsforordningen-er-klare.html

I’ll steer away from the details of what this requires. I’ll rather share with you some of the points I think are worth being aware about and what it may lead to.

Article 2, paragraph 17 – “Sustainable Investments”

What do you think of when I say sustainable investments?

Each and one of you will likely have a personal tilt to the definition of this, especially if I ask you to define a little more in detail. This is normal, as this is something we all have had exposure to in real life on the personal side before this became a big topic on the professional side. Additionally, today there is quite a gap in between the sustainability specialists and the others in the financial industry. That gap relates to knowledge of the area, the definitions of the different aspects and how we talk about this, i.e. the vocabulary we use.

And now we can welcome to the debate the “sustainable investment” definition of the SFDR Level 1:

‘sustainable investment’ means an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance;

Notice the “contributes to an environmental objective”. Did the SFDR hijack this expression? This is clearly reducing a good part of today’s use of the expression “sustainable investments”, even among specialists!

 Many would define this as investments with an SRI (Sustainable and Responsible Investing) strategy, that is mainly; Norm screening, Exclusion, ESG integration, Best in Class, Engagement, Thematic, Impact.

This is the Eurosif definition:

Ethical investments, Responsible Investments (RI), sustainable investments, and any other investment process that combines investors’ financial objectives with their concern about environmental, social and governance (ESG) issues. (EUROSIF in 2008).

It is a long way from “concern about ESG issues” to “contributes to an environmental objective” while being transparent and capable to report on this.

ESG integration for example is first and foremost ensuring that the investor invests in companies with sustainable business models, see EFFAS definition here of corporate sustainability:

The capacity of companies and organisations to remain productive over time and safeguard their potential for long term maintenance of profitability. Being sustainable means that companies actively pursue goals such as responsible use of natural resources, both in their own operation and the operations of their clients, as well as respecting social rights in their markets of operation and those markets where their products and services are in use and being accountable to providers of equity and debt capital. (EFFAS)

It will be hard to tie this into “contributes to an environmental objective” while being transparent and capable to report on this.

More central definitions can be found here: https://www.sustainax.com/index.php/sustainability-vocabulary/

Recently the Swedish SEB Investment Management announced they would remove the part of certain fund names alluding to “sustainability”, is the above discussed the real reason? See press release here: https://sebgroup.com/press/news/seb-strengthens-sustainability-policy-for-all-funds

It will be interesting to see how this will be dealt with in the coming year.

Article 4 -Principal Adverse Impact – 100%?

This one is quite tricky and widely debated. Despite this, a statement and some light details is required on 10 March 2021.

Today, no generalist asset manager can say they on a entity level 1) “consider principal adverse impacts of investment decisions on sustainability factors” as it requires 2)”a statement on due diligence policies with respect to those impacts, taking due account of their size, the nature and scale of their activities and the types of financial products they make available”.

At least if this is required for 100% of their investments. This comes out even more obvious when having a look at the Level 2 final proposal from the ESAs. There are too many indicators and by far too little data out there from the investee companies. For those still choosing to say yes, there is job to make policies and processes transparent.

I expect to see some asset managers declaring they do consider PAI in their investment decisions on 10 March to take down the ambitions on this when they have to take into account the requirements of the Level 2 regulation. 

Is it better to say that today it is technically impossible due to lacking data fro the companies out there, and describe what is being done today even it it does not cover fully as described in the Level 2 final proposal?

Article 6 – Anyone with an actively managed fund opting out? Nope.

Do you integrate sustainability risks in your investment decisions? (And here sustainability risk is defined by SFDR as being equivalent to ESG risk)

Not a choice really for actively managed funds, this is clear to sustainability specialists. For us and a growing part of the investment community this is part of the fiduciary duty. Can you opt out of integrating all the relevant risks? No. End of line.

The commercial pressure to avoid saying no and on top of that having to publicly explain why you do not, is limiting this option to passive and special strategies.

Sustainability risk integration is or will very shortly be the norm in Europe.

But that is just the starting point, now you must tell on an entity and product level how you integrate ESG risks in your investment processes. Some thoughts about this here: https://www.linkedin.com/pulse/esg-integration-do-most-asset-managers-only-pretend-dag-a-d-/

Article 8 – Promote sustainable factors – What?

There has been a lengthy discussion on what qualifies. It seems to be the plan that this group of funds shall be large, hence no reason to be stricter than the SFDR permits.

But the limit between Art 8 and “other funds” (often referred to erroneously as Article 6 funds) is blurry. What is sure is that ESG risk integration (discussed in the above) does not qualify as promoting sustainable factors (defined by SFDR as environmental and social).

The debate is on the requirements of qualifying exclusions and how the binding requirement is expressed and reported on. Interestingly, the French regulator AMF, has stated a strict minimum exclusion effect of 20% of the universe. The problem with that approach is that for two funds with the identic sustainability strategy excluding exactly on the same criteria, one will be Art 8 and the other not qualifying. And the one qualifying to Art 8 is the one with the “worst” universe with regards to exclusions as it will exclude a lot.

Hopefully, we will get more guidance in the final SFDR Level 2 and also when the EU commission has given answers on questions from the ESAs on the Level 1 unclarity.

Anyway, all relevant financial products will have to be classified by 10 March 2021, well before all of this is answered, so there is a clear risk of funds changing classification later in 2021.

I’ll leave it there for this time as we very soon…

…we’ll be starting to work on SFDR RTS Level2

The final proposal from the ESAs (EBA, EIOPA and ESMA; together called the ESAs) to the commission was published early February. These are the technical details specifying what is required in the Level 1 regulation.

The Level 2 is at another…level, and despite the reduced scope of required details in reporting compared to the first draft, it still stands out as very demanding for anyone that claim a certain sustainability approach on both entity and product level.

It is a strong reminder of the main rationale of the EU Sustainable Finance, reaching the 2050 EU climate goals by redirecting capital in the green way. This by imposing very thorough transparency and reporting for those claiming to be sustainable in a way or the other, to end the greenwashing.

When a broader public in the asset management business realises what the SFDR Level 2 is requiring many will still be surprised, I think. This will require serious data gathering, data treatment, process integration and reporting for funds. And to do that you need data, that to a certain extent does not exist today. Here we need help from the companies, and the smaller they are, the less we get.

Just to give you an idea of how challenging this is, have a look at the templates for the required pre contractual and reporting for PAI (Principal Adverse Impact), Art 8 and Article 9 in the current proposal that is likely going to be very close to the final version acted by the EU Commission.

Doccument link: https://www.esma.europa.eu/file/111459/download?token=fFznXUqc

Se pages

• Table 1 – Principle Adverse Impact – page 59
• Annexe II – Art 8 pre contractual – page 83
• Annexe III – Art 9 pre contractual – page 87
• Annexe IV – Art 8 periodic reporting – page 91
• Annexe V – Art 9 periodic reporting – page 95

SFDR Level 2 will be implemented 1 January 2022, but we will start working on this on the day after the SFDR Level 1 requirements are completed, so 11 March 2021, and we will be busy this year!

101 SFDR Implications – Conclusion: Pull up the sleeves

I think the EU will succeed in their main target of this regulation, capital will invest greener and more social. Nobody wish to be seen not taking part in this as it will not be commercially viable. The big institutional clients will ditch you. Just have a look at the RFP documents and how they have been changing in the last 12 months.

It will require a lot more work and engage more costs for the asset managers, and it will have deep impacts on investment processes, other processes and how transparent they have to be about all of it.

It will cost more, but not increase revenues. As usual since some time with increasing regulation, and actually a little sad for the industry I must say. Keep in mind that the potential cost of pretending being sustainable while not in reality being it, is increasing very fast with this regulation. I’d even say the time it was possible to pretend being sustainable id definitely over.

I foresee a 2021 where many funds will be “downgraded” from Article 8, partly due to reporting requirements that will be too demanding for many smaller but also some big actors, and I also foresee numerous fund name changes removing sustainability allusions.

Brace for important changes in the asset management industry and prepare for a rather heavy workload and more costs to be aligned with market and regulator expectations!

If all of this seems to be very exaggerated, I would be happy discussing this with you. You tell me how you deal with sustainability in your investing activities, what you target and I can give you an indication of what you need to do.

I’m a big fan of a cup of fair-trade tea or coffee (but then not too dark) and a small piece of cake, if we can’t meet in person, we can Team or Zoom up!