Disclosure Obligations for Sustainable Investment Funds and Products

There are only six months left until the Sustainable Finance Disclosure Regulation ("SFDR") comes into force on 10 March 2021. Asset managers need to be aware of the new ESG disclosure rules that will apply at both manager and product level.

The Sustainability Boom

The European Parliament adopted the SFDR on 27 November 2019, followed closely by the Taxonomy Regulation on 18 June 2020. These regulations have been spurred into action by the phenomenon tagged "ESG" – Environmental, Social and Governance factors. Regulators do not regulate in a vacuum – these milestones should not be a surprise to asset managers, given the drive for environmental sustainability.

ESG has become an important global consideration, with investors now demanding the alteration of current products to be re-aligned with ESG benchmarks. Pension funds and public bodies are frequently asking tough questions regarding the ESG credentials of fund managers. In Q2 2020 alone, €774 bn was invested in Sustainable Fund Assets in Europe.

It is vital to note that investments will not be classified as 'green' if an investee company promotes a beneficial environmental outcome yet also causes disruption to another environmental objective. For example, a company viewed as environmentally sustainable on the basis of low carbon emissions yet is also polluting rivers with contaminants. The investment will not qualify if it causes significant harm to another objective.

One cannot simply tick one box; each component of 'ESG' must be satisfied:

E – Environmental factors;

S – Social, diversity and employment factors; and

G – Governance factors.

The investment can pass the environmental test by promoting beneficial environmental outcomes and not causing significant harm to any other environmental objectives. The social test can be passed by promoting ethical employment standards, but if a decent structure with regard to the governance of the portfolio is lacking, such as the lack of a whistleblowing procedure, it will fail. 

Integration of ESG into the Investment Process

ESG issues can actively be incorporated into existing investment practises. Investment managers can use the following tactics to implement a responsible investment policy across their investments:

a) Negative Exclusion: excluding certain sectors or companies involved in activities deemed unacceptable or controversial, such as the production of fossil fuels.

b) Positive Integration: invest and pursue sectors or companies for their positive ESG credentials. This also includes giving a 'positive tilt' or bias to such companies.

c) Impact Investing: pursue investments aimed at solving environmental or social issues.

d) Stewardship: favour the companies with a better track record of ESG credentials and actively contribute in reporting and monitoring to ensure compliance with the objectives.

Sustainable Finance Disclosure Regulation 2019 

The SDFR lays down the framework for disclosure obligations imposed on ESG funds and products and tasks the managers with preparing regulatory technical standards by 30 December 2020. The ESG framework aims to harmonise disclosure obligations for funds that market themselves as 'green' and combat those that 'green-wash', i.e. those that appear on the face of it to be promoting ESG objectives, yet upon closer expectation are causing harm to the environment.

The SDFR also creates a new product classification for products and segregated accounts:

• Funds which promote environmental or social characteristics and invest in companies that follow good governance practices ("Article 8 funds");
• Funds which have sustainable investment objectives ("Article 9 funds"); and
• Out of scope products.

All product providers (even out of scope products) will be subject to additional disclosure requirements to some extent. As the definition of Article 8 funds appears to be very wide in scope, it is suggested that managers should decide if the promotion of environmental and social factors are a binding part of their mandate. If the answer is yes, it is very likely to be an ESG product. Managers are also advised to determine if they promote environmental and social features in their marketing materials.

In addition, the ESG fund will be subject to additional disclosure obligations set down in the Taxonomy Regulation, if the fund is promoting environmental characteristic or contributes to an environmental objective and not merely social ones.

Scope and Timing of the SFDR 

There are two ways a business can be caught:

1) EEA authorised financial market participant (all EU authorised asset managers)

2) Marketing products into the EU, including fund products and portfolio management services.

Timeframes for Compliance:

We may see a UK domestic regime under the Finance Services Bill, post 31 December 2020, but this is yet to be confirmed.

Manager Level Disclosure

From 1 March 2021, the requirements will become more onerous and burdensome. Asset Manager's will have to disclose the following:

• An explanation of how sustainability risks are incorporated into their investment process. For example, an investment into an airport will need to consider how lower carbon forms of travel may impact the value of such an investment;
• An explanation of how their remuneration policies are consistent with the incorporation of sustainability risk into the investment process; and
• The adverse (non-financial) impact of the investee companies may have on society and the planet in a Principal Adverse Impact Statement. The requirements here are very onerous and burdensome:

Principal Adverse Impact Statements will be an annual requirement and must include (without limitation) a summary of:

• Policies on identification and prioritisation of principal adverse sustainability impacts;
• Engagement with investee companies to address these adverse impacts;
• The action taken during the reporting period to attain the environmental/social characteristics or the objective of sustainable investment (including shareholder engagement); and
• The 32 mandatory reporting items (plus 18 optional items) such as emissions, waste, pollution and social/employee matters. The metrics for reporting on these items are highly prescriptive.

These principal adverse effects of investment decisions on social and environmental criteria must be published on the company's website. Completing this statement will require very active engagement with investee companies - a feat which may be very challenging for private asset classes. SME's are unlikely to be producing the data that this statement requires, especially if the firm is based outside the EU.

Please note this is only a requirement for firms/groups with fewer than 500 employees, although the threshold for this limit is slightly unclear. It is likely to only apply at group level if the parent entity in the group is a financial market participant, otherwise the 500 threshold will apply on an entity level. Firms should carefully consider if including a statement explaining why they are not publishing a statement will have a detrimental effect on their reputation.

Product Level Disclosure 

 From 10 March 2021, all financial products (even those that do not promote ESG objectives) will require pre-contractual disclosure on how sustainability risks are taken into account for investment decisions and the likely impacts of such risks on the products returns. If these are not included or considered, it must be explained.

In addition, from December 2022, those firms with over 500 employees must also disclose how the product deals with the principal adverse impacts on the sustainability of the product.

Suggested Next Steps

We recommend that all businesses review the following points to ensure compliance with the SFDR:

1. Scope at entity and product level to determine whether or not your firm or products are in the scope of the SFDR;
2. Begin drafting initial disclosures;
3. Formalising and documenting processes – AIFMD, UCITS and MiFID will expect ESG to be incorporated into risk management frameworks;
4. Consider what to say in investor due diligence questionnaires with regards to their ESG position;
5. If you will be required to produce a Principal Adverse Impact Statement or opt to, it is advisable to have a project leader to coordinate the vast data collection that is required; and
6. If you have already entered into an Investment Management Agreement, it seems you will not be required to make a pre-contractual disclosure, but the ongoing disclosures will apply.

UK based Asset Managers may query whether and to what extent the substantive obligations under both SDFR and the Taxonomy Regulation from March 2021 onwards, will apply to them after the Brexit transition period has ended on 31 December 2020. The UK Government's intention is to on-shore key in-flight EU financial services regulations, such as the SDFR and the Taxonomy Regulation, although it has yet to introduce the necessary legislative instruments for this.

It is likely firms will be waiting for the final regulatory technical standards to fully comprehend the detail required for ongoing disclosures. For further information on any of the above requirements, please contact Caitlin Spence or Jonathan Cohen.