Re-orienting capital towards sustainable growth

European Union (EU) governments and business leaders realise that one of the best ways to achieve the sustainability goals is to encourage capital to flow towards efforts that promote a more sustainable economy. Many investors also want to support a more sustainable economy, but often lack enough information to assess and compare investment options on the basis of standards. To that end, the EU has put together a sustainable finance action plan (EU Action Plan on Sustainable Finance)

The EU Action Plan on Sustainable Finance is a major step towards redirecting capital to the sustainable economy. The plan features a series of interlinking regulations designed to encourage sustainable investing, including the SFDR.

Helping clients make better sustainable investing choices

The primary goals of the SFDR are to provide greater transparency on sustainability within the financial markets and create standards for reporting and disclosing information related to sustainable investing.

Increasing transparency and introducing standards promotes two important additional effects. First, it makes it hard for asset managers to “greenwash” their products – in other words, they cannot simply brand a product with an ESG or sustainable label, without actually having the process and portfolio to back it up.

Second, investors enjoy a significantly improved ability to compare investment options in terms of sustainability and ESG factors, which helps them make informed decisions that align with their investing goals.

The SFDR applies to all financial market participants and financial advisers based in the EU. A financial market participant is any firm creating investment products, or generally, an asset manager. Financial advisers are individuals providing investment or insurance advice.

Investment managers or advisers based outside of the EU, who wish to market their products to clients in the EU under Art. 42 AIFMD, will also need to follow the SFDR disclosures.

Disclosures will apply to UCITS, AIFs, separately-managed portfolios, sub-advisory mandates and financial advice.

We understand the UK to be currently out of the scope of the SFDR and that the UK as yet does not intend to adhere to the regulation as set out by the EU. In time, the UK may decide on a different set of sustainability disclosure rules for UK legal entities and products, or elect to replicate the SFDR requirements. We will need to wait and see.

To achieve the SFDR’s goals of improving sustainable finance by increasing transparency and creating standards, asset managers and advisers will need to begin disclosing the way they consider two key factors: Sustainability Risks and Principal Adverse Impacts. Asset managers will have to disclose their policies at both the firm and product level, while advisers will have to explain how they consider these factors in their advice.

The SFDR offers specific definitions for Sustainability Risks and Principal Adverse Impacts:

Sustainability Risks refer to environmental, social or governance events or conditions, such as climate change, which could cause a material negative impact on the value of an investment.

Principal Adverse Impacts are any negative effects that investment decisions or advice could have on sustainability factors. Examples could include investing in a company with business operations that significantly contribute to carbon dioxide emissions or that has poor water, waste or land management practices.

Asset managers and advisers need to provide specific information on Sustainability Risks and Principal Adverse Impacts

In the future, asset managers will be required to break out how they consider Principal Adverse Impacts into more specific and quantifiable detail. The updated measures identify nine indicators related to climate and the environment and five indicators related to social and employee issues, respect for human rights, and anti-corruption and anti-bribery matters. There are an additional 16 environmental and 24 social indicators, which are optional, for which investment managers are encouraged to provide detail, when possible. Larger firms will be required to disclose how they consider Principal Adverse Impacts from 30 June 2021, with Principal Adverse Impact reporting estimated to commence mid-2023 (representing Principal Adverse Impact reporting throughout 2022).

Number and type of sustainability indicators for measuring Principal Adverse Impacts

For asset managers, incorporating Sustainability Risks and Principal Adverse Impacts will happen at many points during the investment process. We expect updates to several key areas as detailed in the table below.

Checklist for asset managers incorporating Sustainability Risks and Principal Adverse Impacts into the investment process

Key Impacts

Investors are navigating record-breaking growth in assets and product choices

Sustainable and ESG investing are among the fastest growing types of investment strategies. 2020 was a record-breaking year: assets under management in European sustainable funds rose over 50% to reach EUR 1.1 trillion; meanwhile over 500 new sustainable funds were launched and over 250 repurposed or rebranded, bringing the total number of European sustainable funds to almost 3,200 at year end.¹

The tremendous growth in products spans all asset classes and product ranges – from equities to bonds and from ETFs to separately managed accounts. Even more critical for investors is the wide range of how sustainability and ESG strategies are managed. Some strategies are explicitly focused on sustainability and have specific impact goals. At the other end of the spectrum are passive ESG ETFs. In between are thousands of strategies with widely varying levels of sustainability or ESG integration into their investment processes.

¹ Morningstar, European Sustainable Funds Landscape: 2020 in Review, 3 February 2021.

Differentiating between Article 6, Article 8 and Article 9 products

One of the goals of the SFDR is to help investors better differentiate between the many sustainability and ESG products by creating classifications and disclosures. The SFDR specifies three distinct categories for investment products with regards to sustainable and ESG considerations:

Article 6 products are “other” investment products that either integrate considerations or explain why sustainability risk is not relevant, but do not meet the additional criteria of Article 8 or Article 9 strategies.

Article 8 products promote environmental and/or social characteristics, and may invest in sustainable investments, but do not have sustainable investing as a core objective.

Article 9 products have sustainable investment as their core objective. The SFDR defines sustainable investment as an investment in an economic activity that contributes to an environmental or social objective, provided that the investment does not significantly harm any environmental or social objective and that the investee companies follow good governance practices.

Practically speaking, Article 9 products must invest primarily in sustainable companies or companies that demonstrate improving sustainable characteristics that contribute positively to a particular outcome, such as a low carbon economy.

Article 6, Article 8 and Article 9 disclosures

Article 6 products will need to disclose the manner in which sustainability risks are integrated into their investment decisions as well as an assessment of the likely impacts of sustainability risks on the returns of the financial products.

Disclosures for both Article 8 and Article 9 products will feature details on select topics

The first set of SFDR disclosures are effective 10 March 2021. There remain a few areas for investors to watch, where the guidance is not finalised:

• The draft Level 2 regulatory technical standards (RTS) disclosures were released 4 February 2021. Approval for these proposed standards remains outstanding but is expected in the medium term.
• Following the completion of Brexit, it is not yet known whether the UK will adopt the SFDR or a different set of regulations for UK-based asset managers and advisers.
• Third party data providers, such as MSCI, which are not directly covered under the SFDR, will need to clarify how they will incorporate the new SFDR disclosures into their sustainability-related data, research and rankings.
• Third party ESG related industry standards will need to be reviewed as they get updated to align with SFDR and the EU Taxonomy Regulation.
• The adoption of amendments to the delegated acts (DAs) under the UCITS, AIFMD, MiFID II, IDD and Solvency II frameworks on the integration of ESG considerations remains outstanding, but is expected to be confirmed in the medium term.  Guidance for handling data requests from individual clients, such as insurance and sub-advised business, is not yet finalised.