Sustainable Finance Disclosure Regulation – new ESG challenges for asset managers
What is SFDR?
The SFDR is part of the European Commission’s package of reforms to implement its sustainable finance strategy. The strategy focuses on three areas:
Strengthening the foundations for sustainable investment by creating an enabling framework. The Commission believes many financial (and non-financial) companies still focus excessively on short term financial performance instead of long term development and sustainability-related challenges and opportunities.
Increasing opportunities to have a positive impact on sustainability for citizens, financial institutions and corporates – enabling them to “finance green”.
Integrating climate, environmental, and social risks into financial institutions and the financial system as a whole.
To that end SDFR introduces a series of disclosure requirements for investment firms to address environmental, social and governance (ESG) concerns. It applies to asset and fund managers (e.g. MiFID investment managers, alternative investment fund managers (AIFMs), and UCITS managers), and investment firms, as well as credit institutions and insurers. The SFDR entered into force in December 2019 and its implementation date is on 10 March 2021.
How does it apply to UK firms?
To general surprise, the UK government has opted not to implement the SFDR into UK domestic law following the end of the UK’s Brexit transition period. However, SFDR will most likely still be relevant for UK firms either as a requirement under the regulation or in practical terms. For example, if a UK-based private equity firm wants to market into the EU or manage EU-based funds, it will be subject to the SFDR in its capacity as an Alternative Investment Fund Manager (AIFM). Additionally, we are likely to see firms complying with the SFDR for commercial reasons, particularly due to client or investor pressure.
Even if a UK firm does not have to comply with the SFDR, the UK government has made no secret about its intentions to put green finance high on its agenda. In November 2020, Rishi Sunak announced that the UK will be the first country in the world to make disclosures that are aligned with the Task Force on Climate related Financial Disclosures (TCFD) fully mandatory by 2025, going beyond the “comply or explain” approach adopted under the SFDR. See our Roadmap here. For asset managers, the FCA is consulting in H1 2021 on potential TCFD-aligned client disclosure rules, aimed at providing ESG information at the firm, fund, and portfolio level to aid decision-making for investors. That nascent UK regime is therefore likely to overlap substantially with SFDR.
What changes will SFDR bring?
The SFDR disclosure requirements involve a number of potentially challenging compliance hurdles for firms to overcome. There is a requirement to disclose “principal adverse impacts” (PAIs) of investment decisions on sustainability factors on a “comply or explain” basis. PAIs are defined as impacts of investment decisions and advice that result in negative effects on sustainability factors. The key challenge will be the collection of data. Firms will need to collect data from various sources, then map that data into a singular and robust data model. Data quality checks and transparency will be important compliance factors. Challenges like these will be costly and time consuming.
At the very least, firms now should be getting up to speed with the SFDR and the related Taxonomy Regulation and understanding where they fall within the scope of the regulation and what changes that will entail to their current practice. In light of the requirements, firms should start reviewing marketing materials and website disclosures. Firms should prepare their position on PAIs. If PAIs are voluntary then firms may wish to implement a phased approach, whereby they explain in March that they aren’t ready to disclose against the rules but will be reporting later in the year.
Firms should not wait to start making implementation plans. Client and investor demand remains a key developing driver of ESG changes and firms need to make headway in this area or risk being left behind.
The text of the SFDR can be viewed here.