Sustainable finance is a major priority for lawmakers, and the Sustainable Finance Disclosure Regulation (SFDR), which entered into effect in March 2021, is a key concern for asset managers. New Level 2 technical standards entered into effect on 1st January 2023. CACEIS expert analysis.
When the SFDR was drafted, the European regulator’s objectives were clear: direct capital towards sustainable investment, combat “greenwashing”, integrate a sustainability criterion into investment risk management, encourage transparency and long-term investment, and categorise funds based on their commitment to non-financial ESG criteria: funds with a sustainable investment objective (”Article 9”), those that promote non-financial characteristics (”Article 8”) and others that do not integrate any explicit sustainability objective (”Article 6”).
“Compliance with this regulation presents a real challenge for our clients, because it involves understanding a new set of procedures: set up an appropriate risk management system, ensure full commitment from management bodies, train and keep employees up to date, and digitise processes by adapting their tools, which means taking on higher costs”, said Eliane Méziani, Senior Advisor - Public Affairs at CACEIS.
The new Level 2 standards (Regulatory Technical Standards, ”RTS”) in force since the beginning of the year more precisely define the rules for implementing SFDR, thereby eliminating uncertainty in the interpretation and application of this regulation.
They have the same objective: better protect end-investors by improving the disclosure of environmental, social and governance (ESG) information. They require financial institutions to report the main adverse effects of their investment decisions and the sustainability characteristics of their range of financial products.
From now on, management firms and other financial stakeholders concerned must clearly state their stance on adverse impacts - Principal Adverse Impacts or PAIs, namely by responding to the following questions: Have they taken these impacts into account? If not, why not? In what way?
As such, funds classified under “Article 8 and 9”, i.e. those that integrate sustainability into the investment process, must provide clear justifications in their regular disclosure documents, such as the annual report and prospectus, and must maintain a dedicated section on their website entitled “Information on sustainability factors”. Sustainability factors include environmental and social matters, respect for human rights and the fight against corruption.
Calculating impacts for PAI reporting must include direct and indirect exposure via the funds, funds of funds, derivatives, holding companies and SPVs. Managers must therefore examine the underlying investments and consider the resulting negative impacts. Publication of these impacts will be mandatory from next spring (June 2023).
Unfortunately, this information may be unavailable or unreliable, meaning managers have few options: They can submit questions to the issuers and companies concerned, call on non-financial data providers, for a cost, or they can use their own internal resources to analyse the data from a sectoral and qualitative standpoint.
“The new mission for the European Supervisory Authorities (ESMA, IOPA, EBA) for 2023 mainly aims to streamline the regulatory framework in this area and specifically integrate a review of PAI indicators, in particular with a view to refining the content of all adverse impact indicators and their respective definitions, applicable methodologies, presentation, etc.”, said Eliane Méziani.
Towards conviction-based sustainable finance
The problems encountered and lack of clarity will continue well beyond 1st January 2023. However, financial players are working to address these concerns and ensure greater compliance with SFDR requirements by establishing best practices and implementing standards such as the European EET (European ESG Template).
“Until publication of the Level 2 standards, SFDR was used more by asset managers as a marketing label (Articles 6, 8 and 9), undoubtedly due to the lack of a standardised and universally recognised label. However, this isn’t the purpose of this regulation, which is primarily aimed at ensuring transparency. The RTS are perfectly in line with this, and actively work to combat greenwashing,” added Eliane Meziani.
If a manager indicates that their investment fund meets the SFDR Level 2 sustainability criteria, they will have no choice but to strictly adhere to the sustainability criteria under these reporting requirements.
At the end of 2022, the introduction of Level 2 automatically entailed an overhaul of the range of investment funds in order to precisely align with the purpose of SFDR: offer the end-investor transparency over the sustainability characteristics of investment funds as well as the ability to compare them. In fact, there was an increase in recategorisations as the Level 2 rules came into effect. Most of these reclassifications involved upscaling from “Article 6” funds to “Article 8” funds. Many managers took a cautious approach when SFDR came into effect and classified most of their funds in the lowest category. Others opted to reclassify Article 9 funds as Article 8 funds, which is less demanding in terms of sustainability credentials.
As part of this effort to combat greenwashing, ESMA (the European Securities and Markets Authority) launched a consultation at the end of November with a view to issuing guidelines on the use of ESG terms in fund names, the use of the terms “green”, “sustainable”, “light green”, “dark green”, “impact”, etc., which remain unregulated to date.
As a leading asset servicer, CACEIS seeks to support its clients in successfully meeting this important challenge. “To this end, we’ve partnered with Clarity AI with the aim of offering our clients a complete range of solutions in terms of ESG, impact and climate risk management, thereby ensuring regulatory compliance,” explained Laurent Majchrzak, Group Head of Products at CACEIS.
The Clarity AI platform, which is available on the CACEIS Connect Store in the OLIS portal, analyses over 50,000 companies, 300,000 funds, 198 countries and 188 local authorities through the use of machine learning and big data, to measure and optimise the sustainable impact of investments and calculate PAIs. It offers direct access to a broad coverage of high-quality ESG, climate and impact-related data, as well as tools to meet SFDR’s regulatory reporting requirements, in addition to the requirements of the EU Taxonomy, TCFD (Task Force on Climate-related Financial Disclosures) and EET (European ESG Template).
“This practical and efficient solution lets clients manage all of their sustainability objectives and commitments while avoiding complicated and costly IT integration,” added Laurent Majchrzak.