The Perils and Promise of the EU’s Sustainable Finance Disclosure Regulation

Concerns that the ESG sector is awash with greenwash have been growing in recent years. In response, this March, the EU’s Sustainable Finance Disclosure Regulation came into force, with far-reaching implications for both fund managers and the companies they invest in. 

 
What’s new

The regulations sit within the EU’s Sustainable Finance Action Plan, which aims to push capital flows into sustainable finance, manage climate change risks and foster transparency and long-termism.

The concern is that greenwashing – erroneous or exaggerated claims of sustainability credentials – has been depriving truly sustainable funds of investment.  

Moreover, in the absence of clear and comparable information, there have been fears of growing risks in the market, with investors vulnerable if their ‘sustainable’ assets are found to be not-so-sustainable after all and potentially losing value. Indeed, recent research shows one of the biggest concerns for financial advisers is advising clients to invest products that are later accused of greenwashing. 

And even investors who make no environmental and social claims about their financial products can be exposed to sustainability risks, in the occurrence of an environmental, social or governance event that causes a negative material impact on the value of an investment. 

So, since March 2021, financial market players and advisers operating in the EU have been required to publish descriptions of the integration of sustainability risks into their investment decision-making process, whether they consider principal adverse impacts on sustainability factors in their investment decision-making process, and disclose how sustainability considerations are incorporated into remuneration.

As well as this entity-level information, product-level disclosures are also expected. The most basic of these are for funds that don’t promote environmental or social characteristics, called an Article 6 fund in the regulations, for which either a sustainability risks policy and an assessment of the impact of risks on returns are required, or an explanation of why these are not relevant. More rigorous disclosures apply to funds that either promote environmental or social characteristics (an Article 8 fund) or has sustainability as its objective (an Article 9 fund). 

Central is the concept of double materiality, which means that in-scope companies must not only consider how ESG risks affect them, but also how their activities impact environmental and social factors.

These regulations are currently what the EU terms level one regulations, which means they are high-level principle-based. More arduous and detailed disclosures will be required when the level 2 regulations kick-in from July 2022. That date was pushed back from January 2022 because of a delay in the finalisation of the regulatory technical standards, which will provide detail on the content and presentation of the required disclosures. In-scope companies will also have to report against the EU Taxonomy, a scientific framework to classify environmentally sustainable activities. 
 

Implications: Data and compliance

The new regulations will have significant implications for in-scope companies. Compliance costs will likely rise. Much of the extra data required for reporting relates to metrics which are not easily measurable, related to, for example, investee company exposure to fossil fuels and carbon emissions. 

Under the SFDR, firms are required to use their “best efforts” to gather this data through direct engagement with investee companies. Where the necessary cannot be attained this way, firms can use third party data, conduct additional research and/or make reasonable assumptions. 

All of this will take time and money. Some boutique asset firms believe they will be unfairly impacted by the compliance burden, and have called for European regulators to impose caps on ESG research costs for resources provided by third parties in order to create a more even playing field between boutiques and larger firms. 

Further, there will be inevitable knock-on effects for investee companies that will be now be subjected to requests for diverse range of additional data, much of which they have might not have even considered gathering before. 

 
Implications: Confusion and deliberate misinterpretation 

Another challenge is that, despite the fact the regulations were brought in part to improve transparency, there is still considerable confusion in the industry about what constitutes a green fund, and the differences between an Article 8 fund and an Article 9 fund. A study of ESG funds by Morningstar and Zeb Consulting, for instance, found “various interpretations of the regulation have resulted in a diverse group of funds represented by Article 8 with entirely different ambition levels and heterogeneous investment strategies .”

While the vague categories increase the chances of genuine mistakes, experts also fear that fund managers are deliberately exploiting the uncertainty and erroneously labelling certain funds as sustainable. As a recent Reuters analysis shows, asset managers are adopting a wide range of strategies to justify green labels since the EU brought in disclosure rules in March.

But firms should not count on this ambiguity lasting going forward. The next step in improving precision will be in July 2022 when the EU implements the Regulatory Technical Standards that will clarify disclosure requirements. 

More broadly, therefore, the key challenge going forward is that financial market players will have to think deeply about their sustainability strategy; paying lip-service to ESG factors will no longer be enough. And investee companies will also have to take seriously their sustainability efforts if they want to continue attract funds. 

Yet, in a different light, this could also be seen as an opportunity. For those firms that really want to take their responsibilities to society and the environment seriously, the playing field is levelling.  And for those who don’t buy the philosophical argument, the regulations will at least ensure they understand their business and their operating environment in greater depth.  

Firms that already are ahead of the game, or are ready to quickly and thoughtfully engage with the SDFR, will be at an advantage. After all, these regulations should be seen not as another administrative hurdle, but part of a broader societal shift that demands companies create real value and take a wide and responsible approach to their social and environmental obligations. Indeed, right now the EU is working on a social taxonomy to complement the environmental taxonomy, and more regulations should be expected.