To achieve the global targets set out by the Paris Agreement, countries all over the world must impose legal and regulatory obligations on financial institutions. With this in mind, all advisors and financial market participants ought to prepare themselves for the introduction of the European Union's Sustainable Finance Disclosure Regulation on 10 March.
Climate change risk mitigation has been a priority for many nations for some time and remains so. The ESG (environmental, social and governance-related) phenomenon is no longer a ‘nice to have’ element in a corporate social responsibility (CSR) portfolio. It has become part of mainstream business, thanks to the regulatory landscape rapidly changing the way in which the financial industry operates, both in terms of transparency and in terms of ever-higher standards of governance.
The EU Sustainable Finance Disclosure Regulation (SFDR) will come into effect on 10 March. It will standardise and strengthen existing rules for Financial Market Participants (FMPs) and Financial Advisors (FAs) with regards to the integration of sustainability risks into their processes as well as the provision of sustainability-related information in financial products.
The regulation will require FMPs and FAs (entities) to consider "sustainability risks" in various aspects of their operations. This includes the integration of sustainability risks into their internal processes, including investment processes, product governance, remuneration policies and disclosure frameworks. Enhancements to remuneration policies are also vital because they set out the ways in which the business takes account of sustainability risks and they link remuneration to key performance indicators (KPIs). The idea is to ensure that remuneration practices at all FMPs and FAs does not encourage excessive risk taking that could lead to an inaccurate description of products as ‘green,’ a phenomenon known as ‘greenwashing.’
With regards to the UK, the SFDR has not been included as part of the ‘Brexit onshoring’ process, although many firms in the UK may still need to comply with it in their capacities as Alternative Investment Fund Managers (e.g. when they market funds into the EU or manage EU-based funds).
British entities may also feel an impetus to volunteer to adopt or align themselves with the SFDR due to the higher degree of disclosure that it demands. They may also do so because of the final draft RTS (regulatory technical standards, generated by the European Supervisory Authorities) and the Financial Stability Board's Task Force on Climate-related Financial Disclosures or TCFD.
The UK has set forth a five-year staggered implementation disclosure regime that will oblige its financial firms to adopt the "guided disclosures" of the FSB Task Force on Climate-related Financial Disclosures. The UK's Prudential Regulation Authority has already issued guidelines about physical and 'transition' risks and expects firms to quantify and mitigate these risks. HM Treasury’s TCFD implementation roadmap is staggered, with disclosures required for premium listed companies in 2021, the largest UK-authorised asset managers from 2022 onwards, other UK-authorised asset managers in 2023 and wider categories in 2024-25.
Companies in the purview of the rules
In order to consider the application of the regulations, we must identify the entities and products that fall into their ambit and that ought to be preparing to comply. The regulations, after all, do not apply only to firms with headquarters in the EU or ESG-branded products. Entities that may be ‘in-scope’ include:
- financial market participants;
- financial advisors;
- managers with investments in the EU;
- managers with investors from the EU;
- financial products with an ESG focus; and
- financial products defined in the SFDR.
Additionally, with the release of the final draft Regulatory Technical Standards on 4th February, particularly Annex 1, investee entities should also be evaluated for 'Principal Adverse' indicators.
The obligation to disclose information under the SFDR applies to all products marketed into Europe, including those managed by non-EU firms. A further cross-jurisdictional element pertains to non-EU entities that manage EU funds. This is particularly interesting for EU management companies (or 'ManCos') that delegate decisions to non-EU managers or advisors.
The scope of the regulations will, it is anticipated, have consequences beyond the EU's jurisdictional boundaries. A firm from outside the EU that markets its products in the EU will need to take account of the regulations in any placement or distribution process. Additionally, the implications for EU-based mancos that ‘host’ or service non-EU delegates may also affect the internal operations of non-EU delegates that both market into the EU and manage EU-based funds.
The issue of whose decision-making process (in the case of FMPs) or product governance process (in the case of FAs) will apply where a ManCo hosting service is used is a question that FMPs and FAs must consider.
The key consideration is the definition of the term 'FMP' in line with the regulations (Article 2). Another important consideration is the objective of the regulations, which is to make the investment-decision-making process take account of sustainability risks. The process, in turn, may have to include all entities that "manage funds, even where a ManCo is used."
Many management companies provide both management and advisory services. In such cases the requirements for FMPs and FAs apply. UCITS management companies that also provide investment advice, for example, will also be counted as financial advisors by Article 2(11) of the regulations.
Other non-EU regulators in other financial centres are imposing their own disclosure regimes. The Monetary Authority of Singapore, for instance, is now requiring management entities, and particularly the ones that take discretionary decisions, to consider ‘environmental risk’ and draw reference to the FSB TCFD.
The important legislative deadlines are set out below. Some jurisdictions have set dates for fast-track approvals, either to speed the process up or to make it more gradual, so it is imperative that managers and financial advisors must comply with their national requirements for implementation, although the deadline of 10th March seems to apply universally. The final draft RTS, issued in February, also provides invaluable insight into the manner in which the SFDR will be implemented throughout the EU in respect of requirements to disclose information and maintain data. The objective of this is to allow investors to compare data across various reporting periods and make decisions after reviewing key information (informed decision making).
The final draft RTS also provides more information about the disclosures that entities have to make about various underlying processes in FMPs and FAs, including detailed disclosures about 'due diligence' processes that apply to the management of financial products with sustainable objectives (Article 55 RTS). Indirectly, the obligations that institutions have to disclose information about processes on their websites will, in turn, compel them to make some necessary changes throughout their internal operations. This will apply not just to FMPs and FAs but also to investee companies that will also be subject to review in respect of their governance practices (Article 49 RTS) as part of any investment.
Entities must make information public and publish it on corporate websites.
- March 10, 2021 – Entities must publish information about the ways in which sustainability risks have been integrated into their decisions about investments as FMPs or their decision-making processes for FAs. They must also "disclose Principal Adverse Impact on a comply-or-explain basis."
- June 30, 2021 – Disclosure with respect to the principal adverse effects of investment decisions on sustainability factors become mandatory for entities with >500 employees.
- June 30, 2022 – First quantitative report to be published covering the mandatory ESG metrics which the EU reduced for the purposes of "simplified data disclosure."
- – Product-level action: pre-contractual disclosures.
- March 10, 2021 – products with ESG characteristics or sustainable objectives (Article 8 or 9 of the SFDR) must disclose information on their corporate websites.
- June 30, 2021 – assessment of "Principal Adverse Impact" becomes mandatory for entities with more than 500 employees.
- January 1, 2022 – entities must ensure that any periodic reporting does not contradict other disclosures.
- December 30, 2022 – entities must describe the "principal adverse impacts" of product-investment decisions.
The release of the final draft of the Regulatory Technical Standards (RTS) in February 2021 by the EU, specifically Chapter III and related Appendix 1, provides templates for standardised disclosure which will aid the removal of the information asymmetries that FMPs and FAs present to investors to make pieces of data consistent with each other and more comparable with each other, the better to help investors make informed decisions and cause real change. When those investors’ appetites change, the financial services industry will have to evolve – a nd rapidly.
Technology helps you comply!
The constant maintenance of data is burdensome for participants and advisors with regards to compliance. One solution is to seek tailored services and reliable information from service providers, who themselves should make recommendations about the steps to take to keep complying.
Data metrics will become increasingly more pertinent. They will ensure that FMPs and FAs can quantify and tell investors about products that have "an environmental and social characteristic" (Article 8 SFDR) and a "sustainable objective" (Article 9 SFDR). The reliability of such data will become crucial in the process. With this in mind, the European regulators are consulting interested parties to determine whether service providers which provide ESG data should also fall be subject to some aspect of regulatory oversight so as to introduce integrity into the data-capture process.
Software that helps people to collect data ought to monitor and manage investment decisions to ensure that they remain compliant. This requires the continuous tracking of performance over time and will become ever-more useful in entities' efforts to comply with the rules.
It is evident that ESG regulation will remain a priority for market participants and advisors in 2021 and beyond. The introduction of the SFDR is the most pressing ESG-related event on the agenda and it is approaching fast. It presents all relevant entities in the financial sector with a new and daunting challenge.