Whilst legal clarity and standardisation of product disclosures around ESG risks and factors are very welcome, there are clearly challenges to overcome by the practitioners – especially in light of the growing number of national and regional regimes to comply with, and the fact that the differing regimes are very unlikely to fully converge. These challenges include:
1. Regulatory guidance continues to evolve
One of the biggest stumbling blocks towards a consistent and smooth implementation of ESG disclosures has been the room for interpretation created by new frameworks such as the SFDR, where additional guidance and clarifications were only provided by regulators and policymakers after their introduction.
To this end, financial market participants had to first implement SFDR based on the primary legislation (Level 1 text), including the disclosure requirements for so-called Article 8 [1] (or Article 8+ [2] funds) vs Article 9 funds [3]. However, some of the technical requirements from amended MIFID II ESG rules [4] changed the perspective on what “sustainable” is. Later, detailed technical standards (RTS) were published [5], providing much needed details around what must be disclosed. In addition, the European Commission released further guidance to clarify some of the terms that were not precisely defined in the primary legislation [6]. Once all these new clarifications had come in, investment managers needed to significantly change their labels and methodologies, in order to meet the new specifications. Going forward, more clarifications are expected, for example on what constitutes “greenwashing” [7].
Further, the implementation of these ESG regulations happened amidst a shortage of reliable and comparable ESG data from portfolio companies – a challenge that has been well recognised for a long time. In the light of the changing regulatory guidance and increased scrutiny over greenwashing, the market has recently seen a wave of reclassifications of fund designations – specifically from Article 9 into what is known as a more flexible category, Article 8. Yet, there are still many questions remaining to be answered; for example, what would be considered environmental and / or socially sustainable investment for sovereign issuers?
2. High quality ESG data remains scarce
With regard to the availability of ESG data, a bulk of it is yet to be released into the market. Specifically, large corporates operating within the scope of the EU Non-Financial Reporting Directive (NFRD), that will have to report on EU taxonomy alignment of their revenues, capex and opex for the first time in 2023. Proxies and estimates are not allowed to be used for investment product level reporting. It is therefore not surprising that taxonomy alignment data reported to date has been very scarce and lacks comparability. According to a recent report by Morningstar [8], of the Article 8 and Article 9 products reviewed [9] that reported taxonomy alignment, 90% provided 0% values and only 2% target exposure higher than 10%.
3. Private Markets and Alternative Investment Classes face a bumpy implementation journey
In the market segments where ESG data availability is even more constrained, the implementation of the SFDR has been a journey with many hoops to jump through. March 2021, which marked the SFDR application deadline, saw a large drive to qualify investment funds as Article 6 [10], as many didn’t have the right policy and procedures at entity level to be able to comply with the Article 8 or 9 disclosure requirements.
However, the past two years have seen asset managers advancing basic policies towards multi-level policies covering different jurisdictions – a positive development. The Regulation has also been a useful tool in guiding discussions with Limited Partners (LPs), for example, about frameworks and details around Articles 6, 8, 8+, 9 designations, as it has provided a clear way –for essentially the first time - to differentiate funds based on ESG characteristics and objectives. In the future, it will further drive benchmarking approaches between asset managers (e.g. based on taxonomy alignment; Principal Adverse Impacts (PAI) impact, etc.).
Looking at other challenges in private markets and alternative investment classes, they are similar in principle to those experienced by money managers of listed / liquid investment funds (e.g. lack of standard definitions leading to different interpretations and approaches) but are more profound and difficult to tackle. For example, data gaps are harder to fill in in the private space where investment managers are still collecting the data manually through engagement with companies.
There may be the impression that engaging with companies is easy and that investment managers can obtain any required data directly, however, this is not quite true. It is therefore important to pick battles and truly focus on material information. Equally, data validation is important and can only be achieved by setting up the right infrastructure and governance processes – but that involves significant time and resources.
The complexity doesn’t stop here. In fact, SFDR compliance comes with challenges for each asset class and each investment strategy. For example, in private loan markets, processes can be established to enable the screening of individual loans through an ESG lens by dedicated corporate debt teams (e.g. exclusion criteria screening, identifying controversies, analysing commitments to the Paris Agreement etc.). However, the same cannot be done for other private debt strategies, in particular, if they involve a pool of investments and the pools are not static. The main question in such cases is how to assess ESG considerations reasonably quickly and complete due diligence for these types of investments – especially when proxies and estimates are not allowed to be used. Furthermore, the private asset market in general is quite fragmented. Hence, the assessment will vary significantly depending on the size of the asset manager and the underlying size of the asset pools.
Faced with all those hurdles, on the private side most asset managers are in ‘stand still’ mode. Some funds are beginning to consider fund designations beyond Article 6 (such as Article 8 or 9), however, they are doing so with caution: investments in private markets are much less liquid than in public markets and thus investment managers may not be able to easily replace the investment in a portfolio if the regulation changes (or further clarification/guidance is provided) to meet the regulatory requirements and keep the product designation.
4. Greenwashing
Finally, greenwashing risks have been top-of-mind across the investment industry. In the context where regulation lacks precision and creates moving targets in terms of compliance, dealing with greenwashing is becoming increasingly difficult. An investment manager can implement the rules in good faith and to their best ability, but the outcome may still be misinterpreted - and they could still be accused of greenwashing. Currently, asset managers are trying to deal with this challenge in several ways:
Internally:
- Trying to make sure that policies are clear about what kind of investments are considered sustainable or not
- Making sure all relevant stakeholders in the organisation are aware of the policies
- The Compliance functions having a responsibility to ensure that relevant teams (e.g. investment team, risk, control, marketing) understand the policies
Externally:
- Documentation and marketing: establishing processes to monitor how product information is documented and distributed (which is not limited to fund documents only, but any supporting communications, such as side letters)
- Over-disclosing and being very transparent about how sustainable investment, as well as other ESG considerations, are defined, including any legal interpretations
- Seeking external assurance
