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Will SFDR be meaningful and not a confusing productivity drain?

The EU’s green agenda is taking major strides this year with the launch of the Sustainable Finance Disclosure Requirements.

Along with aspects of Mifid II and a new taxonomy, it promises to create a framework for assessing and reporting on ESG risks in portfolios.

However, it hasn’t had the most auspicious start, with draft rules dispatched back to the regulators for a rewrite and only a watered-down version introduced in March.

It begs the question, will SFDR ultimately achieve its aims?

Ambitious but overwhelming

Those aims have been relatively clear from the start.

Eoin Fahy, head of responsible investing at KBI Global Investors, says: “These SFDR regulations are in effect designed to help investors distinguish between investment products which genuinely use sustainability factors/ESG factors, and ‘greenwashed’ products – those that have some minor ESG element, probably for marketing purposes, but where the ‘ESG-ness’ of the product is skin-deep.”

However, the draft proposals, particularly on how to disclose Principal Adverse Sustainability Indicators (as defined in the regulations) sent shockwaves through the industry.

Vastly more detailed and prescriptive than the industry was expecting, local industry associations led by Esma sent the regulator back for a comprehensive rethink.

The original proposals held over 30 different reporting parameters for each investee company; including greenhouse gases, biodiversity, water usage, anti-corruption and waste management.

Ingrid Holmes, head of policy and advocacy at Federated Hermes said: “The initial draft rules were not fit for purpose. Not all the factors were relevant for all areas, yet there was a universal expectation of disclosure.

“There was considerable push back from the industry and this has seen a delay in the detailed reporting requirements.”

Meaningful efforts

In addition to the sheer weight of requirements designed to be delivered in a relatively short time frame, there was also a data gap.

Companies don’t always monitor or disclose areas such as water usage, biodiversity or anti-corruption and it’s also not clear that this is desirable in all cases.

“Do the rules necessarily drive the best behaviour?” asks Charles Sincock, managing principal and ESG lead at consultancy Capco.

“Or do fund managers risk spending time trying to work out a company’s electricity bills? There has been a lot of talk about ‘best efforts’ being a more practical and effective target.”

A second problem was whether investors would be able to use this volume of data.

Holmes asks: “Are the users of this information able to digest it?”

She points out that initiatives such as the ‘Eco label’ that may prove to be much more useful to retail fund buyers rather than the article 8/9 labelling, which is more complex.

Holmes adds that the regulations due to come in in March are now effectively “do your best to report against the high level principles”.

Sincock says that these are often disclosures that investors have to hand: “These are things that most people do already, involving areas such as modern slavery. Many have been doing it for years and this will just strengthen up those disclosures and ensure everyone is in line.

“It shouldn’t be difficult and fund managers should have most of the information.”

Productivity drain

Nevertheless, it may still be time-consuming.

Fahy points to all the literature that needs updating: “Pre-contractual documents” – prospectuses and similar – for many thousands of funds and investment products have to be amended to include significant additional disclosures around sustainability risks, by the middle of March.

“Annual reports have to contain similar though not identical disclosures, as do investment manager websites.”

The new, more detailed, rules now seem likely to come in during 2022.

Sincock believes some fundamental disclosures will remain, even if requirements are watered down. There are still concerns that the weight of disclosure requirements will create problems.

Hugh Cuthbert, manager of the SVM Continental Europe fund, says smaller fund managers not versed in ESG analysis may increasingly come to rely on third parties to get their data.

This introduces a layer of risk.

Will it leave fund managers unable to invest in certain stocks? Sincock thinks not. It will simply ensure that the right risks are assigned to those stocks. “It’s not about getting rid of all stocks that aren’t sustainable, it’s about understanding the risks of ESG concerns.”

This has been seen this year with companies such as BooHoo, once a sustainable fund darling, but which got into hot water over its zero hours contracts and employment practices. If there had been proper disclosure, these problems would have been recognised earlier and investors would have acted accordingly.

Holmes says some fund managers could be in for a shock, even with the longer timeframe to comply.

She adds: “It will get serious when the detailed regulations come into force. It will be a big step for central and Eastern European markets, who are still in the foothills of ESG integration. Across Europe, it will prove to be a step-change in the way people do things.”

Alright on the night

Nevertheless, Fahy believes it should be worth it in the end: “Most of us will agree that it was a worthwhile exercise. Investors wanting to know if a particular product is genuinely sustainable currently have to rely on glossy marketing materials which tend to play up the ESG credentials of almost all products, making it difficult for investors to know how to distinguish between real ESG products and those that are greenwashed.

“And any investment product can today claim to be ‘ESG’ or ‘sustainable’ without any need to comply with regulations to ensure compliance.”

In this, the combination of the SFDR and the taxonomy (coming out later this year) may prove to be important for identifying and tackling greenwashing. Cuthbert says: “The taxonomy will make things so much clearer. We’ve been screening for a long time and it will make comparison a lot easier, particularly peer group analysis.”

The SFDR may not have had an auspicious start and even after a rewrite, the rules may prove excessively prescriptive. However, the industry is feeling its way towards a compromise that may slowly bring about investor and corporate behaviour change.

Just don’t expect instant results.