ESG and the Sustainable Finance Disclosure RegulationAs part of the EU’s strategy on climate change following the Paris Agreement of 2015, a number of EU regulations have been enacted in the past 12 months. From the fund management industry’s point of view, the two most important are the “Sustainable Finance Disclosure Regulation” and the “Taxonomy Regulation.”
The Taxonomy Regulation seeks to establish a classification system in relation to environmental objectives to provide more information and greater transparency to investors in relation to sustainable investments. One aim is to counter so called “greenwashing,” where fund products are marketed with environmental aims, but do not deliver on those promises. Although enacted earlier this year, the main provisions of the Taxonomy Regulation will come into force in two stages: the first in January 2022 following the publication of “technical screening criteria” in relation to two of the environmental objectives (climate change mitigation and climate change adaptation), and the second in January 2023.
The Sustainable Finance Disclosure Regulation will however come into force on 10 March 2021. The regulation sets out the framework of the obligations, but is light on detail on how exactly to comply. That detail will come into clearer view through “regulatory technical standards” (RTS), but their introduction has been delayed and they will not be ready for the start date of 10 March 2021. Instead, compliance with the “high level principles” of the regulation is expected from 10 March 2021, and following the finalization of the RTS, more detailed compliance can then follow (expected to be from January 2022).
The immediate task for those entities within scope, so called “Financial Market Participants,” which includes AIFMs, portfolio managers and EuVECA managers among others, and “Financial Advisers” which covers investment advisers, is to determine how to comply with the Disclosure Regulation from 10 March 2021. From this date, all in-scope entities will need to comply with certain provisions regardless of whether their funds have an ESG focus or sustainable investment objectives. There are additional obligations in relation to these types of funds but there is a baseline of compliance required by all.
All EU based entities will be in scope, but so too will non-EU entities marketing fund products to EU investors. While the UK may not be subject to EU law from 1 January 2021, if UK managers are intending to market under NPPRs into the EU they will fall within the scope of the Regulation.
The disclosure obligations can be split broadly into website disclosures and pre-contractual disclosures.
WEBSITE DISCLOSURESWebsite disclosures are in relation to the manager’s/adviser’s practices in general and are not product specific, and will include information on (i) the integration of sustainability risks in the investment decision making process or investment advice, (ii) whether or not the manager considers the principal adverse impacts of investment decisions on sustainability factors (and if so, a statement on their due diligence policies with respect to those impacts, and if not, clear reasons for why they do not do so), and (iii) information on how its remuneration policies are consistent with the integration of sustainability risks.
PRE-CONTRACTUAL DISCLOSURESIn addition to the general website disclosures, AIFMs will be required to include certain disclosures in the fund documents. Portfolio managers and investment advisers will have to include similar disclosures in the delegation/advisory agreements. The disclosures will include (i) the manner in which sustainability risks are integrated into investment decisions/advice, (ii) the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products, and (iii) where principal adverse impacts of investment decisions on sustainability factors are not considered, a clear statement that it does not consider the adverse impacts of investment decisions on sustainability factors and the reasons why.
While much of the disclosures are relatively straightforward, the consideration of the principal adverse impacts is the main area of concern for fund managers. Draft RTS designed to provide the detail on these disclosures were published earlier this year as part of the EU’s consultation and could have been incredibly onerous and difficult to comply with. However, the introduction of the RTS has been delayed and hopefully the EU will revisit their approach to make detailed compliance more straightforward. This still leaves a large degree of uncertainty, so we would expect that whilst some fund managers will seek to get to grips with this disclosure obligation despite the uncertainty, others may seek to explain why they choose not to comply with the principal adverse impact obligations from 10 March 2021 onwards until publication of the RTS. However, this “comply or explain” option is not available for managers who are part of groups that have more than 500 employees, as they are obligated to comply from 30 June 2021.
ADDITIONAL OBLIGATIONS IN RELATION TO CERTAIN TYPES OF FUNDSThe other area of concern for fund managers is how to determine whether a fund that they manage will fall into the definitions of an “Article 8” or “Article 9” fund, as they will then be subject to additional disclosure requirements. For Article 9 it is relatively clear – as the fund needs to have sustainable investment as its objective in order to be an Article 9 fund, and managers of these types of funds will likely be better equipped to comply with obligations surrounding the methodologies used to assess these objectives, providing information on any indices used as a benchmark, and reporting on the overall impact of the fund in the annual reports.
For Article 8, however, the criteria are that the fund must promote, among other characteristics, environmental or social characteristics. This is, on the face of it, going to catch a large number of funds even if environmental and social objectives are not the primary goal. A large number of fund managers place significant importance on ESG and could be said to be promoting these characteristics. The result may be that fund managers are actually discouraged from adopting or expanding ESG policies and best practices, given that doing so may result in an increased burden regarding disclosures and reporting. Coupled with the recent Department of Labor Regulation that may well discourage fund managers targeting ERISA money from promoting ESG practices or policies, the result is a possible retrenchment by fund managers at a time when good ESG practices should be encouraged. However, the disclosures required for Article 8 funds, such as reporting on whether the environmental or social characteristics have been met and the methodologies and benchmarks used to assess, measure and monitor the characteristics, suggest that an Article 8 fund requires more than the inclusion of investment restrictions precluding environmentally or socially unfriendly investments, or merely having an ESG policy to which the fund manager adheres. Industry guidance and market practice will certainly shape this area over the next few months.
All in-scope entities should now be looking towards 10 March 2021 and ensuring that the required website disclosures are made by that date, and any funds actively being marketed beyond 10 March must have the necessary pre-contractual disclosures included. Later in 2021 there will be further work required to ensure compliance with the detailed technical standards, and from January 2022 onward the first part of the Taxonomy Regulation will be in play. The direction of travel is clear in this area (in Europe at least): if you wish to hold yourself out as making sustainable investments then there is going to be a great deal of work involved to back that up.