In response to investor demand, asset managers are increasingly using environmental, social, and governance (ESG) factors as part of their security selection. Some 505 new ESG funds were launched in 2020 and another 250+ pre-existing funds repurposed with a new ESG focus.

However, because funds use widely varying nomenclature to describe their aims and approaches, investors still face challenges in determining what a sustainable fund does.
The EU’s Sustainable Finance Disclosure Regulation (SFDR) is policymakers’ most extensive work so far in helping investors navigate the growing choice of products.

The full details of what these additional disclosures will look like have now been put forward, having been delayed from 2020. At first glance it looks like it was time well used, with many questions answered and improvements made to the first draft.

Lack of Common Nomenclature is Problematic 

To recap, the regulation aims to prevent product providers from exaggerating their funds’ green credentials. It also looks to embed consideration of environmental and social factors into investment processes, encouraging firms to think about sustainability risks that pose a threat to their investments and the negative impacts their investments might have on factors such as climate, the environment, social and employee matters, and respect for human rights.

This is being done by dividing the entire landscape of European investment products into four levels of ESG ambition including those with no such specific or binding aims; those with environmental or social characteristics; and those with an out-and-out sustainability mandate.

Alas, while the categories will help investors narrow down sets of similar products, solving the nomenclature challenge has some way to go. Unhelpfully, the four types are named after regulatory clauses and currently go by Article 6, Article 8 (a and b) and Article 9.

Managers assign products to one of the levels based on the ESG claims they make in their promotions. Those funds with ESG references in their name or in marketing materials will likely be deemed, at a minimum, as a product promoting environmental and social characteristics, and so will require additional disclosures on their websites, prospectuses and annual reports to back up their aims and achievements.

Advisers Must Help Investors See the Benefits of the New Data

Regulated disclosures can be a double-edged sword. More transparency is good, especially if executed without overwhelming, intimidating or just flat-out boring people. But ESG disclosures are particularly challenging because of the huge diversity of issues encompassed and the wide variety of ways they can be tackled.

Given the volume and technicality, the new regulation isn’t going to be an immediate nirvana of useful, concise, simple language information that is easy for investors to interpret. It will include a fair amount of text about how firms consider ESG factors, and new metrics tied to the specific investment strategy of each product will appear. At least 16 new indicators will be calculated by each firm, showing the effects of their investments on issues including climate, water, waste, and diversity.

Bridging the gap, several measures within the EU Sustainable Finance Action Plan are directed at advisers, including elements of SFDR. Like asset managers, advisers must update their websites to tell clients if they consider principal adverse impacts within their advice process, and if and how they use firms’ SFDR data in choosing the products on which they advise.

Changes Will Take Time

Investors will start seeing prospectuses and websites updated as soon as March 10, but it will be next year and 2023 before real measurable data emerges.

Firstly, documents – including prospectuses for UCITS funds and Key Information Documents for pan-European pension products – must include explanations of how a product intends to meet its ESG objectives and how they will be measured.

A new fixed form template will be inserted as an annex to these documents. Investors will see which indicators will be used to measure progress against the objectives; how a product will be benchmarked; its intended asset allocation and amount of indirect investment (via derivatives or fund of funds).

Subsequent annual reports will get an equivalent annex showing products’ actual results over their prior financial year versus its benchmark, the top 15 holdings in the period, an explanation of any investments classified as “other”, and the proportion of the portfolio held in sustainable investments.

Finally, from 2022, firms will report on their overall performance against a table of specified environmental and social measures of adverse impacts for the calendar year.

The Next Steps for an ESG Investment Framework

SFDR is a milestone for ESG investing, providing a structure for the growing array of products available to investors. Assuming the above rules are ratified in the coming three months, providers have much to do and in part, face a significant dependency on their investee companies making available a full range of sustainability data about their businesses.

The European Commission is aware of this issue and details are due soon about company reporting requirements, as well as the EU taxonomy and fuller details about its flagship

Meanwhile, as one of the newest pieces of EU legislation, the UK has exercised its post-Brexit right not to implement SFDR. The government has previously committed to at least matching the EU ambitions and future FCA proposals for a UK disclosure regime can reasonably be expected to try and raise the bar further. The challenge is to do so without creating conflicting requirements, increasing costs and confusing investors.

SFDR will kick-off a seminal year for ESG investing. For fuller analysis of what is but a short summary please keep an eye out for updates to our EU Policy Research.