With the EU Commission expected to announce amendments to the Sustainable Finance Disclosure Regulation (SFDR) before the end of the year, regulation and compliance service provider, Ocorian, has urged asset managers to stay prepared, highlighting what they can do to stay one step ahead of more stringent ESG reporting expected to take effect in 2025.
While there’s no indication of any significant change in scope on who the regulation applies to, Ocorian expects many of the reporting requirements to be made broader. This means that regulation might even apply to financial market participants who don’t promote themselves as ‘sustainable’.
Additionally, the Commission could standardise sustainability reporting across all financial products. This would mean some level of ESG reporting would be mandatory for all asset managers, regardless of whether their products fall under Articles 6, 8 or 9.
Hatim Baheranwala, co-founder and CEO of Treety, Ocorian’s ESG reporting partner, explained the aim of the original SFDR, implemented by the European Commission in 2021, was to provide retail investors and Limited Partners such as pension funds clarity and transparency on the sustainability characteristics of investment funds marketed to them – thereby tackling greenwashing.
The chosen approach “was to define a set of expected disclosures and reports”, and not undertake any formal labelling. However, this “unfortunately backfired” during implementation, with reporting categories such as Articles 6, 8 and 9 emerging as de facto labels.
“Additionally, the decision to allow investment firms to establish their own definition for terms such as ‘sustainable investments’ has led to even more confusion in the market, where differing firms have developed diverse definitions for these terms,” continued Baheranwala.
“It is therefore a welcome sign the EU is undertaking this review, and we expect the forthcoming amendments to the structure of the SFDR and its related technical standards to be announced soon. We are also urging asset managers to stay one step ahead and be prepared – while the regime is being improved and simplified, by entering into this review the EU has clearly signalled that its aim is to eliminate loopholes and ensure standardised sustainability reporting across the entire market.
“We recommend all alternative asset managers start by reviewing their current ESG and sustainability reporting processes and ensure that they are taking steps to ensure completeness, credibility and efficiency in their reporting flows – just like they do for their financial disclosures.”
Five potential SFDR changes
Among the five key changes anticipated in the next SFDR update, Ocorian expects disclosure requirements to require more granular information on sustainability factors considered in investment decisions, portfolio characteristics related to sustainability objectives and investment impacts.
Andrius Makin, senior portfolio manager at Killik & Co, added that the European Securities and Markets Authority (ESMA) suggested that changes to disclosure requirements should focus on data that can be translated into KPIs and monitored over time, hoping this will promote the “international interoperability” of the EU’s sustainable investing framework.
“Focusing on a smaller amount of high-quality data would allow investors to compare products more effectively. This would also help advisers better gauge clients’ sustainability preferences and recommend suitable investments,” Makin continued.
“Another change we may see is that all investment products will need to disclose basic sustainability data. This recognises that some funds have good sustainability characteristics without it being central to their investment process.”
Ocorian also expects the EU Taxonomy for sustainable activities to play a more prominent role in SFDR classification. Products labelled ‘Article 8’ (promoting environmental or social characteristics) or ‘Article 9’ (sustainable investment objective) will likely need to demonstrate a stronger alignment with the taxonomy.
Additionally, existing SFDR labels might be revised or supplemented with new categories to offer more clarity and comparability between different products.
Makin added: “A common criticism of the regulation is that the definition of ‘sustainable’ is open-ended. Asset managers will therefore have a variety of approaches to determine if a company is meeting these goals. This makes it difficult for investors to compare funds effectively.
“I expect this to be eventually replaced with a taxonomy-based framework. This would level the playing field in terms of measuring the sustainability of funds while alleviating the comparability issues. The taxonomy is focused on environmental activities, so it would need to be expanded to include social outcomes. However, this would be a significant project so we may not see it in the set of changes expected next year.”
On product labelling, Makin noted that the ESMA has already recommended replacing the current article system with two categories of investments – ‘sustainable’ and ‘transition’.
“Clearly, they liked the approach taken by the Financial Conduct Authority when designing the Sustainable Disclosure Requirements. The two labels would be easy to understand and follow the ‘focus’ and ‘improvers’ labels implemented in the UK.”
Other expected changes include the increase in focus on the concept of ‘sustainability risks’, with disclosures needing to elaborate on how these risks are integrated into investment processes and risk management frameworks.
Likewise, more emphasis might be placed on disclosures regarding Principle Adverse Sustainability Impacts (how investments negatively affect environmental or social goals). Reporting on engagement activities with companies on these issues could also be required.
Makin concluded: “The expected changes are not a complete overhaul of the regulation. Instead, they are adjustments so outcomes better suit what investors want to see – meaningful disclosures and easier comparability between investments. We can’t forget that sustainable investing is a fairly new concept, so regulations need to be adaptable as the market starts to mature.”
