A conversation between Joerg Walden of iPoint and Juan Ibañez and Dr. Chris Bayer of Development International e.V.
Joerg Walden, founder and CEO of iPoint-systems, recently resumed his chat with Juan Ibañez and Dr. Chris Bayer of Development International e.V., this time to discuss the European Union Sustainable Finance Disclosure Regulation (SFDR), adopted on November 27, 2019, and which came into force March 10, 2021. Their conversation follows.
Joerg: We recently discussed the ins and outs of the upcoming Corporate Sustainability Reporting Directive (CSRD), and in the context of indicators and KPIs, the subject of the new Sustainable Finance Disclosure Regulation (SFDR) came up. Could you remind us how they relate?
Juan: Sure thing. The EU is rolling out three interrelated directives. They are a part of a single process: the EU Sustainable Finance Action Plan, with the CSRD becoming the latest addition. All these elements ultimately seek to enhance the symmetry of information concerning a corporate sustainability performance. While the CSRD is an attempt to refine the Non-financial Reporting Directive (NFRD) by tackling its shortcomings, the EU Taxonomy Law establishes a framework to classify activities, distinguishing those which are sustainable from those which are not. The SFDR, in turn, has a narrower focus: increasing transparency of sustainability risks in the financial markets.
Joerg: Today I’d like to dive into the SFDR. Who is targeted by this directive?
Chris: The Directive regulates two kinds of players: financial market “participants” and financial “advisers”. The former includes issuers of all kinds of schemes managing a portfolio of investments: investment funds and undertakings, retirement and pension providers, managers of venture funds, and insurance funds, credit institutions, etc. The latter include organizations providing investment or insurance advice.
Juan: Financial market participants will need to integrate sustainability risks in their investment decision-making. Financial advisers will need to integrate them in the advice itself. And both of them will have to reveal the details of this process. In essence, the SFDR sparks a demand for (comparable) sustainability information: By creating a mandate to disclose or publish sustainability information related to investments, the SFDR effectively incentivizes investors to get that information from investees. The resulting knock-on effect means that much information on sustainability risks will begin to circulate, which is ultimately expected to increase long-termism and potentiates the reorientation of investment flows to sustainable opportunities.
Joerg: And what do we understand by “sustainability risk” exactly?
Juan: It is defined as an environmental, social, or governance event which, if materialized, could cause a “negative material impact” on the value of the investment.
Joerg: But it’s not just about how sustainability risks could negatively impact their financial returns, from the investor’s perspective.
Juan: Exactly. That’s one side of the coin. The other is the impact “in itself.” The impact from the perspective of the stakeholders. Double materiality. The analysis must go both ways.
Joerg: A common denominator between these three directives is that while they do not themselves mandate companies to change their ESG behavior, they serve to produce the disclosure of more specific, harmonized information, which potentiates more evidence-based decision-making within companies themselves and the marketplace.
Chris: Technically, yes. But there is a behavioral component in that companies need to “consider principal adverse impacts” and report on that. So, while you are not mandated to change ESG behavior, you need to have at least considered the impact of your decisions.
Joerg: Under the NFRD regime, there were no fixed KPIs, which the CSRD will also address. Now the SFRD is the first to come out with fixed indicators!
Chris: Indeed, it represents a huge step forward to now have fixed – as in mandated – KPIs, even if aggregated at the investor level. Broad ESG performance pursuant to the CSRD will follow suit, and quite possibly copy indicators pursuant to the SFDR. These SFDR indicators feature 18 mandatory indicators and 46 optional indicators. The compulsory data points range from carbon emissions, fossil fuel consumption and waste levels (E), to gender diversity and human rights due diligence (S) and a company’s exposure to corruption, bribery, or other scandals (G). More indicators were supposed to be mandatory in an initial version, but this changed after industry input to the ESAs. In sum, indicators must be relevant for the sustainable investment objective, and you must follow the reference benchmark whenever there is one.
Joerg: Who develops these reference benchmarks?
Chris: The SFDR empowers the ESAs to develop technical drafts for these. The ultimate decider, however, is the European Commission. We are just waiting for the final word from the Commission.
Juan: Moreover, these indicators on the website, the statement and pre-contractual disclosures cannot be contradicted by the marketing communications. The discourse must be coherent.
Joerg: Let’s recap who discloses what, starting with the market participants.
Juan: Investors – the “market participants” – will ask investees to disclose their data. To do so, investees will need to measure their adverse sustainability impacts and pass that information along. Then, the investors, in turn, publicly disclose the required information specific to each “financial product.”
Joerg: Let’s talk about data origin. Who supplies what data?
Chris: Both investors and advisors will rely, primarily, on data supplied to them directly by investee companies. But, as explained in Article 7 of the draft Regulatory Technical Standards, data may also be obtained through 3rd parties, or, in the worst case, by making reasonable assumptions.
Joerg: I am assuming that investors cannot claim to have performed this work when this is not really the case – correct?
Juan: Indeed. But the requirement to “show and tell” only kicks in fully for large companies and parents of large companies or groups: market participants exceeding 500 employees in a financial year or for parent companies of groups exceeding this threshold on a consolidated basis. These companies must publish a principal adverse impact (PAI) statement on their website regarding their “due diligence policies with respect to the principal adverse impacts of investment decisions on sustainability factors” (SFDR, Article 3.4). Companies below this threshold are also subject to this requisite, but they have the option to comply or explain through a statement clarifying whether and when they intend to consider impacts.
Joerg: What must the statement contain?
Juan: The statement must include how and why specific adverse impacts are considered. If the analysis was performed, the findings must report what impacts were identified, how they are prioritized, the actions taken, the actions planned, alignment with Paris objectives, and due diligence policies. Finally, it is worth noting that there is a specific requirement to report how remuneration policies are consistent with the integration of sustainability risks, which is mandatory even for companies below the threshold.
Joerg: When must these statements be published?
Joerg: Are the requirements the same for the financial advisers?
Chris: They are slightly different, adapting the regulation to the nature of their activities. For instance, advisers are not expected to explain their future plans to address an impact, as they usually do not have impacts of their own. However, they should reveal if and how they assess these impacts and if, in the case they have not started doing it, and when they will begin to do so. Furthermore, all of this information must be not only be available on the website, but also in the “pre-contractual disclosures” that advisers make to investors.
Joerg: I’m imagining knock-on effects for investee companies, where previously information was not provided. Some companies will need to do additional homework.
Chris: No doubt, yes. Apart from the new effort required, a fascinating question is whether the SFDR will cause some impacts to become material that had previously either not been reported, or not in a standardized fashion.
Joerg: It will be interesting to see the practical implementation play out. You mentioned greenwashing – as in providing false or misleading information to create the impression that a product is ‘greener’ than it really is.
Juan: Yes. While the directive itself never mentions the term, it is safe to say that preventing greenwashing is one rationale behind the pre-contractual disclosure requirements for “dark green” and “light green” products. For example, the technical draft by the European Supervisory Authorities (ESAs) mentions the term several times, and defines it as: “the practice of gaining an unfair competitive advantage by recommending a financial product as environmentally friendly or sustainable, when in fact that financial product does not meet basic environmental or other sustainability-related standards.”
Joerg: And how is greenwashing addressed?
Juan: The law distinguishes between three kinds of products according to how they are advertised. We can call them “mainstream products,” “light green products” and “dark green products.” The requirements that we have mentioned so far are the “baseline requirements” which apply to all three categories. However, there are extra obligations for the other two, designed to address greenwashing specifically.
Joerg: How does that work?
Chris: “Light green products” are products advertised as having positive environmental or social characteristics. For light green products, disclosures to end-investors must explain how those characteristics are met, as well as explain the consistency of the index chosen as reference benchmark with these characteristics. “Dark green products” are those products advertised as having a sustainable investment as its very objective. In these cases, the disclosure must describe how this investment performs according to a designated benchmark index, and how this differs from a broad market index. Digging deeper, there is a fine print to this too: if the positive sustainability impact is a reduction in carbon emissions, alignment with the Paris Agreement must be described.
Juan: And there’s more. On top of the baseline requirements, the company’s website must describe the sustainable characteristics of “light” and “dark” green products, inform the methodologies for assessing, measuring, and monitoring of the characteristics, report the due diligence practices, and inform the data sources and screening criteria for the underlying assets and relevant sustainability indicators, as well as the methodological and data limitations. Benchmark standards must be followed for this as well.
Chris: And, on top of this, the company must publish periodic disclosure reports.
Joerg: What do these reports include?
Chris: The report contains a company’s actions, the sustainable goals met, and the performance relative to the designated benchmark. And if the product is “dark green,” also the overall sustainability impact (with indicators) and the comparison with a benchmark index and the broad market index that we mentioned before.
Joerg: Let me quibble for a moment. What if a product contributes to some sustainable objectives, but has a negative impact in relation to others?
Juan: Then it may be “light green” – and the negative impacts must be reported – as long as the negative impact is not in relation to the sustainable characteristic of the product. However, it cannot be “dark green.” This is because dark green products are explicitly subject to the bar of the “do no significant harm” principle.
Joerg: I see. Does this replace existing reporting or disclosure obligations?
Juan: No, it comes in addition to them. But overlap between regulations is accounted for. You are allowed to use information in management reports and non-financial statements to comply with this regulation.
Joerg: Will this regulation be applied identically across all EU Member States?
Chris: Everything we’ve discussed so far constitutes the baseline. Member States may be more stringent in their implementations if they so desire. For instance, they can extend the Regulation to apply to national social security schemes (which are in principle exempt) and they can be stricter with regard to the publication of climate change adaptation policies, as well as to additional disclosures to end investors on sustainability risks. There is just one caveat: these provisions cannot impede the effective application of the Regulation itself or the achievement of its objectives.
Joerg: Some may be afraid that this all turns out to be costly. What can you say about that?
Chris: There is an exemption for some financial advisers employing fewer than three people. They have to factor in sustainability risks anyway, but they are free from the other requirements. This is another area where Member States may choose to be more stringent by removing this exemption, though.
Juan: Moreover, not conducting any analysis whatsoever is not necessarily cheaper. Not doing any sustainability analysis could very well hurt one’s business.
Joerg: This conversation has been very productive. As a final question, all of this is already live?
Juan: On March 10, 2021, the Regulation came into force and by June 30, 2021, companies had to start considering principal adverse impacts. However, because the technical standards are so lengthy and detailed, the Commission has deferred a good chunk of the obligations. Basically, “level 1” obligations – that is, obligations not dependent on the acts delegated to the Commission – are already enforced, but “level 2” obligations – obligations that are depended on the acts – and entity-level reporting of principal adverse impacts kick in on July 1, 2022.
Joerg: And with that, I’d like to conclude our discussion today. Thanks, gents!
Juan: Anytime.