In a previous edition of ETF Insider, we touched on the implementation challenges of the Sustainable Finance Disclosure Regulation (SFDR) level 1, which became effective in March 2021. With SFDR level 2 coming into force next January, we revisit this topic to discuss what the next release has in store for the industry.
To re-cap, SFDR’s level 1 Regulatory Technical Standard (RTS) required fund managers to report on ESG-related activity, with disclosure requirements of funds falling under Article 6, 8 or 9. Specifically, funds which do not integrate sustainability into the investment process (Article 6), funds which promotes environmental and/or social characteristics (Article 8) or funds with a sustainable investment objective (Article 9).
The new RTS that form part of SFDR level 2 will supplement level 1, providing granularity on what asset managers will have to disclose and how it should be presented, with a focus on sustainability risks, sustainability factors and technical disclosures.
This will be achieved via both qualitative and quantitative measures, mandating both a clear explanation of the approach taken by the fund manager alongside pre-contractual and annual reporting disclosures in standardised templates.
Asset managers will also be required to report on an additional metric to assess the sustainable impact of their investments, specifically, the 18 mandatory principle adverse impact statements (PAIS), ranging from GHG emissions (Scope 1, 2 and 3) to board gender diversity.
The regulation is focused on transparency. Hopefully, this is the clarity on the regulation the industry has been calling for since the inception of level 1, providing access to fund specific data which will be, most importantly, in a comparable format.
The aim is for investors to compile a sustainable portfolio more easily, with greater certainty on what a given strategy achieves in terms of fulfilling ESG criteria and better align this to their own pre-defined objectives.
Although a significant milestone, it is important to be cognisant of the long journey ahead. A key industry body, the European Supervisory Authorities (ESAs), published a list of questions to the EU Commission to clarify further some key aspects of the SFDR, including the definition of “sustainable investments”, among others.
If national law is seeking further clarification from the European Commission, then it is to be expected that ETF issuers will find outstanding grey areas, too.
The more descriptive and demanding regulation will call ETF issuers to review fund disclosure requirements that were previously assigned during level 1 roll out.
As a result, ETFs face the potential reclassification of products that do not meet the more stringent and thorough sustainability criteria clarified by level 2 with Article 9 funds required to meet 100% sustainable investment requirements.
With all new regulations that are yet to be fully defined, revaluating disclosures is a necessary and expected step in the infant stages of roll out and implementation.
ETF issuers are working hard to ensure they adhere to their classifications as greater requirements are stipulated. Some issuers, which had previously locked-in less stringent disclosures, may feel there is sufficient guidance to reassess these.
Index providers have a key role to play in aligning data to sustainable disclosure standards – such as SFDR – and including into the index production certain minimum standards which are aligned with the requirements of either Article 8 or 9 requirements.
With appropriate alignment to disclosure standards, issuers will have the data to assure they meet their own product disclosure obligations for Article 8 or Article 9.
As mentioned in the previous SFDR article, index providers are subject to very different disclosure rules under Benchmarks Regulation (BMR) requirements and their incentive to provide such information required to meet SFDR-specific product disclosure obligations is, at present, essentially commercial and attempted only on a “best-efforts” basis.
BMR should integrate as many SFDR and Taxonomy disclosures including Sustainable Investing commitments if available, Taxonomy figures and PAIs.
The availability of data reporting on sustainable metrics remains the bane of sustainable disclosures, with issuers grappling at the task of reporting on taxonomy alignment without sufficient data from underlying holdings.
Even so, it is important not to overlook the fact this is a big step closer to a regulatory framework that holds market integrity at its core.
It will provide guidance on specific requirements for internal controls and governance processes to avoid conflicts of interest and will lay further foundations for a level playing field by ensuring that all major firms assigning ratings to funds domiciled in the EU are within scope.
We welcome the next stage of the regulation to better guide investors amid a currently muddled regulatory landscape.
Keshava Shastry is head of capital markets at DWS, chair of ETF task force at EFAMA and chair of the ETF committee at the Investment Association and Anastasia Manuel is associate, ETF capital markets, at DWS
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full issue, click here.
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