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Unboxing SFDR in 2023

Caution: Batteries not included.

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We are all aware of that sense of disappointment, especially at this time of year, when our new “toy” is missing a vital working component. Asset managers have spent a great deal of effort implementing Sustainable Finance Disclosure Regulation (SFDR) and preparing their SFDR reporting solutions over the festive season, but are they about to discover that they will be hampered in the new year by issues of data alignment, reporting and distribution into multiple jurisdictions? In this insight we review SFDR and the roll out of Level 2 at the start of January 2023, but importantly we will identify for you some of the potential pitfalls surrounding the practicalities of reporting for this regulation. 

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Why has SFDR become so important?

ESG (environmental, social, governance) investing has experienced exponential growth over the last decade, and this trend shows no sign of decelerating. Assets in dedicated ESG funds have gone up rapidly in the last five years and could grow from US$8 trillion today, to as much as US$30 trillion by 2030. They are playing a vital role both in the allocation of capital towards a more resilient economy and in addressing sustainability challenges.

Total Retail and Institutional ESG AUM Forecast Chart

While these volumes demonstrate real business opportunities for asset managers, the sustainable investment landscape has grown increasingly complex and challenging to navigate. 

To safeguard market integrity and prevent greenwashing or product mislabeling, the EU regulator introduced SFDR transparency rules and reporting requirements around ESG investing. But what does this mean for asset managers?

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What should I already know about SFDR?

The Level 1 provisions of SFDR have been live since March 2021 and oblige impacted asset managers to categorise their funds into one of three distinct buckets, namely Article 6, Article 8 or Article 9.  

But what are the differences between these labels?

Article 6 funds are defined as investment products which do not integrate any kind of sustainability factors into the investment process; while Article 8 funds promote environmental, social and governance characteristics, or a combination of them; and Article 9 funds have clearly defined sustainability objectives and targets. The purpose of these various SFDR designations is to make it easier for investors to benchmark funds using ESG sustainability metrics.

However it is the Level 2 provisions of SFDR which asset managers are focusing on right now, because these have taken effect from January 2023. The Level 2 rules oblige asset managers distributing into the EU (or those distributing from the EU into the UK) to provide more information on sustainability factors, sustainability risks, and technical disclosures at product and entity level. 

Afzal Amijee, Commercial Director at Broadridge, said asset managers need to provide several additional disclosures under SFDR Level 2, including a pre-contractual disclosure outlining a firm’s sustainability goals and objectives, which will need to be appended to their prospectuses. 

“In addition to that, there is a periodic disclosure, which is an annual update that measures how firms are doing against those sustainability goals set in the pre-contractual disclosure. There is also a website disclosure requirement as set out in Article 10 for Article 8 and 9 funds. And finally, asset managers must report on principle adverse impact statements (PAIS) plus a handful of voluntary disclosures from June 2023,” said Amijee. 

PAIS are essentially ESG metrics which are designed to measure and consider principal adverse impacts of the fund’s investment decisions on sustainability factors. The also cover measurables, such as climate and environment metrics for example, greenhouse gas emissions, energy performance, waste material emissions; as well as social, employee and governance factors.

As part of these disclosure requirements, asset managers have to obtain granular ESG data on their underlying investments so that they can report this information accurately.  Obtaining and aligning the data, however, is not going be straightforward.

Deck of Cards

Have I been building a house of cards?

At the heart of SFDR is the process of collating and reporting data, but how much confidence can you put in the accuracy of the data you have gathered? Defining what constitutes a sustainable investment is very challenging, as there are so many different interpretations as to what sustainability actually is. In a recent survey that Broadridge conducted, 20% of respondents said that interpreting the various sustainability definitions was their biggest strategic priority for SFDR now.

At the root of the challenge lies data. This is because ESG data had to be sourced from multiple sources and as a result a lot of it is not consistent. Collating this information and organising it into a number of SFDR disclosure reports can therefore be a challenge for asset managers.  “One of the problems which asset managers are having is around data alignment and consistency,” said Amijee.

Similarly, the inconsistency of ESG data is causing problems for firms when aligning their Level 2 SFDR requirements with the EU Taxonomy. In certain instances where fund managers do not possess the relevant data, the European Commission has instructed them to report 0% alignment with the taxonomy, an outcome which makes some firms feel uncomfortable.

A recent development from European Securities and Markets Authority (ESMA) on guidelines in naming of funds using ESG or sustainability-related terms, requires that a fund must have a minimum proportion of 80% of investments meet environmental and social characteristics or sustainable investment objectives to use the ESG-related terminology in the name of the fund. “We are seeing a number of Article 9 funds having to reclassify themselves as Article 8 funds because they are unable to obtain the necessary data sets from portfolio companies to demonstrate that they adhere to minimum proportion of 80% under Article 9 principles”, said Amijee.

While the European Commission has tightened up on the naming of ESG-funds, the UK’s Financial Conduct Authority released their Sustainable Disclosure Requirements (SDR) consultation paper in October with guidance on proposed ESG-funds labelling. The SDR introduces three ESG-funds labels: Sustainable Focus, Sustainable Improvers, and Sustainable Impacts funds. Not surprisingly, some practitioners have expressed concern about the lack of a globally accepted ESG labelling which, if it existed, would certainly bring clarity to what has become an increasingly opaque market. 

A robust data strategy is therefore critical and something that organizations appear to be taking seriously. Indeed in the aforementioned survey a fifth  of respondents said that methodology and alignment of ESG data was top of their mind when asked which area they were prioritizing when preparing to meet the requirements of SFDR.

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What else should I be aware of when reporting on SFDR?

In our survey we discovered that 20% of the respondents also had “Report production and dissemination” at the top of their priority list in preparation for the upcoming SFDR Level 2 roll out.

A smart approach towards data gathering, alignment and collation is a prerequisite for sound reporting. In 2023, managers will need to think about how they compile the various ESG reports. “A lot of effort has gone into collecting the data…I think the effort now needs to shift towards the reporting side, and getting the disclosures to platforms and investors,” said Amijee.

Two additional potential difficulties that firms may find themselves facing in early 2023 are those of translating their disclosures and ensuring they have a robust distribution network in place so that they are reaching all their end investors in multiple jurisdictions.

First, during our recent webcast with Ignites Europe, experts stressed that asset managers needed to be clear and transparent with clients when describing their ESG methodologies and SFDR data. One significant part of this is making sure their clients have a range of different languages to choose from when consuming the SFDR disclosures. Along with validation, composition and dissemination, translation should not be overlooked as one of the key steps in the service process chain for SFDR reporting.

Second, when considering all the moving parts and requirements for SFDR, asset managers should also be reviewing the efficiencies of cost and time when meeting this regulatory requirement from in-house resources. The investment management industry has embraced the outsourcing of functions to third-party providers, from regulatory reporting and data management to back and middle office operations. SFDR reporting is a good case for outsourcing, as in itself it does not provide competitive advantage for an asset manager. More importantly though, we see this being a voyage and the requirements will inevitably evolve. By outsourcing, asset managers can future proof their solution leaving it to the industry wide service providers to follow the course this regulation takes.

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So what’s the message for SFDR reporting in 2023 and beyond?

To answer this question Arun Sarwal, CEO of Broadridge Fund Communication Solutions, suggested:

“The SFDR’s reporting requirements landed on 1st January 2023, and there is no doubt through 2023 the debate and evolution will continue on classifications of ESG categories under SFDR and SDR and how best asset managers communicate their ESG approach to investment decisions.”

“The key for us as an industry as we unbox SFDR and related ESG reporting in 2023 and beyond is not only to meet the requirements of the regulation, but at all times to consider, how effectively what is reported actually represents reality.”

“After five years of solid growth, for the first time, in 2022, the ESG-funds on average have had worse returns than funds not taking an ESG approach. ESG-branded funds will over time come under pressure on performance and returns against non-ESG funds again. This will mean that investors will be challenged on their convictions and beliefs when making choices. It is therefore fundamentally important that the labelling and reporting for a fund meets regulatory standards. But more importantly, what is really inside the box must stand up to internal governance and investor scrutiny in terms of meeting the objectives of the spirit of ESG. Each of us in the investment industry has a role to play in striving for quality and integrity in meeting SFDR to ensure ESG funds deliver on the promise of a better world.”

Available! Comprehensive management of European ESG Reporting and Disclosures

Broadridge has worked closely with asset managers and platforms and has extensive experience and the necessary tools to extract the relevant data and prepare templates for dissemination across a wide-reaching distribution network. In addition to this Broadridge can provides translation of documents, in over 35 languages, in line with SFDR requirements. Broadridge also has a variety of distribution channels for SFDR, including embedded URLs or a document library, for dissemination to platforms or additional end points.

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