We have seen two major steps in the European regulation intended to promote sustainable investment and prevent greenwashing. None has been without controversy and concerns but it continues to move the industry in Europe ahead at a faster pace than elsewhere.
We saw Sustainable Finance Disclosure Regulation (SFDR) Level 1 become effective in March 2021, which required each fund to disclose whether it has a sustainability objective (article 9), promotes sustainability characteristics (article 8) or neither (article 6). It required asset managers to disclose their sustainability risk policies at entity level and explain how their remuneration policies take sustainability into account. The sheer number of article 8 and 9 funds, and Article 8 being used as a label in the industry when it is no such thing are key matters of concern.
The EU Taxonomy – the classification system which defines activities that can be considered sustainable – was established to help combat greenwashing and direct capital to truly sustainable activities. We have now seen two taxonomy objectives fully defined – climate change mitigation and adaptation. As companies are not yet required to publish these figures themselves, taxonomy alignment figures for funds are estimated by rating providers and individual asset managers. There are therefore concerns regarding the data accuracy, blurring the effectiveness of this part of the regulation to cut through greenwashing and provide an objective set of data.
We are now moving towards SFDR level 2, where the regulation should start to have a more meaningful impact on how funds are evaluated and perceived by investors. As a reminder, the regulation is focused on transparency, enabling each investor to have access to significantly more information about the strategy, process, resource and data used for each fund, and unlike before now, it will all be in a comparable format.
From a qualitative perspective, the new Regulatory Technical Standards (RTS) that form part of SFDR Level 2 will require a clear explanation of the approach taken by the fund manager. From a quantitative perspective, funds will then have to report annually on the key metrics outlined in the RTS. Clients will be able to see whether the strategy is doing what it says it will do.
This regulation is not designed to dictate what is an acceptable sustainable strategy, and we welcome that. This is important, because we expect to continue to see different views on what can be considered a sustainable investment and what cannot, and this may show up in the metrics reported. We have three good examples to why:
- Investors disagree about what is most important. Can a fund with a high carbon emission intensity be considered sustainable? In our opinion, yes it can, if the fund manager is engaging the company to reduce their emissions and/or the company is having a significant impact on reducing future carbon emissions. Other investors may wish to enforce a threshold, or a filter based on this metric, viewing it as now mandatory that companies are operationally in line with a 1.5 degrees scenario. It should be up to the investor to decide whether this is a fit to their values and their investment strategy.
- Few indicators are perfect. An example is whether a company is a signatory to the UN Global Compact. The answer can only be either yes or no. The preference is for companies that recognise and commit to these principles, but equally it should be acknowledged that it is a voluntary initiative that is not policed and therefore not binding. This is not to say it is not informative as a KPI, but for us it is only a piece of the puzzle when we look at companies. A company who is signatory to the UN Global Compact but has a history full of controversies may not be as sustainable as first thought. We continue to believe a qualitative perspective on each investment is more important than any datapoint.
- Data quality is still generally poor. Much of the data used for ESG analysis is unaudited and some of it is incomplete. Additionally, providers are estimating data gaps which result in inaccuracies. This will improve over time – in Europe we will see audited data from companies from next year.
As long-term active manager, we will continue to take the time to understand the companies we invest in and understand their approach to various elements within ESG. Some of these might be reflected effectively by datapoints, but others might not be.
We welcome the next stage of the regulation but encourage investors to continue to apply due diligence to the fund manager, strategy and process alongside interrogating the data. We hope the next step to the SFDR will encourage investors to look at each fund from all perspectives.