Sustainable Finance Disclosures: Confusion, chaos and cost explosion.
Why blanket acceptance of current EU ESG regulation has reached a dangerous turning point. We, the financial community, must make ESG investing attractive again—and not a disdained minefield.
By Martin Raab, CAIA
Known as SFDR, the bureaucratic elite, made up of regulators and political influencers in Brussels, have created a rare masterpiece of financial regulation. Two years on, however, and it is clear that, in practice, it is simply unworkable. It’s time to recalibrate the current version of the legislation so that it is easier to implement. Otherwise, ESG regulations like SFDR, Taxonomy and PAIs will end up becoming major deterrents for those investors who are serious about going green with their portfolios.
If you can’t articulate your aims clearly or your services are highly complex, it’s inevitable that you will face a lot of questions. Little wonder then, that a tome of legislation about Sustainable Finance totaling nearly 1,000 pages is causing a flood of queries. Over the last 12 months, both investors and the asset management industry have become increasingly uncomfortable with the often confusing, sometimes chaotic and to some extent, impractical requirements outlined in the EU’s Sustainable Finance Disclosure Regulation.
Almost everybody is affected
Known as SFDR, it’s a rare masterpiece of financial regulation created by the bureaucratic elite made up of regulators and political influencers in Brussels and it affects more than 370 million financial consumers – from retail investors to pension trusts. Estimates as to the total amount in assets it stands to affect currently range between EUR 30 trillion and EUR 40 trillion. Essentially, anybody who is engaged in investing on one level or another, is affected.
Month after month, the lack of common sense and practical application of several elements of SFDR have been raising eyebrows amongst an ever-increasing number of investment practitioners. In addition, many investors also found it confusing: Clarity, comprehensibility, and an easy-to-implement approach seemed to be missing from this raft of EU-wide rules.
Ultimately, the by-product of all this is that the SFDR’s overarching goal of steering big money towards listed companies who care about the environment, social responsibility and good governance has ended up being derailed.
Questionable and diffuse rules
One such example are the so-called “Paris-aligned benchmarks” (PAB) and “climate transition benchmarks” (CTB). Part of the increasingly impractical “SFDR jungle,” these benchmarks have been used by mutual funds and Exchange Traded Funds to create “green(er) portfolios”. EU lawmakers outlined how those two ESG-themed benchmarks should be calculated – using some questionable parameters, in my opinion – and stated that any fund applying these benchmark rules would automatically be labelled a “dark green” investment, known as an Article 9 fund under SFDR rules.
However, due to murky clarification on how such PAB and CTB strategies should be measured (along with the post-release awareness about how complex ESG data about various portfolio companies is to access in reality, and the need for it to be put into context), it turned out that these funds would be unlikely to meet the criteria of 100% sustainable investment requirements, as outlined in SFDR. This has recently led to a number of prominent asset managers having to hastily reclassify their mutual funds and ETF offerings (some totaling up to EUR 50 billion in value) before January 2023. These funds will now become “light green” offerings instead of “dark green”, which is how they have been marketed and sold to clients until now ? light green funds/ETFs are categorized as Article 8 under the EU’s Sustainable Finance Disclosure Regulations.
Such actions are merely the latest indication that the majority of the EU’s sustainability rules were written and passed into law without any real attention devoted to making them progressive and practice-focused, while also widely overstating the real needs of financial consumers. An easy-to-understand, meaningful approach seems to be largely missing.
Investors should be fans of ESG; however, the reality is very different
Of course, the confusion about EU benchmark regulation such as PABs and CTBs has ended up carrying over to investors. To be frank, the whole sustainability topic needs more transparent, honest and meaningful measurements and rules, and should not descend into an ideological battlefield. Only in this way can we convince most investors to fully embrace and voluntarily include ESG-elements in their investment decisions. However, due to the wrong approach being taken by green regulators, the reality currently looks very different.
Behind closed doors, even ultra-large institutional investors have voiced their displeasure at this oftentimes completely impractical legislation.
Behind closed doors, even ultra-large institutional investors have voiced their displeasure at this oftentimes completely impractical legislation. To avoid further compliance hassles around sustainable investing, a growing number of independent asset managers and wealth advisors have advised their clients to elect in their sustainability preferences assessment simply “not consider sustainable factors” for their portfolio. “In this way, we can build a robust portfolio with ESG and green companies as well as other industries” is the often-heard client benefit. Over the last few months, it’s become increasingly clear that neither private clients nor professional investors really like the SFDR’s legislative paternalism and rigid, often impractical rules about how they should invest their money.
In truth, many financial product providers know they may soon be forced to amend their provisional disclosures if the EU Commission’s proposal to integrate the EU Taxonomy extension to include both nuclear energy and fossil gas – both are fully green in the eyes of Brussel’s lawmakers – into the SFDR Delegated Regulation before year end is successful.
Justificatoin attempts in the "green rules jungle"
Meanwhile, European Supervisory Authorities (ESAs) are trying to calm the brewing thunderstorm. On 17 November 2022, they published a collection of FAQs on the practical execution and implementation of SFDR in a document called “SFDR RTS“, which will also apply from 1 January 2023 onwards. The Q&A catalogue (comprising over 34 pages) covers answers to 70 common questions asked by market participants and industry associations — to some market observers, this is just the tip of the iceberg. However, the ESAs Q&A is by far the most extensive and detailed guidance document that has been issued since SFDR came into effect in March 2021.
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We, the financial community, must make ESG investing attractive again—and not a disdained minefield.
However, it isn’t only the finance and investment industry that is confused ? many national regulators of EU member states are becoming increasingly uncomfortable by the hundreds of queries raised by the investment community about sustainable finance regulation. So much so, that the EU securities regulator, ESMA, felt compelled to issue a supervisory briefing to national regulators on how to supervise sustainability risk management and disclosures in investment management on a local level (supervisory briefing dated 31 May 2022 ).
In addition to the interpretation of the SFDR Delegated Regulation, the ESAs have also conducted a market review on voluntary PAI disclosures under SFDR which contains recommendations on good and bad practices (report dated 28 July 2022 ). Further questions on the interpretation of SFDR were submitted to the EU Commission by the ESAs on 9 September 2022 but have not yet been answered. Unfortunately, the ESA’s answers do not always match the questions asked, since the ESAs use certain questions to issue general clarifications on topics they deem important.
Solving the most confusing, inefficient element
A meaningful first step to making sustainable investing more comfortable and significant for investors would be to drastically reshape, or better yet, abandon the most chaotic and cost-inducing element of SFDR for investors: the Principal Adverse Impacts (PAIs).
In an effort to increase transparency and integrate sustainability risks, the SFDR began imposing a set of mandatory ESG disclosures on the EU investment industry: from mid-2021 onwards, asset managers would have to begin reporting on the Principal Adverse Impacts (PAIs) of all the companies in their portfolios. PAIs consist of a list of sustainability factors that firms need to consider for their investment policies and decisions. These indicators relate to various environmental and social topics.
However, the problem with PAIs is that –long story short – by inputting some random numbers onto the pages of a “PAI disclosure document”, the investor’s money is not necessarily being guided towards the most desirable companies. In many investment professionals’ view, a few of the PAIs are fatuous, and the calculation and creation of the PAI document is often a costly venture with little to no added-value for investors. In addition, the most pressing questions relating to PAIs often go unanswered: What does it mean to “consider” PAIs? Is this limited to disclosures or is there any duty to undertake meaningful action to maintain a certain ESG rating?
Virtually every conversation I have had with ESG-friendly retail investors, product providers as well as wealth managers such as financial advisors, family offices and other professional investors on sustainability disclosures, revolves around two big challenges: 1) the complex, confusing and non-comprehensible nature of the current regulation; and 2) the general lack of reliable, correctly-captured and affordable underlying ESG data.
Countdown to more chaos
With less than five weeks to go until EU SFDR Delegated Regulation applies, many questions surrounding the fundamental concepts underlying SFDR remain unanswered, such as the questions on the interpretation of SFDR submitted to the EU Commission by the ESAs on 9 September 2022. In addition, from 1 January 2023, financial product providers will also need to disclose their alignment with the remaining four EU Taxonomy objectives (water & marine resources, circular economy, pollution and biodiversity/ecosystems). Despite this, there is still no regulation in place—not even in draft form—that defines the technical screening criteria for meeting these objectives.
Making ESG regulation better? Yes, we can!
The messiness of the current situation in the European Union is exactly what has driven political support for populist hardline opponents of sustainability and ESG elements in financial services elsewhere, such as Florida’s governor Ron DeSantis or the Texas Republican Comptroller Glenn Hegar.
Again, the basic idea of steering big money towards companies who choose to do the responsible thing ? by actively fighting to bring down their CO2 emissions, reduce waste and air pollution ? must continue by any and all means possible.
All investors are well-advised to start a balanced, progressive dialogue with their local European politicians of all ranks to end the out-of-control sustainability laws and fancy overregulation that threatens to stifle the very thing they seeks to encourage.
However, now is the time to drastically muck out the EU’s green-laws farm before support for it begins to wane. We all know that complexity kills execution, and in the case of the SFDR, this is exactly the problem. All investors and the whole financial community are therefore well-advised to start a balanced, progressive dialogue with their local European politicians of all ranks and parties as soon as possible to end the out-of-control sustainability laws and fancy overregulation that threatens to stifle the very thing they seeks to encourage.
At present, nobody really understands these regulations and no investor feels empowered enough to confidently invest in companies with meaningful green, social and good governance credentials in the absence of adequate, cost-efficient and transparent solutions to help them make responsible choices.
If “green” regulation can’t be reshaped better, the whole topic of sustainability and ESG quickly will rapidly descend into a legally dangerous, inauthentic and eventually, defective field of investing, and the accusations of “greenwashing” levelled at the finance industry by environmental campaigners will become ever more difficult to refute.
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