Week 10: The EU SFDR has arrived!

Dear all,

I hope everyone is well and ready for a new edition of ‘ESG on a Sunday’.

Please note that it will be accompanied by a Clubhouse session this afternoon (more info at the end of the newsletter).

After weeks of travelling around the world, looking at the state of ESG in different regions, we now turn our attention towards the D-day for ESG in the EU: The launch the Sustainable Finance Disclosure Regulation (SFDR).

Making EU’s economy more sustainable

The SFDR is a monumental shift in the regulatory space of ESG in so many ways. However, we must keep in mind that it does not apply to all countries in the EU, only the ones that are situated in the western part of it.

So why are we even talking about SFDR? To understand that, we need to first look at the bigger picture in the EU.

Given the environmental and social issues the world is facing, action and increased effort from all actors – including the financial services sector – is urgently required. To make Europe’s economy more sustainable, the European Commission presented the EU Green Deal at the end of 2019. This Green Deal is the European Commission’s plan to transform climate and environmental challenges into opportunities and make the transition just and inclusive for all.

A crucial piece of the puzzle in attaining this goal is the financing of the transition. In recognition of finance’s important role, and the importance of getting the right financing, the European Commission has put forward an action plan for sustainable finance prior to launching the EU Green Deal. Without capital flows directed in the right direction, no EU Green Deal.

The aim of the action plan is to create a stable, sustainable, and transparent financial system. It seeks to establish a re-orientation of capital flows towards sustainable investment, promote the inclusion of sustainability in risk management, and foster transparency and long-termism into financial and economic thinking. One of the pieces of legislation that has been created out of this action plan is the EU Taxonomy.

All about SFDR

And now, yet another highly important piece of legislation is coming into force: the EU Sustainable Finance Disclosure Regulation (SFDR). The EU SFDR applies to financial market participants ranging from asset managers to financial advisors and officially came into use a few days ago, on Wednesday 10 March.

So what is it? The goal of the EU SFDR is to increase transparency on sustainability among financial institutions and market participants. It consists of disclosure requirements on firm and product levels, to standardise sustainability disclosure. This is needed to improve industry-wide comparability and prevent greenwashing.

Where does it apply? The regulation applies to financial market participants (FMPs) whose business is in Europe, non-EU FMPs (and their subsidiaries) who do business in the EU or sell products to the EU, and non-EU firms that sub-manage EU assets or funds.

What is the scope of disclosure? FMPs need to report on two levels: first, disclosure is mandatory about sustainability information on a firm-level. Second, if applicable, FMPs need to disclose information on the ‘sustainable’ products they offer. For both levels, there are general and specific disclosure requirements. The specific disclosure requirements are further elaborated on in the Regulatory Technical Standard (RTS).

The purpose of the RTS is to provide further detail and guidance to ensure that firms take a harmonised approach in their methods of collecting and disclosing information. This is needed to meet the objective of the EU SFDR.

Clarity or confusion?

There are number of questions related to interpretation of articles 6, 8 and 9 in this regulation, for very right reasons. In particular, asset managers must decide whether a fund they offer fits in one of three sections; Article 6, Article 8 and Article 9.

Article 6 is for regular funds while Article 8 is for “light green” funds that exhibit certain sustainable characteristics and Article 9 is for “dark green” funds that look to reduce carbon emissions such as the ETFs tracking the two EU climate benchmarks.

However, the directive has the potential to cause more confusion as funds placed in the same ‘article’ could exhibit very different sustainable characteristics.

For example, Article 9 funds include any fund tracking the Paris Aligned Benchmark (PAB) or a Climate Transition Benchmark (CTB), however, this is not a requirement for inclusion.

More or less greenwashing?

This could mean that we could end up with multiple sub-sets of Article 9 funds without uniformity. And without the ability to adequately compare funds under the SFDR classification system, things could get very confusing.

Lack of uniform standards may open the doors to instances of greenwashing.

The idea of a fund classification system was designed to allow for a spectrum of ESG commitment across the EU fund universe, underpinned by data in order to remove greenwashing.

However, since we lack precise methods of measurement, it actually means there may be confusion about what is and what is not the more sustainably-focused fund. So most of the asset managers will probably look for positioning on article 6 and 8 in order to avoid what could be very costly legal penalties.

If you want to dig deeper into the topic, you can find more information here. And if you want to know more about the implications of the two articles that the entire financial industry is talking about right now – Article 8 and 9 – you can have a look here.

Asset managers are still not acting

You may ask yourself: “why is all of this so important?”

Well, we live in the age of alternative ESG realities. On the one hand we have all the commitments; all the publicly communicated pledges and targets; a zillion texts about why it’s important. And on the other hand we have the harsh reality where things move very, very slow.

The largest 50 asset managers are not sufficiently pushing the ESG agenda. And, in many cases, they are voting against environmental and social proposals. 

This is not just my own observation. This is according to bespoke research into voting patterns undertaken by Robeco’s Wilma de Groot and Jan de Koning. The duo analysed the voting patterns of four groupings – the three largest passive managers, the largest asset managers, the mid-sized players and the smaller players – to see how often they voted in favour of certain proposals linked to ESG.

It was found that the mid-sized players in assets terms voted for environmental proposals more than half the time, while the smaller players did so around two-fifths of the time. 

However, the larger players and passive giants only did so on around one in five votes. Let me repeat that: Only one in five. And we need all five.

Similarly, small- and medium-sized players led the way on social proposals, voting in favour between 35-40% of the time. However, the larger players and the passive giants did so roughly 10% of the time.

In other words: We are not even close to shifting capital flows on the governance side, and that part is crucial to make things happen!

We’re being greenwashed

We continue down the same road. FT has intensified their coverage of ESG and greenwashing, and this article gives you quite a read. As ESG becomes a part of the investment mainstream, it is reaching a critical juncture: without some way to police the way the concept is used, it runs the risk of being reduced to a marketing exercise with only modest substance.

To a certain extent, greenwashing is primarily a consideration with regards to retail investors because they have no possibility to verify the information they are fed, and have no ability to cross-check what they are told.

Here’s a killer example of that. Reading this will certainly make you feel bad that millions of retail investors are taken for an ESG ride. Can you guess who, according to the article, are the five companies with the highest ESG rating in the FTSE 100? I think you are in for a surprise…

What kind of role does media play in all of this? Not a small one, I would say, and as this report makes clear, climate information is still very low priority. 

Media Matters analysed climate coverage on the morning news programs on ABC, CBS, and NBC in 2020, and climate coverage as a whole made up only 0.4% of overall coverage.

And then there’s all these misperceptions about what you as an individual can do to save the world!

If you really want to understand what your actions and inactions mean in relation to hidden social and environmental costs, you should read this meta-study. 

My 10 ESG Commandments

So, maybe we need some kind of guidance to navigate the ESG waters. For that reason, I have formulated my “10 ESG commandments”. You can read them here:

The 10 Commandments of ESG Investing

These ten points are based on my 20+ years of doing ESG investing across the world. In short, they are an attempt to summarise some of the insights and share them with you.

Today, we will do a Clubhouse session at 5pm CET and discuss the commandments. I hope you are up for joining the session, even just a small part of it.

Clubhouse session – 14 March at 5pm CET

That’s all for now!

Best regards,

Sasja