Disclosure, disclosure, disclosure: Get ahead of regulation

ESG and sustainable investment funds are currently the fastest growing segment of the European funds market, reflecting increasing investor appetite for such investments – according to the UK’s Financial Conduct Authority (FCA) this month.

Regulators and the market are accelerating their focus on ESG/sustainability and climate-related disclosures – disclosures aimed at identifying the adverse impacts of investments on sustainability factors, ensuring credibility of sustainable investments and increasing awareness about sustainability risks. Better information will help investors make more informed decisions, which should help the drive towards investments with greater sustainable credentials.

Regulators and legislatures are raising the bar with mandatory disclosures – which creates issues with the dynamic international interaction between different and evolving rules. For instance, the EU has been progressing with the Sustainable Finance Disclosure Regulation (SFDR), which requires fund managers and other financial market participants to disclose how they have integrated in their processes, including in their due diligence, an assessment of all relevant “sustainability risks” that might have a material negative impact on the financial return of a fund investment.

Unless they have more than 500 employees, fund managers must also decide to either: implement a due-diligence policy relating to the “principal adverse impacts” – deleterious effects of investment decisions on environmental and social criteria – of its ESG investment decisions; or explain on their websites and summaries of engagement policies why they do not consider principal adverse impacts. Managers with more than 500 employees cannot rely on the comply-or-explain option and must disclose principal adverse impacts.

Details of the required disclosures are to be contained in the SFDR regulatory technical standards (RTS), which will include a template that managers that are considering principal adverse impacts will need to complete each year. The template will include a list of impacts which relevant managers must always consider and report on, and others which they should consider if material. The first RTS reference period will run from 1 July 2022 and the first reports based on the RTS will be published in 2023.

In relation to fund products being marketed within the EU, EU AIFMs, as well as non-EU managers marketing products to EU investors, should ensure SFDR compliance with the marketing of the products.

All managers must update their existing remuneration policy to include information on how the policy is consistent with integrating sustainability risks and include on their websites a description of their policies with respect to how sustainability risks are integrated into the investment process and remuneration practices.

The must also ensure compliance with the marketing of their financial products with reference to specified SFDR articles:

Article 8 products promote environmental or social characteristics, and managers need to provide information on how those characteristics are met and (if there is a relevant index) information on whether and how this index is consistent with those characteristics.

Article 9 products have sustainable investment as their objectives, and managers need to provide information on how sustainable investment objectives are achieved and (if there is a relevant index) information on how the index is aligned with that objective and an explanation as to why and how the index differs from a broad market index.

The Taxonomy Regulation is aimed at introducing a dictionary for defining which economic activities are environmentally sustainable and, in future, those that are socially sustainable. The aim is to encourage capital flows towards sustainable investments and to prevent ‘greenwashing’ – that is, investment products and underlying companies that do not meaningfully address ESG issues even though they claim to do so.

Among other things, the Taxonomy Regulation (by amendment of the SFDR) requires managers that market funds that make environmental claims to disclose the level of “taxonomy-alignment” of the underlying investments in the funds.

The environmental taxonomy deals with activities that make a significant contribution to six core objectives, and the disclosure obligations relating to these objectives are being phased in as follows:

• 1 January 2022: climate change mitigation and climate change adaptation objectives.
• 1 January 2023: the sustainable use and protection of water and marine resources; the transition to a circular economy; pollution prevention and control; and the protection and restoration of biodiversity and ecosystems.

In addition, there will be further EU regulatory developments. For instance, this month the European Commission adopted a new Sustainable Finance Strategy and issued a “Fit for 55” package to tackle climate change and other environmental challenges.

The UK is looking to match the ambitions of the EU’s sustainable finance agenda and will launch a UK Green Taxonomy. Significantly, the FCA issued proposals in June 2021 for fund managers and others in the financial sector to comply with mandatory diclosures aligned to Taskforce on Climate-related Financial Disclosures (TCFD). Both SFDR and TCFD are linked to the IFRS Foundation’s welcomed work to develop a baseline global reporting standard for sustainability. Key elements of the FCA proposals include annual reports containing:

• Entity-level disclosures – TCFD-aligned disclosures on taking climate-related risks and opportunities into account with investments.
• Product or portfolio-level disclosures – a baseline set of consistent, comparable TCFD-aligned disclosures in respect of their products and portfolios, including a core set of metrics.

On account of the type of fund manager and/or product or portfolio, these disclosures will be either published in a TCFD product report in a prominent place on the main website for the manager, while also being included in investor communication, or made upon request to certain eligible institutional investors. 

The FCA anticipates capturing 98% of UK asset managers and asset owners, with exemptions for those with less than £5bn in assets under management or administration, on a three-year rolling average.

The FCA is proposing a phased implementation, with from 2022 the largest, most interconnected managers needing to make the first disclosures by 30 June 2023, and from 2023 the remaining managers making first disclosures by 30 June 2024.

The FCA’s TCFD initiative links with proposals issued by the UK Pensions Regulator this month which look to enhance UK pension fund fiduciary obligations. The trustees of certain UK pension schemes face new requirements from 1 October 2021 intended to improve the quality of governance and reporting as they address climate-related risks and opportunities.

In addition, the UK has announced that it will introduce sustainability disclosure requirements, which will also require certain sustainability disclosures that go beyond the TCFD’s focus on climate change.

Best practice and strategic solutions

Pension funds and institutional investors – in the UK, EU and elsewhere – are reacting to (not-always convergent) regulatory reforms as well as fiduciary obligations, other stakeholder expectations, and setting market benchmarks which may result in the regulation having an extra-territorial and/or accelerated market effect.

Investors, not strictly subject to EU and/or UK regulations, may be attracted by, and adopt, overriding consistent and comparable SFDR and TCFD-like disclosures for due-diligence purposes when looking at prospective fund products. Investor expectations and managers strategically opting to adhere to best practice benchmarks could result in more extensive manager compliance aligned with SFDR and TCFD principles.

In the context of ESG disclosures, managers need to operate proactively with sustainable and climate-finance strategic solutions. Such solutions would include the adoption of governance rigour and the monitoring and pre-empting regulatory and market trends – aiming for financial reports seamlessly combining with ESG reports, the latter based on robust and transparent metrics. This will hopefully dovetail with collaborative fund manager and investor industry initiatives, combining with regulators, to create uniform ESG reporting standards. In addition when a fund – which has an ESG or sustainability focus – is being promoted or subsequent reports issued to investors, there should be a consistent design, delivery and disclosure in the promotion material and reports.

Managers should also efficiently collect, process and report on ESG-related data, recognising there is continuing IT innovation and demand for high quality reporting. They should reassess and scenario-test investment strategies, as underlying assets evolve in terms of their product characteristics – for instance, ESG criteria expanding to involve a focus on well-being and social impact.

Decarbonisation and the progressing of net-carbon zero goals (with credible targets and meaningful data) are overriding drivers. In the case of real estate investments, this could result in a greater attention to occupier energy-use and preference to preserve rather than demolish and re-construct. Another area is collaboration with occupiers and other stakeholders on items like their use of, and travel to and from, the locations.

• These issues will invariably interconnect with managers’ financial strategies, for instance:
• Fund investment valuations and the scope for enhancement or conversely depreciation;
• Identifying and managing risk factors, which can involve elements of physical risk, which tend to be exogenous, and transition risks, which are more endogenous and borne locally.
• The emergence of questions between fund managers and investors around who should bear the cost of sustainable finance and climate-finance reporting, and whether financial returns should be linked to performance on ESG-related issues.

In addressing the disclosure obligations, managers need to consider the risks and opportunities that come from the rapidly evolving regulation. Managers should consider their disclosure analysis and refocus their investment strategy to mitigate the risks and realise the opportunities. The disclosure process provides a toolkit for review of, and reporting on, strategic solutions.

Real estate fund managers must recognise the scope for competitive and reputational advantage as well as other positives that come with embracing the ESG challenges, and constructively contribute to addressing what is the defining crisis of our time: climate change.