New EU regulations on sustainable finance and investor requirements pose challenges for fund managers. Melville Rodrigues reports

Sustainability and responsible investment are becoming mainstream priorities for pension funds, insurers and other investors, and fund managers are responding with products that look to meet these priorities.

Managers must prepare for regulations (and associated investor expectations) focused on sustainability-related disclosure – regulations aimed at identifying the adverse impacts of investments on sustainability, ensuring credibility of sustainable investments and increasing awareness about sustainability risks. 

There are two new EU regulatory initiatives: 

• Sustainable finance disclosure regulation (SFDR), which will take effect on 10 March 2021; 

• The taxonomy regulation, which has already entered into force.

SFDR requires fund managers, such as those operating as alternative investment fund managers (AIFMs), 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. This will be detailed in the SFDR regulatory technical standards (RTS), in which managers will need to quantify or describe Principal adverse impacts associated with sustainability risks. It is expected that the European Commission will confirm the RTS during 2021, with the first reference period covering the whole of 2022 and the first reporting based on the RTS in 2023. 

In relation to fund products to be marketed within the EU after 10 March 2021, EU AIFMs, as well as non-EU managers marketing products to EU investors, should ensure SFDR compliance with the marketing of the products. There may be an extra-territorial market effect; non-EU investors are attracted by – and adopt – the SFDR disclosure benchmarks for due-diligence purposes when looking at prospective fund products. Investor expectations and managers strategically opting to adhere to best practice benchmarks may result in more extensive manager compliance with SFDR principles.

Managers must formulate a policy on integrating sustainability risks in their investment decision-making process. They 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 why they do not consider the principal adverse impacts to apply.

Managers must also: 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.

Managers with more than 500 employees from 30 June 2021 are not entitled to rely on the comply-or-explain regime and must disclose principal adverse impacts on their websites and summaries of engagement policies. Managers with fewer than 500 employees can continue to rely on the comply-or-explain regime.

All managers will have to articulate how their sustainability-risk policies impact their products. Specifically, they must either assess the likely impacts of sustainability risks on their products’ returns or explain why they consider sustainability risks not to be relevant to their products.

From December 2022, managers must also disclose whether and, if so, how, they consider principal adverse impacts for each of their products. If the managers do not consider principal adverse impacts, they must explain for each financial product the reasons why they do not consider principal adverse impacts to apply.

In addition, each manager will be required to review its marketing documents and ensure that the documents do not contradict SFDR mandatory disclosures. It will also need to assess each product, and – if applicable – provide additional product disclosures with reference to specified SFDR articles:

Article 8 product: promotes environmental or social characteristics – 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 product: has sustainable investment as its objective – 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 manager will need to implement pre-contractual disclosures for article 8 and 9 products.

SFDR taxonomy regulation
The taxonomy regulation is aimed at introducing a benchmark for environmentally sustainable economic activities and to prevent ‘greenwashing’ – that is, investments that do not meaningfully address ‘E’ or ‘S’ issues.

Managers marketing a fund with environmentally sustainable credentials must, on a staggered basis from 2021/2022:

• Comply with such criteria and minimum safeguards (to be set out in future legislation);

• Demonstrate that the fund does not cause harm to six environmental objectives (climate-change mitigation, climate-change adaptation, sustainable use and protection of water and marine resources, the transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems);

• Disclose which objective(s) the product contributes to and to what extent its underlying investments qualify as taxonomy regulation-compliant (by January 2022 for climate change mitigation or adaptation, and by January 2023 for the remaining four objectives).

UK and Brexit dimensions
The December 2020 post-Brexit trade and cooperation agreement indicated that the UK and EU will ensure a level playing field in a manner conducive to sustainable development. However, both parties “recognise that they are not committed to harmonise standards… though determined to maintain and improve their respective high standards”.

The UK government announced in November 2020 that the UK will implement fully mandatory climate-related financial disclosures across the economy by 2025 (with many disclosures coming into force by 2023), and go beyond the comply-or-explain approach. It has announced a green taxonomy, a common framework for determining which activities can be defined as environmentally sustainable, which will take the scientific metrics in the EU taxonomy regulation as its basis.

In the UK legislation, there will be an FCA consultation about implementing associated rules in its handbook. EU SFDR-related legislation will not apply to UK managers by March 2021, unless the managers operate via an EEA AIFM and/or wish to market fund products into the EEA from 10 March 2021. Furthermore, as indicated above, the UK managers may opt to adhere to best-practice benchmarks based on EU financial disclosure legislative principles.

Fund managers must consider the implications of the SFDR and the taxonomy regulation, and (as appropriate) similar UK legislation. In the context of compliance, managers should progress preparations including with their investment procedures and efficient solutions to gather and report on ESG data. Strategically, managers need to recognise the reputational and other positives – albeit balanced with additional operational costs – of embracing the challenges of sustainable finance disclosure.

Melville Rodrigues is a senior consultant, UK funds services at Ocorian