What you need to know about the ramifications of the EU Sustainable Finance Disclosure Regulation

While the Alternative Investment Fund Managers Directive (AIFMD) and the Market in Financial Instruments Directive II (MiFID II) may be two pieces of regulation that have had the largest impacts in recent years, there is plenty more coming down the pipeline for fund managers to concern themselves with.

At the front of the queue is the EU Sustainable Finance Disclosure Regulation (SFDR), which is part of the larger EU Sustainable Finance Action Plan. 

With an increased global focus on environmental, sustainability and governance (ESG) issues, including through accords such as the Paris Agreement, investors are seeking to align their investments with personal beliefs. And it is a growing market. At the end of 2020, total assets held in sustainable funds hit $1.7 trillion, up 50 percent on the start of the year.

Despite this, there remains a lack of clarity over the exact extent to which ESG is actually incorporated into funds, to the point where accusations of "greenwashing" have been levelled at certain providers. 

At its heart, the aim of the SFDR is to provide the required clarity and enable end investors to make informed decisions between service providers in relation to sustainability.

Under level one of the SFDR, which applies from March 10, funds have to be classified as sustainable funds (under article 9), partially sustainable (under article 8) or not sustainable/out of scope (under article 6). All of this must be clearly disclosed to investors; the regulations cover pre-contractual disclosures, disclosures in reports as well as websites and marketing communications.
 
While this clearly appears to be beneficial for investors, it provides a particular challenge for managers who need to determine under which article they should be placed. 

In some instances, the decision will be straightforward — when the fund is an impact fund, for instance, or is clearly ESG. In other cases, however, the classification could preclude certain investments. By categorising funds as partially sustainable or sustainable, managers will no longer be able to invest in assets that are not ESG-compliant.

Opting to be placed under article 8 as partially sustainable may, for the time being, seem like a common-sense approach. Other managers may opt for non-sustainable under article 6, as they may not want to prevent themselves from making an investment or, indeed, making a misstatement.

Critically, there is still much that needs to be confirmed with regard to the full extent of the regulation, as this is only the level one phase. Notably, it is uncertain whether managers will be able to change their classification at a later stage if they decide to. 

At this stage, it is a case of playing a waiting game to see the level of disclosure and transparency that managers reach. This is unlikely to become clear until January 2022, when level two of the SFDR is due to come into force. This will require much more stringent disclosure from managers and is yet to be finalised.  

As with the implementation of any regulation, the level of preparedness is already seen to vary significantly from one manager to another. The most ESG-sophisticated managers may well have policies in place, because the new regulation is very much in their wheelhouse. But others are clearly playing catch up.

Aside from the clear challenges around classification, the regulation is, unsurprisingly, more complex, and additional measures on taxonomy, sustainability benchmarks and how sustainability risks will be integrated into acts such as MiFID II will also create additional work for managers. One thing is certain, managers will rely more and more on third-party AIFMs for guidance and implementation. 

The roll out of this entire piece of regulation will likely run through until the end of 2022, and potentially beyond that. It is crucial, therefore, for managers to take the right approach now and build strong foundations for the future. Getting it right in terms of interpretation and implementation of the SFDR will be key for compliance and the running of business going forward.