By far the biggest regulatory change this year has been the SFDR regime, which went live on 10 March 2021. Years in the making, and the result of painstaking negotiations between thousands of public and private stakeholders, the sweeping new rules involve disclosure requirements on firm and product levels, and hope to improve industry-wide comparability and prevent the greenwashing that has plagued the nascent industry.
Even getting to this point has required substantial efforts by financial firms and asset managers, including UCITS and AIFM management companies. These efforts include making important decisions around fund categorisations (Non-Green, Light Green or Dark Green), firm-wide sustainability considerations, and disclosures on various websites and marketing materials have been months in the making. But that’s been the easy part.
The hard work ahead
For Light Green (Article 8) and Dark Green (Article 9) funds, much of the hard work still lies ahead, especially as it relates to the EU Taxonomy, a hugely ambitious classification system that establishes a science-based criteria on what should count as truly “sustainable”.
Whereas all firms must comply with the basic Level 1 SFDR requirements, which comprise high level disclosures, these rules are then supplemented by far more detailed Level 2 Regulatory Technical Standards (RTS), many of which relate directly to the alignment of the Taxonomy.
Crucially, this means that both Light and Dark Green products must disclose how their funds contribute to the Taxonomy objectives, and to what extent they are invested in Taxonomy compliant activities in order to be considered “sustainable”.
This will have huge ramifications for the investment industry. Research from Morningstar, for instance, shows that 21% of European funds, with some €2.5 trillion of assets, are likely to fall under the most stringent SFDR requirements, known as level 2.
But many more fund managers will be working hard to ensure that their Non-Green, Article 6, funds soon fall under the green umbrella, such is the wave of capital that’s expected to flood into the sector in the coming years; a recent analysis by Bloomberg found that ESG assets could top $53 trillion in 2025, which would account for nearly one-third of global assets under management.
Investment firms now have to work out what data they’ll need, how they plan to analyse that data, and how they’ll report all of their various disclosures. This, in turn, may mean a significant overhaul to their marketing, their third party providers, and perhaps even their investment strategy. There is clearly a lot to do with the Taxonomy rules now less than eight months away.
Through meetings with dozens of clients, prospects and legal experts, it’s clear to AQMetrics that the level of preparedness with regards to the Taxonomy varies significantly within the industry. Some firms, particularly the larger ones, have spent significant resources in order to ensure they have the data, expertise and resources they need. But some firms we’ve met with do still seem complacent.
That’s perhaps somewhat understandable given the uncertainties hanging over the rules themselves. For example, the RTS Level 2 Guidelines, which are set to inform the Taxonomy, have yet to be finalised, with the draft guidelines only published in February. Nor, in fact, has the Taxonomy itself been finalised, with various European members still at loggerheads over whether natural gas and nuclear energy should be considered as partially sustainable under the landmark labeling system.
Officially, at least, supervisory guidance suggests funds work toward the Taxonomy with the information they have. But law firms have pushed back and said that this is unhelpful, and Irish Funds has come out saying that it would be challenging and problematic to work toward these guidelines now.
There is also some confusion around whether the RTS Guidelines will be finalised before the Taxonomy itself. Irish Funds and others are calling for RTS Level 2 Guidelines to be applicable from 1 January 2022, which would still allow firms to prepare and align under the application of the EU Taxonomy Regulation.
Then there is the data. Unfortunately, there is no provider that has a full set of data which incorporates every data point required under the RTS Level 2 Guidelines or EU Taxonomy. Large gaps, especially when it comes to smaller companies or private markets, still exist, although providers are trying to fill these as quickly as possible.
And although ESG data may be a burgeoning industry, with dozens of players now, it’s still largely unregulated and major discrepancies still exist: a 2019 paper found that sustainable ratings agencies agree with each other just 60% of the time, compared to 90% for credit ratings.
This has led to ESMA calling for the standardisation and regulation of ESG data providers. But any significant actions on this still seems some way off – and almost certainly won’t be in effect before the Taxonomy regulations go live.
Given this, it’s easy to understand how uncertainty may breed complacency. It’s hard, if not impossible, to fully understand and prepare for rules that haven’t yet been finalised, as is the case with the RTS Level 2 Guidelines and the Taxonomy itself. The aggressive deadlines will mean that some firms have their work cut out for them, and the next few months are sure to be challenging.
With that being said, the three European Supervisory Authorities published their final draft of the Level 2 Guidelines back in February, and major amendments to the Taxonomy are not expected. That gives firms a good starting point.
As the supervisory guidance suggests, Light Green and Dark Green funds must get ready to meet the Level 2 and Taxonomy requirements as best they can, despite the lingering uncertainty. Similarly, although there are issues with data quality and assurance, especially if firms must use multiple providers or are finalising their own proprietary models, regulators will take a more generous view of those firms that have made significant efforts in this area.
That leaves scant time for firms to finalise the data, resources, personnel and possible third parties they’ll need in order to be ready for 1 January 2022. With the Level 1 requirements now behind us, sustainable firms should gear up for the more onerous Level 2 requirements. The hard work has only just begun.