ESG disclosures: The new EU regime

ARTICLE

ESG disclosures: The new EU regime

Background

March 2021 saw the phasing in of the Sustainable Finance Disclosure Regulation (SFDR) as part of a number of EU initiatives to promote investment towards the green economy and sustainable business development more generally. This particular measure seeks to combat ‘greenwash’ and help verify that financial markets are taking seriously the need for longer term and sustainable investment.

The measure is part of an EU Action Plan on Sustainable Finance, the aim of which is to:

■ shift capital flows away from activities that have negative social and environmental consequences; and instead

■ channel finance towards economic activities that have genuine long-term sustainability benefits.

In particular the SFDR demands transparency on how market participants handle the risks of possible adverse sustainability impacts both for the product itself and for the entity handling the investment.

The SFDR should be reviewed alongside two other measures:

■ the Climate Benchmarks Regulation which seeks to create new benchmarks to help investors compare the carbon footprint of their investments; and

■ the Taxonomy Regulation which provides a unified EU classification system of environmentally sustainable economic activities.

Disclosures

The SFDR applies to Financial Market Participants, a group of investors under ten categories in Article 2(1) of the regulation including, certain insurers, pension providers, portfolio and fund managers. Such entities need to disclose:

■ policies on integration of sustainability risks in investment decision-making;

■ information on the extent of consideration of ‘principal adverse impacts’ of its investment decisions on sustainability (subject to size of entity);

■ remuneration policies and consistency with the integration of sustainability risks.

There are also disclosures in relation to products which could include:

■ pre-contract disclosures to investors on the integration of sustainability risks into investment decisions;

■ likely impacts of sustainability risks on the financial product in question and its returns on the investment;

■ information on the mechanisms by which the financial product addresses ‘principal adverse impacts’ on sustainability factors

It is permissible to state that sustainability risk is not relevant to a particular financial product but if this is done some statement of why this is so should be included.

Where a financial product promotes, alone or in combination with other attributes, environmental or social characteristics, the following information should be disclosed:

■ information on how those characteristics are met;

■ if an index has been designated as a reference benchmark, information on whether and how this index is consistent with those characteristics.

Certain products may seek to promote ‘sustainable investment’, namely investment in an economic activity that contributes to an environmental objective (such as decarbonisation of energy or conservation of natural resources) or social objectives (such as addressing inequality or promoting social cohesion).

For products with such an objective it should be clear:

■ how the index used is aligned with that objective;

■ how the designated aligned index differs from a broad market index; OR if no indexation

■ how objective is measured

For now…

At this stage we await more detail on the measures which will set out the content of the necessary disclosures and their presentation. These have been subject to consultation but were delayed when the market expressed concerns about their onerous nature. From 10 March 2021, however, the broad (‘level one’) duties apply to financial market participants.

As a result, it makes sense at this stage for companies within the relevant sectors to begin to harmonise financial disclosures in line with the requirements of the Regulation.

This might include:

■ written statements demonstrating the integration of sustainability risks into investment decisions;

■ online information about methodologies for assessing and monitoring investments made;

■ initial data gathering on principal adverse impacts (see below);

■ preparation for periodic reporting relating to sustainable investments by reference to appropriate indicators;

■ pre-contractual measures meet transparency requirements including disclosure of sustainability risk weighting

■ re-vamped websites ensuring that information meets SFDR requirements and is up-to-date.

The Future

There are some future dates to note as SFDR proceeds:

■ June 30, 2021: is the very latest date by which Financial Market Participants with more than 500 employees at group level should begin collecting data to account for any principal adverse impacts.

■ December 31, 2021: First reference period ends - such reference periods are used for the purpose of historical comparison

■ January 1, 2022: Second reference period starts;

■ June 30, 2022: By this date, the Financial Market Participants which began the process at least a year ago, must make their initial report in an adverse sustainability impacts statement, demonstrating entity performance against ESG indicators together with explanatory commentary.

■ December 31, 2022: Second reference period ends;

■ June 30, 2023: The final date for the second report but now comparative data across reference periods must now be introduced. Eventually reports may track across five reference periods.

The UK and the SFDR

The SFDR applies to investments and entities based in the European Single Market and not to third country firms, including (now) the UK. Where firms market financial products within the EU, however, they will need to meet SFDR obligations. Similarly, UK fund managers acting under a delegation agreement with an EU equivalent manager may need to assist that EU fund manager with SFDR compliance.

For a time, it appeared either that SFDR might apply before the Brexit date or that the UK would choose to apply both SFDR and the Taxonomy. Neither happened but in November 2020, the Chancellor of the Exchequer introduced financial sector proposals in support of the green economy.

At least two developments seem likely:

■ Mandatory climate-related financial disclosures for certain financial sector firms; and

■ A UK version of the EU Taxonomy.

All of which strongly suggests that ESG reporting will take hold in the UK as it is doing in the EU. Methodology to track sustainability risks and adverse sustainability impacts has become a matter of some significance.

If you would like to hear more about Landmark’s Risk Horizon tool and its functionality, please contact Tom Venables or Sally Redman at esg@landmark.co.uk. ■

Professor Robert Lee

By Professor Robert Lee, recently retired Director of the Centre for Legal Education and Research at the University of Birmingham. Professor Lee is a Special Advisor on ESG to Landmark Information Group