The Week: Will the SFDR change the world?

A new raft of EU disclosure requirements on sustainability are in the offing. What are the implications for investors?

  • Initial drafts of the SFDR rules have been seen as excessively prescriptive and have been pushed back
  • There have been concerns that excessive information could undermine the utility of the new regulation for investors
  • Ultimately, little is likely to change in March, but this is still an important process

The investment management industry must tangle with a new piece of EU legislation this year – the Sustainable Finance Disclosure Regulation (or SFDR for short). Designed to create a framework for sustainability disclosures, its intentions are good, but will it really help investors distinguish between investment products that genuinely use sustainability factors and those that merely window-dress on ESG?

The early incarnations of the proposals sent shudders down the spines of compliance officers across Europe. In particular, the rules on how to disclose Principal Adverse Sustainability Indicators were head-bangingly detailed and prescriptive. As Eoin Fahy, head of responsible investing at KBI Global Investors puts it: “It is hard to think of any other occasion when regulators required such a volume of changes to the information made available to investors in such a short period of time.”

Ultimately, there was a danger that a surfeit of information would undermine the main purpose of the legislation - to help investors determine whether a fund is sustainable and if there are sustainability risks, what financial price should be placed on those risks? There were also concerns that companies do not yet monitor areas such as biodiversity, water usage or anti-corruption in sufficient detail to satisfy the new disclosure requirements. The local regulators, led by ESMA, waved the EU away to redraft.

As such, the rules that come in this March are watered down, with investment managers being asked to observe the broad sweep of the rules in the absence of detail. Even these will require some work, but for the most part they should be details fund managers already have to hand and that companies are already disclosing, such as modern slavery requirements. More detailed rules are back on the drawing board and due to come in early in 2022.

In the longer-term, most are more optimistic, believing the new rules will ultimately help investors distinguish the wheat from the chaff on ESG, particularly when it is put alongside the taxonomy due later this year. Any product that claims to be sustainable must disclose a considerable amount of extra information about why it is sustainable, how the investment manager is managing sustainability risks and opportunities, how and why they engage with investee companies on sustainability issues. This may also finally rid the industry of charges of greenwashing.

For the time being, the March deadline is a point in a process rather than an end in itself. The end goal of full disclosure from companies and comprehensive data that can be used by investors is some way off, but, with each increment, it comes a little closer.