Imminence does not mean haste

This article was originally published in Agefi Luxembourg, November 2020 and is reproduced with permission from the publisher.

Sustainability and ESG stewardship are at the forefront of investment managers’ and investment funds’ agendas under the combined pressure of investors and as a result of several important pieces of regulation becoming live. SFDR¹  is one of them. It will become applicable in phases, the first deadline being as early as 10 March 2021.

The direction of travel is clear

SFDR requirements are far reaching and will have a profound impact on the investment management sector. Together with other regulatory initiatives such as the Taxonomy regulation (Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020) it aims at integrating the sustainability concept across the entire value chain. Asset managers will need to rethink their transparency process. Among other things, they will be required to integrate sustainability risks and adverse sustainability impacts of their investments into the investment process of their investment funds and discretionary mandates and to comply with additional disclosure requirements when marketing their products in the EU.

Therefore, the direction of travel is clear. However, as is often the case when a significant new piece of regulation becomes applicable, the devil is in the detail and practical questions with no obvious answers arise. Although the regulatory technical standards (RTS) providing for further details have been published on 4 February 2021, some practical issues still remain and fund industry players would welcome further guidance from the CSSF and the ESMA.

On 16 December 2020 the CSSF opened a fast-track procedure aiming to facilitate the submission ofupdated prospectus/issuing documents for the visa stamp, in line with SFDR requirements. All documents must be submitted by 28 February 2021. The CSSF also clarified that this procedure is only available to the extent that no material change is made in relation to the investment policy of the fund. Depending on the type of fund (AIF or UCITS), the disclosures must be made as part of AIFMD Article 23 or in prospectuses/issuing documents, as applicable.

Based on the current position of the Luxembourg market, registered AIFMs and non-EU AIFMs (not marketing their AIFs in the EU) are not subject to the SFDR. Such position is in line with the position adopted by the industry. However, such an interpretation of the regulation is not cast in stone and may still evolve in the coming days or weeks. Moreover, it may vary across the jurisdictions where an AIFM (registered or non-EU) operates.

But what about practicalities? Key challenges faced by investment funds

Working on a daily basis with investment funds and their managers, it is interesting to note a number of recurring challenges. One could think that considering the buzz created around the sustainability topic, the level of maturity is high among market players.

This is not what we see in practice. The landscape remains fragmented with some early adopters already well advanced in their thought process and implementation programs and others still struggling to see how they will meet the first requirements.

Indeed the complexity of the new provisions and underlying concepts should not be underestimated for fund managers wishing to set up sustainable products.

One of the first challenges is to clearly understand the double materiality concept whereby a 2-tier approach is introduced and will need to be implemented. Indeed in SFDR, the sustainability concept is operationalized in line with the double materiality principle. In practice and in the final text of SFDR, transparency obligations in relation to the integration of sustainability risks (Article 6) are complemented with transparency obligations in relation to adverse sustainability impacts (also called Principal Adverse Impacts referred as PAI) (Article 7). What is the difference?

• Sustainability risks are risks encompassing short-term or long term environmental, social or governance risks that AIFMs should assess as part of their investment decision-making processes - including their due diligence ones - in addition to financial risks as a result of such risks potentially causing a negative material impact on the value of the investment i.e. on its financial return;
• Adverse sustainability impacts are the overall impacts of the investments made on ESG factors. Hence these are the risks that economic activities to which the investment exposes itself could have negative impacts on the environment, employees and communities, or on the governance of entities.

There may be cases where only one of these two aspects is relevant. However, in other cases AIFMs will need to consider (and integrate in their processes) two types of risks in addition to relevant financial ones: principal adverse impacts and relevant sustainability risks.

A good example to clearly distinguish between both concepts is that of a fund investing in coal plants producing electricity. Here the fund manager might wish to be mindful of ESG risks while investing (such as water management, child labor, appropriate policies and governance in the plants, etc). but by investing in such a business the fund could also cause principal adverse impacts on ESG factors (mainly on the environment) which the manager will need to consider and assess.

Other practical challenges often encountered include:

• The desire (or imperative?) of lots of players to appear as ‘ESG friendly’ and include ESG considerations without such a choice affecting their business operations as well as the difficulty for smaller managers to assess the impact of such decisions on their operations in practice or to get a clear view of the minimum requirements that they need to fulfil to match their intention. The question we often hear is: by doing this, are we doing enough? What about our reputational risk?
• The determination of the regime applicable to a fund. Indeed and in order to identify which requirements apply, investment funds need to determine under which article of the regulation they fall, namely Article 6, Article 8 (a product promoting an environmental or social characteristic) or Article 9 (a product which has sustainable investment as one of its objectives). Such a categorization is not something that can be decided by the managers but has to be determined based on a set of rather prescriptive criteria provided for by the SFDR. However and even with further criteria provided by RTS, this scoping exercise does not prove easy in practice. In relation to article 8 products, for instance, the topic has been largely debated throughout Europe, in particular in relation to the meaning of “promotion”. It results from the current state of the discussion that a standard blacklist of sectors such as tobacco, firearms, etc (so called ‘exclusion approach) should not be considered as promoting ESG under article 8. Indeed, the current approach is that a fund shall be designed (i.e. drafted in view of) for the promotion of ESG to avail itself of article 8 category.
• The multi-layer and multi-location disclosure requirements (product and manager level, legal documentation / website / annual reports to name a few).

Thinking strategically about sustainability, a must do

Because sustainability has become a board level strategic issue and requires a forward-looking approach, it is clear that an all-encompassing sustainable strategy must be designed, which cannot be limited to enhancing disclosures as part of a PPM.

Setting the tone from the top requires to engage with boards, starting with awareness raising sessions with senior-level executives to provide a summarized though accurate overview of the sustainability agenda, its major regulatory requirements and impacts of the existing as well as new products to be launched.

Once the tone is set and the sustainability-related vision is there, the first challenge often lies on the ability to turn general legal principles into a manageable action plan. This requires to be able to identify key priorities out of what can clearly be perceived as the next regulatory tsunami for the industry, after the AIFMD one. Another challenge to tackle which must not be underestimated is the data one. In order to be able to meet the new requirements on a sustainable and efficient basis, well-advanced players are putting in place an ESG governance structure with clear indicators, reporting lines and a framework of policies and procedures encompassing the full spectrum of the ESG agenda. Depending on the size of the players this will often be done on a cross-jurisdiction basis and will involve cross-functional teams, hence the importance to be in a position to be assisted seamlessly across multiple geographies and expertise.

To conclude:

The sustainability journey can be perceived as highly challenging to numerous players in the market. It is indeed a complex and multi-layered one requiring on the one hand to deal with the uncertainty of a work-in-progress regulatory framework whilst meeting rapidly approaching regulatory deadlines, and on the other hand to set up an all-encompassing sustainable strategy driven by the board. Imminence does not mean haste and the journey will be long. However it is definitely time to onboard now. This could be the most appealing journey in times of COVID-19.

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¹ SFDR: Sustainable Finance Disclosure Regulation (Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019)