Recent allegations of greenwashing and highly critical articles on ESG in the influential magazine The Economist suggest that regulators have been right to take up the issue. Only a few weeks remain before the deadline for the implementation of the second level of the SFDR regulation1. Is this a good opportunity to make some provisional assessments?
Definitely! The initial findings uniformly point to a lack of clarity and understanding for investors, as well as to the complexity of meeting the regulatory requirements and the even greater risk of greenwashing.
A LACK OF CLARITY AND UNDERSTANDING
The SFDR regulation is intended to provide more transparency on financial products and, in particular, on their environmental objectives (a little, a lot, extremely, not at all). The MiFID2 regulation requires that clients be asked about their sustainability preferences and allow them to respond in the most appropriate and transparent way.
The issue of non-aligned timing between the two regulations will not be discussed here, as we can work around that issue. More importantly, let’s focus on the complexity of the language requirements of the regulations, which have left professionals working on them for several months tearing their hair out! Consider for a moment the situation of a private investor who has most likely not considered the ins and outs of the individual indicators.
Some concrete examples to illustrate this:
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Investors can express their preferences based on a degree of sustainability objectives as defined by the SFDR for the eligible products. First problem: the SFDR does not impose a minimum percentage of sustainable targets. Accordingly, initial research shows a range of between 5% and 80% of sustainable objectives depending on the products in the same category. Second problem: while the European Commission wanted to be clear on the scope of Article 9 and its minimum sustainability rate, i.e. a target of 100% of sustainable instruments excluding cash and derivatives, the market has opted for a minimum of between 20% and a maximum of 70% for this type of product.
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Investors can also express their preferences in terms of the familiar PAIs (principal adverse impact indicators). PAIs are a comprehensive list of 14 mandatory environmental and social indicators that must be integrated and measured by products aiming at sustainability. Although these indicators are certainly relevant (i.e. items like carbon emissions, water management, hazardous waste, gender pay gap and board diversity), it is important to recognise that the metrics called for are neither measurable nor available for all sectors and stakeholders. In addition, their value to investors is highly questionable as they are reported as a weighted average of the portfolio.
The complexity of the information required increases the risk of accusations of greenwashing.
Depending on their SFDR classification, financial products are required to submit a document in a strict and precise format, which is attached to the product prospectus or the client’s management agreement. It must also be approved by the supervisory authorities with a deadline of 1 January 2023.
So-called “Article 9” products will be required to tick the left-hand column of the annex and make a pre-contractual commitment to meeting a certain number of minimum percentages for their environmental and social objectives.
This means that the product must commit to minimum objectives in line with the European taxonomy, minimum environmental objectives that are not in line with the European taxonomy and minimum social objectives.
Firstly, at the level of the European taxonomy, it is common knowledge that the available data, in principle reported by the companies themselves, are still the exception to both the rule and to methodologies that have not yet been sufficiently tested. The alignment of a particular issuer to a specific percentage X today could turn out to be significantly different in 6 or 12 months – all other things being equal – as a result of a correction in methodology or approach.
However, the financial product is required to comply with the minimum requirements set out in the issue prospectus or the management agreement and to report annually on the fulfilment of this contractual commitment.
Secondly, there must be a commitment to a minimum environmental and social target. This implies, for a portfolio of listed shares or corporate bonds – we will ignore the issue of government bonds here – the ability to distinguish the part of the company’s activity that meets a social objective as distinct from its environmental objective. This implies that these aspects are not systematically interconnected.
The level of precision of the contractual commitments drives the market towards a high degree of caution. This is because the sword of Damocles of an accusation of greenwashing is ever present. As a result, caution is exercised in setting minimum commitment rates in order to be sure that they will be reached in a year’s time, when reporting is mandatory. Caution could also mean that the product’s sustainability goals are not lowered, but that the product’s apparent sustainability goals are lowered to avoid a regulatory framework that includes the risk of being accused of greenwashing, considering the required metrics.
The downgrading of product classifications has resulted in a poorly navigable mass of category 8 products with various forms of sustainable commitments. This reduces transparency for investors.
These are challenging times for the financial sector and the regulator when it comes to sustainable investments. The time has come to demonstrate that commitments are genuine in a world where metrics and quantity tend to take precedence over quality. However, although there is a climate and social emergency, we must nonetheless allow time for regulation to find the right balance between universal ideals and pragmatic reality.
See also the section Responsible Investments
1Regulation (Eu) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector.
2Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council regarding organisational requirements and operating conditions for investment firms and the definition of certain terms for the purposes of that Directive.
