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Today, the world faces a pivotal moment and needs to make some momentous choices. How do we not only build back what was lost, but improve on it as well? Whilst the levels of debt was already at all-time-highs in several economies before the pandemic, we are now confronted with claims for monumental relaunch programs, which will lead to further unprecedentedly-high public debt levels. In this context of low interest rates, a potential slight pick-up in inflation, and the need for an economic transformation, we are left to wonder how we fit in sustainable investments?
ESG factor integration proved its added value during the 2008-2009 crisis, which was mainly a corporate governance crisis. It has done so again during the sanitary crisis and the resulting lockdown. This has highlighted why it is so important to assess the potential impact of all stakeholders when making investment decisions at every level: economic, currency, environmental, social and governance. These dimensions are all interconnected and there is no reason for this to change in the coming months, if not years. Indeed, this interconnection has been reinforced over the years through globalisation and technological disruption. This is a structural trend, observed among investors, economic actors, consumers and regulators. There is an urgent need for a profound transformation, not only in terms of resource management, but also in terms of human capital, where innovation plays an important role in creating a balanced ecosystem.
On the environment side, important economies, like China, the US, the EU, and Japan, among others have committed to ambitious climate programs that aim to achieve carbon neutrality by 2050/2060. This impact is no longer limited to sectors like energy, utilities and materials, but now concerns all sectors. The shift to a low-carbon economy is both a material risk and opportunity for all economic actors. Besides the huge climate challenge, we also need to keep in mind the social dimension. The combined health issues and economic shocks caused by the sanitary crisis are raising important questions regarding the delicate balance between priorities that are critical for the short-term revival and those critical for the longer-term transformation towards a sustainable future. Those who have not yet integrated this are unlikely to survive in the short term. This is the aim of sustainable investments: to distinguish those who have already started their transition journey.
The EU has clearly set the tone regarding sustainable investments and its willingness to position itself as leader on this topic. In 2016, they took the lead with their Action Plan for Sustainable Finances, which focused on three main objectives: fostering a long-term focus on the economy, financing sustainable growth and integrating environmental risks as a systematic investment risk. All regulations that have been adopted since then have been pursuing these three targets. In addition, the SFDR and EU Taxonomy pave the way to sustainable financial future and deals with the lack of standards and common definitions. However, the EU needs to avoid the unwanted effects of a regulation that is too rigid and inflexible. Indeed, this could lead to an excessive and potentially-counterproductive set of procedures, administrative burdens and reporting hurdles.
As we take a look at the current state of the SFDR, we can identify some weaknesses from the first level implementation:
The sheer complexity of the texts is clearly an issue. This has been accentuated by the late disclosure of the technical texts that are required to implement the Regulation. It is important to mention that the latest technical texts (disclosed in late February) are not yet final and have yet to be approved by the EU’s regulatory process. Recently, some additional texts that seek to explain the EU’s technical texts have started popping up here and there. These additional texts only serve to emphasise the complexity and interpretational issues of the initial text.
Different interpretations between the individual EU-25 regulatory authorities have led to a disparity between the typological classification of similar products. The financial market regulators have adopted a non-standardised and unique approach towards the implementation of the Regulation. Some have shown immediate understanding in favour of the market participants, and allowed them to find their own way through this complex and sometimes obscure puzzle; others have facilitated the whole process to ensure compliance by March 10. Meanwhile, others still have preferred to stick to a very strict interpretation of the so-called article 9 products, which are the only ones in the official text to be called “sustainable investments”. The local regulatory authorities in charge of controlling the implementation of the SFDR seem to adopt different degrees of severity in their respective interpretations. This makes it easier (or more difficult) to receive an article 9 status depending on the member state one is domiciled. These different approaches and attitudes are a significant hurdle and inhibit the creation of the EU’s expected ‘level playing field’ through the SFDR requirements.
Furthermore, this ‘level playing field’ has also been disrupted by separate individual domestic regulations that have popped up across EU member states. These are not always fully aligned with the SFDR’s typology, making the picture more complex. Indeed, some EU member states are considering their own taxonomy and regulation. Besides, the existence of domestic labels with their own requirements does not help the situation either.
The lack of data from companies is another challenge to consider. This critique has been around for a while now. Even though this issue will be progressively corrected on the EU side by the Non-Financial Report Directive (which requires EU companies to provide the necessary data to financial participants), the scope remains limited to the EU. This makes sustainable investments an asset class restricted to EU investments. Sustainable actors such as DPAM have fought for years to make sustainable investment a mainstream phenomenon instead of a niche investment category.
The SFDR and the EU Taxonomy also aim to reduce green washing, which is undoubtedly a commendable effort. The SFDR is mainly based on quantitative data, which is still not fully available to markets.
The obligation to state its sustainable objectives and respective KPIs, combined with detailed principal adverse indicators to report on, clearly reduces this risk. Those who have not yet properly drawn their path towards a sustainable investment approach will have a hard time fulfilling their commitment. Still, both the SFDR and EU Taxonomy are highly dependent on quantitative data. One or two quantitative indicators are reductive in nature and do not show the full picture of an investment or the complete impact of an economic activity. This is challenging for actors like DPAM, who base their sustainable expertise on an active and research-driven approach with a lot of qualitative, in-depth research. It is far too reductive to translate all this work to one or two quantitative indicators. The EU’s sustainable efforts should not be limited to a deceptive “tick the box exercise”, but unfortunately such a reductive outcome looms on the horizon. Finally, as a brief reminder, we will need to find nearly EUR 180 billion per year to finance the European sustainable development programme by 2030.