Dissipating any long-standing doubt over on the extraterritorial effects of ESG disclosures, the European Commission clarified on Tuesday that third-country alternative investment fund managers (AIFMs) doing business in the region will have to comply with the same level of requirements as EU firms.
Opting for a heightened level of compliance with the Sustainable Finance Disclosure Regulation (SFDR), the EU’s executive arm surprised market participants who had been betting on a less stringent interpretation of the rules’ extraterritorial effects.
While the dust had settled on the first round of the SFDR implementation completed in March 2021, uncertainty had in fact lingered for longer around the applicability of requirements to non-European alternative fund managers marketing in the region, prompting the industry to come up with its own unofficial interpretation of the rules’ scope.
In the industry-led narrative on the extra-territorial effects of the SFDR, for example, compliance for non-EU fund managers was only expected to be at product-level, with disclosures required to be integrated in the offering memoranda of their alternative investment funds. However, based on the official interpretation released by the European Commission yesterday, disclosures will have to be made also on AIFMs websites.
From a general perspective, disclosures under SFDR shall be made at different levels and using different media – in other words, disclosures will be required both at the level of the AIFM and its AIF. This will have to be shown on the website of the company, in the pre-contractual documentation used for the offer of the products and in the fund’s periodic reporting.
Light green, dark green and not-at-all green products
On top of giving its own unofficial interpretation of the scope of SFDR rules, unfortunately a little too loose given the approach now formalised by the Commission, the industry has also indulged itself with devising sustainability-related jargon based on different shades of green.
If you are a non-EU alternative fund manager, familiar with the different national private-placement regimes across Europe, you have most likely stumbled upon the question already, or will in the near future, about what shade of green your financial products are…
For non-EU fund managers marketing in the EU the best way to approach SFDR is to really look at whether – and how – ESG is factored in the investment philosophy of the firm, and in the related considerations dispersed through its investment process.
This means that, without getting into the debate on the varying notion of ESG in the US, the UK and Europe, it helps to look at the basics and ascertain whether the vision and strategy of a firm take into account ESG already or not.
Most likely, when ESG is taken into account, it amounts to some filters applied in the investment process in order to avoid investments not in line with set environmental or social parameters, or not faring well against certain ESG scores.
If ESG is not taken into account at all, that’s fine too – even though it doesn’t exempt the application of certain (reduced) disclosures under SFDR for non-EU AIFMs marketing in the EU.
Once the basics are covered, it makes more sense to start looking at the type of disclosures possibly required under SFDR, and where these should occur.
Be clear on the numbers: Article-6, -8 and -9 products
Here we look at articles 6, 8 and 9 of SFDR to draw a categorisation of financial products – and thereby ascertain related disclosure requirements
- Not-at-all green: SFDR Article 6 – integration of sustainability risks
This disclosure is required for all financial products and shall be made in the pre-contractual documentation of the AIF. For products that either promote sustainable characteristic (article 8) or have a sustainable investment objective (article 9) this disclosure is required in addition to specific additional disclosures.
In essence, it is required to describe i) the manner in which the investment decisions take into account and integrate sustainability risks and ii) the results of the assessment of the impact on the returns of financial products potentially of sustainability risks.
AIFMs that don’t take into account ESG, and accordingly do not deem that sustainability risks are relevant, will be required to disclose why that is the case. This will be the only disclosure required where sustainability is not taken into account at all.
- Light green: SFDR article 8 – promotion of environmental or social characteristics
This additional disclosure shall be made only for AIFs that promote either environmental or social characteristics or a combination of the two.
Before tackling this additional disclosure, it helps to clarify the concept of promoting an environmental or social characteristic within an investment strategy. While this concept has not been officially interpreted yet, there seems to be consensus among European authorities that in this context we are still dealing with strategies with an investment objective that is financial in nature, however, the strategy to obtain the financial objective entails some filtering out of certain investments, for instance, or selecting only certain investments based on assets exclusions, ESG ratings or scores.
In this case, the disclosure required already under article 6 SFDR needs to be integrated with a description of how the promoted characteristics are met. In essence, using the same example of the screening process, here all you want to do is explain the screening process adopted. In cases where a reference benchmark is also indicated, the disclosure shall be integrated with a description of whether and how the index is consistent with the characteristics promoted.
- Dark green: SFDR article 9 – sustainable investments
This additional disclosure shall be made only for AIFs with a sustainable investment objective. In simple terms, a sustainable investment is still an investment in an economic activity, with the crucial addition that it contributes, respectively, to either an environmental or a social objective. In this bracket we may want to include all the investment strategies with an objective of reducing carbon emissions.
Here it is required to describe how the objective will be attained in cases where there is no designated reference index. For cases where an index is instead designated, the disclosure shall contain information to describe how a) the index is aligned with the objective; b) the index differs from a broad market index.
For financial products with objective to reduce carbon emission, this additional disclosure will have to contain a description of how the long-term global warming objectives of the Paris Agreement will be achieved.
The approach adopted by the EU Commission carries a set of immediate consequences for non-EU fund managers planning to market in Europe under national private-placement regimes. At the same time, it also poses some longer-term questions and inevitable challenges for market participants outside of the 27-country bloc.
On the one hand, full compliance with SFDR means that non-EU AIFMs will also have to make disclosures at entity level on their websites. This will require a bigger effort at the onset. More stakeholders within firms should be involved in the disclosure preparation exercise, given that related disclosures will look more deeply at how sustainability is integrated in the investment and other internal processes of the firms themselves.
For non-EU AIFMs intending to start marketing under private-placement regimes in Europe, the lack of sufficient preparation on this exercise – compared to their European competitors – and of appropriate external support might mean longer timeframes to be able to access the EU market with their funds.
On the other hand, from a long-term perspective, while it is realistic to say that sustainability will be high on regulators’ agenda in Europe, the UK and the US, different regimes will develop with different requirements, inevitably creating compliance challenges for both US and UK AIFMs intending to market their AIFs in Europe.