The EU’s new disclosures rules deserve a braver response than they have had so far
ShareAction challenges the recent pushback against Europe’s Sustainable Finance Disclosure Regulation
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Imagine you are about to eat a chocolate bar. You hate raisins and want to know whether this bar contains them. You look on the back of the wrapper. Instead of an ingredients list, you find a mission statement: “We are committed to bringing you healthy food, while making sure it is enjoyable”. This does not solve your problem, so you call the manufacturer. They say, “Sorry, we can’t tell you as our own suppliers aren’t telling us.” Parliament gets wind of the situation and proposes a law to force food manufacturers to come clean about raisins. Food manufacturers lobby against this.
It is 2020, and the investment industry is telling us we cannot have what we all take for granted in the food sector. How did we get here?
Last autumn, the EU’s Sustainable Finance Disclosure Regulation (SFDR) came into law, requiring investors to disclose their adverse impacts on planet and people. Because this is a high-level piece of legislation, a second piece is needed to fill out the details. The EU Commission asked the European Supervisory Authorities (ESAs) for help. The ESAs proposals for so-called Regulatory Technical Standards (Level 2 disclosure requirements) have been out for consultation.
Lots of asset managers have responded to say they do not have the data the EU is asking for, explaining that it will be a great deal of work and furthermore expensive to get hold of such data. This is understandable - and it is also true. SFDR will require a massive effort. But that is why it is so valuable to the EU’s sustainability ambitions. Tackling the climate crisis will require transformational change and substantial effort within the corporate sector, the investment sector and in society at large. And not just the climate crisis: biodiversity loss, global water shortages, deforestation, modern slavery, racial discrimination. If the corporate community and the financial sector are to play their parts in addressing these interlocking social and environmental crises, challenging new legal requirements that set a level playing field are both necessary and inevitable.
The Principles for Responsible Investment (PRI) and EuroSif have both challenged the Level 2 proposals for SFRD, arguing that their members should not be forced to collect and report data they do not have and cannot easily get hold of. They have also argued that the format of disclosure specified is not useful.
A closer look at the Level 2 proposals is instructive. Annex I of the consultation lists 32 principal adverse impacts, which would all be mandatory to report. Each of the impact categories has one or two metrics. A sample of these is below:
- “Weighted average carbon intensity”. 5 years after the TCFD was developed, one would think that this data is a must have.
- “Share of investments in entities without a deforestation policy”. Sounds like a no-brainer: the Amazon is burning and land-use change is the leading cause of biodiversity loss.
- “Total amount in cubic meters of untreated waste water discharged by the investee companies”. Think liabilities: wouldn’t it be prudent to know?
- “Operations and suppliers at significant risk of incidents of forced or compulsory labour”. Too much to ask?
On inspection, whilst the proposed Level 2 requirements may be a stretch in the short term, they set a standard and propose a format that seems far from unreasonable. Are these not factors that a pension fund client or retail investor would want to know their portfolio manager was on top of?
There is no point being naïve. This will require a lot of new work since many asset classes are far from being as transparent as a portfolio of FTSE100 companies. Moreover, SFDR is inevitably somewhat baffling for investors who have yet to engage with the concept of double materiality, which is not only a building block of SFDR but critical to the EU’s agenda of ensuring that financial services contribute to achieving the Paris climate goals and the Sustainable Development Goals. Double materiality recognises that companies and financial institutions are not only responsible for managing the financial risk of social and environmental factors to their bottom line but must manage and take responsibility for the actual and potential adverse impacts of their own decisions on people, society and the environment.
Most European institutional investors still focus only on financial materiality. It is hardly surprising that such investors struggle with the point of reporting some of the data required under SFDR.
The PRI’s consultation submission argues that non-zero values for the 32 categories set out in Annex 1 should not automatically be considered principal adverse. But this ignores the contribution such factors may make to systemic risks. Even if an investor is responsible for just a little bit of methane, just a tiny quantum of wastewater in a river, or a few instances of child labour – in aggregate, tiny impacts can become systemically problematic ones. PRI also argues that adverse impact reporting should not be applied at the entity level (i.e. the impact of all an asset manager’s portfolios in aggregate) but should only apply to products. But what is the point of disclosing impacts that look good at product level if the impact at entity level is deteriorating? Reporting at entity level drives board level engagement with risks and impacts, a prerequisite for the progress needed on sustainability issues in the coming decade.
Of course, data on these impact indicators will not be available in all cases from the outset, and neither are these factors equal in importance. But they are all going to be useful and will inform decisions that bring our economy closer to operating sustainably.
If the data needed is not available, there is a straightforward answer: ask investee companies to produce and report it as soon as possible, and make good use of shareholder voting rights to press the case where necessary. In this critical decade for climate and biodiversity loss, investor engagement has to become a serious tool for action. The same applies to data providers. If investors feel they don’t get data in the form they require, it is for them to tell data providers what the services they are paying for should look like.
Yes, consistency with the Taxonomy and the Non-Financial Reporting Directive would be good, as the PRI argues. Everyone likes consistency, but investors are experts in handling situations where information is incomplete. Where professional investors lack a piece of data, they estimate. If you do not know the share of non-renewable energy consumption of an investee company, and you cannot even come up with an estimate, should you hold that company in your portfolio?
The SDFR is a ground-breaking piece of rulemaking that must not be blocked or slowed down. The urgency of the sustainability crises deserves a braver response.
Wolfgang Kuhn is Director of Financial Sector Strategies at London-based responsible investment NGO ShareAction
Catherine Howarth is the Chief Executive of ShareAction