Ensuring the EU Sustainable Finance Disclosure Regulation can deliver on its ambitions

New rules must be clear and workable to allow investors to compare ESG funds, measure impacts and limit greenwashing, says Eurosif’s Victor van Hoorn

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2020 has been a year of tipping points. The net inflows into funds integrating ESG factors have never increased so dramatically, showing investors are increasingly taking these factors into account in their asset allocation. Yet, it is no wonder when this is the generation that could see extreme global responses to extreme social and environmental crises become the norm.

This year’s response to COVID feels like a practice run in preparation for a whole host of environmental ‘outbreaks’. Unprecedented biodiversity loss and extinctions, more severe droughts witnessed across large parts of the world; and who will forget the red hue wrapped around the San Francisco skyline? Or earlier this year, the Australian navy having to evacuate thousands stranded on beaches due to unprecedented wildfires? If we are to mitigate and adapt to these worsening conditions our economic, industrial and transportation models need to reach net zero by 2050 and it needs to start now.

Governments around the world, and particularly in the EU, have mobilised unprecedented amounts of money to support the economy, through diverse tools as liquidity lines, furlough schemes, state aid and long-term spending on infrastructure. The fundamental question is: will this spending go to sustainable investments? Will it fail to trigger the structural changes required? Or worse – will it lock in capital into investments pushing us further from our 2050 objectives?

Ambiguous or unworkable rules will only add to confusion and slow, or even reverse, progress.

For Eurosif it is clear that the future of sustainable and ESG investing will no longer be limited solely to managing ESG risks and returns for investors. Increasingly, investors’ and asset managers’ social license to operate will require evidence of impact – negative or positive – on sustainability. For many retail investors, being sustainable is not about whether ESG factors are appropriately integrated, but what real world impact their investments are likely to have. If sustainable investments claim to be one of the solutions to solving challenges such as climate change and biodiversity loss, they need to be measurable in impact metrics relevant to these challenges.

A cornerstone of the EU Sustainable Finance Disclosure Regulation (SFDR), which is likely to have an enormous impact on the investment industry, is the principle of double materiality – financial as well as sustainability. A vital starting point in the journey towards an impact driven economy.

European agencies ESMA, EIOPA and the EBA face the challenging task of delivering on the technical rules to make the SFDR work. And their proposals are ambitious. Firms will be expected to report across a very large range of quantitative and qualitative impact indicators, for some of which data is not readily available from either investee companies or data providers.

But it is crucial that firms are required to describe how these impact indicators inform their investment process and allow them to understand, control and mitigate the negative impacts of their investments so they can be held to account. It is also critical that a clear distinction is kept between investment strategies that can evidence sustainable impact and those merely integrating financial ESG risk factors.

If we want the SFDR to deliver more transparency and comparability to trigger necessary behavioural change, it is critical that these disclosure rules are clear and workable. This will help firms to comply and regulators to supervise and take enforcement measures where necessary. Ambiguous or unworkable rules will only add to confusion and slow, or even reverse, progress.

While getting ready for the SFDR to apply in 2021, we should not lose sight of the ultimate goal – what are we trying to achieve? In Eurosif’s view, the ultimate goal is for investors to be able to compare the ‘relative negative/positive impact intensity per EUR/USD/GBP invested’ of different investment strategies. Allowing investors to minimise the negative, and maximise the positive, impact of their money. In our dialogue with policymakers, we are emphasising what we see as fundamental in achieving this:

1. Regulation that shifts the weight from entity to product/portfolio-level disclosure, particularly when it comes to comparing quantitative information.

2. ESMA, EIOPA and the EBA fostering supervisory convergence around key concepts such as the definition of sustainable investment and the Do No Significant Harm (DNSH) principle, to ensure comparability between investment products becomes meaningful. We will next year assess what role the Eurosif Transparency Code may play in making the SFDR successful.

3. Alignment of the SFDR with the EU Taxonomy. For example, an economic activity meeting the technical criteria of the Taxonomy and satisfying the DNSH principle as well as the minimum safeguards should be deemed to be a sustainable investment under the SFDR. This also makes sense as ESG and sustainable investment funds will be required to disclose the alignment of their portfolios with the Taxonomy as of 2023.

Which brings us to the crux of the problem. This system operates on data and is only as effective as the quality of the data available to it. Therefore, it will be vital both that the EU Non-Financial Reporting Directive is upgraded to become a meaningful source of comparable data, and that asset managers engage with investee companies to fill data gaps.

The EU has shown leadership by being the first-mover in this space. With that often comes a level of trial and error. So it is vital we have an open, frank and honest debate to get the SFDR right. Both to protect investors from greenwashing and to ensure the asset management industry can make a measurable contribution to long-term goals of the Paris Climate Agreement and the UN Sustainable Development Goals. This will be one of Eurosif’s priorities in the next years through its advocacy and its research.

Victor van Hoorn is the Executive Director of Eurosif, the European Sustainable Investment Forum