The new Sustainable Finance Disclosure Regulations (SFDR), which came into effect on March 10th, will impact financial institutions, EU entities, and Non-EU entities that have EU subsidiaries. These new obligations aim to reduce greenwashing by requiring firms to disclose how sustainable they are and reveal comparable metrics related to their sustainability. The new SFDR will aim to drive 1 trillion EUR into green investments over the next decade.
Greenwashing has become an increasing problem within financial institutions and companies alike. Greenwashing refers to an entity making misleading claims about its ESG practices, performances, or products. Greenwashing could include using misleading statistics or numbers or publicising environmental promises without following through. Until the SFDR, there has been no clear metric that investors or regulators could use to distinguish how ESG-friendly a company is, or its products are.
The new SFDR will be implemented in several stages over the next two years. All funds must disclose in their pre-contractual information how they factor in sustainability risks into their financial decisions. On the company’s website, they must include their sustainability objectives and their plan on how to meet them. They must also assess the negative impacts their investments have on ESG related topics or be required to explain why they have not done so.
The SFDR in the future will require companies to disclose specific data such as CO2 emissions and water usage across their investment portfolio. They will also be required to allocate themselves under an article. Article 6 describes products that don’t deem ESG risks relevant in their investment decisions. Article 8 refers to a fund that will fully or partially focus on ESG issues in their investment decisions, and Article 9 products are funds that focus on sustainable objectives. Article 8 and 9 products will be required to disclose sustainability criteria and objectives. Ulrika Hasselgren, the head of Arabesque Group, believes that many asset managers are ill-prepared and will be required to allocate their funds as an Article 6 product. This decision will be due to the complexity of the SDFR. Recently, Apex Group revealed that only 17% of their clients believed they are ready for the new regulation.
The demand for ESG products has become increasingly popular over past few years, where ESG assets under management have increased by 29% in this quarter compared to the previous quarter. The total assets under ESG funds are estimated to be roughly 1.7 trillion USD according to Morningstar, with this number expected to grow to 53 trillion USD by 2025, according to Bloomberg Intelligence. BlackRock revealed to their clients that only 17% of their 2 trillion EUR assets under management would be sustainable under the new SFDR. They announced that 74% of investment into actively managed funds in 2020 would be sustainable under the SFDR and 38% of index-tracking products. They believe that sustainable finance instruments are in high demand by clients and see a “transition opportunity” that should occur to allow 50% of their assets under management to be classed as sustainable under the SFDR.
Currently, many ESG funds only screen sectors from their funds rather than directly choosing the best ESG stocks. Other funds use the limited ESG related data to try and handpick companies over all of the sectors. Investors believe that the solution to improving ESG issues over the sectors is to sell those in companies with sub-standard ESG ratings and buy the highest-rated ESG stocks. Contrary to this belief, Merryn Somerset Webb, a journalist in the FT, believes the solution to solve ESG issues within companies are the shareholders. She believes that if a large percentage of shareholders call for change, this would have a more positive effect than reducing the share price. Action such as this has been used by HSBC shareholders regarding fossil fuel investment.
The swift shift to sustainable assets will accelerate over the next decade, with green companies benefiting favourably from these new SFDR regulations and EU investments. This shift is likely to overvalue many companies, leading to a volatile and exposed market in the future. There are speculations that a ‘green bubble’ could form over the next decades as a result of asset managers acting in line requirements to class funds as either Article 8 or 9. The SFDR will be a valuable tool to investors over the next few years, helping regulators crackdown on companies that do not abide by the new regulations and will bring about the reduction of greenwashing.
By James Watson-Gandy
Sector Head: Sophia Li