EU & UK sustainability update

A) Latest EU sustainability developments

1. SFDR draft RTS: recap, latest ETA 

The European Supervisory Authorities (ESAs) consultation on their latest set of SFDR disclosure ‘Level 2’ proposals has now ended.​

Unlike their previous draft RTS (‘Gas and Nuclear’ rules), the ESAs do not indicate when the current version may be presented for official EU endorsement, nor when they should apply legally.

Some experts assume that if the new rules gain EU tripartite approval during Q3-Q4 2023, they will likely apply in 2024, with a legal transition period throughout the remainder of next year.

Meanwhile, a reminder that European Commission (EC) is currently conducting a comprehensive SFDR ‘Level 1’ assessment;  with another consultation expected during Q4, this has led the industry to negatively label the ESA’s interim draft RTS amendments as “SFDR v1.5”.

2. CSSF publish Thematic Review on local SFDR/TR provisions (UCITS, AIFs)

Yesterday, the Luxembourg financial regulator issued a ‘Thematic Review’ of the SFDR/TR rules recently applied to both UCITS and AIF products regimes. This is a useful recap of the CSSF’s observations and expectations concerning the numerous sustainable finance disclosure rules now facing local investment fund managers.

Notable content of interest to Kneip clients covers the ongoing compliance of:

• Precontractual disclosures: including the need to provide “sufficient details” of environmental / social characteristics or sustainable objectives, plus clarity on ‘sustainable investment’ definition;
• Product websites: including the obligatory 2 x page A4 summary and specific ‘data sources and processing’ information;
• Periodic reports: the CSSF expects IFMs to provide “sufficiently detailed and relevant information” on the Principal Adverse Impact (PAI) considered for each fund;
• Marketing communications: must not contradict SFDR disclosure information and should use ‘limited’ hyperlinks directing investors to the exact location where relevant information is found.

NB: alongside the SFDR Level 2 RTS, the CSSF make frequent referral to ESMA’s previous supervisory briefing on sustainability risks and disclosures issued back in May 2022; this forms the basis of the CSSF’s current expectations that fund names should be “aligned with the relevant fund’s investment objective and policy”.

3. SFDR divergence “undermining” EU-UCITS regime

Varying applications of local SFDR legal rules (i.e. mentioned here previously) have led to fund firms reportedly now “struggling” to market their products across multiple EU member states.

Belgium and Germany were recently singled out as the “more difficult markets for cross-border managers” due to regional requirements; France was also cited as a challenging area where asset managers currently face local distributors “deploying their own sustainability rating models” to classify their products.

Senior industry personnel have also pointed to SFDR divergence within EU member states as “undermining the UCITS regime” and “impeding cross-border fund distribution”, with “more bespoke fund documentation” now required “to suit different national requirements”.

Instead of selling the same vehicle across the EEA, one leading asset manager director reckons firms now require “different products to qualify for local sustainability standards”.

Amid key divergence between French and German clients towards the energy sector (nuclear power, coal), another senior spokesperson says asset managers need to “build up a local distribution presence”.

B) EU sustainable market trends

1. Article 8 funds “bleed money”; article 9 funds inflows “at record low”

Morningstar’s latest SFDR quarterly fund report shows an article 8 “light-green” products outflow of EUR14.6bn, while article 9 “dark-green” funds recorded their lowest inflows (EUR3.6bn) since the EU regime was activated in March 2021.

Last quarter, “sustainable” product AUM rose by 1.4% to EUR 5.04 trillion (i.e. 56.4% of Morningstar total fund universe). At the same time, “non-sustainable” article 6 fund assets also increased by 1.7% to EUR 3.9 trillion.

Other takeaways reported from the latest analysis include:

• Half of article 8 funds now target at least 10% sustainable investment allocation in their portfolios
• Nearly 600 “sustainable” products now disclose a carbon reduction objective
• Latest principal adverse impacts (PAI) trends:
  • Most article 8 funds consider at least half the 14 mandatory PAIs for corporate investment
  • Less than 10% of article 9 funds consider all 14 corporate PAIs.
  • The majority of article 9 funds consider at least 11 PAIs

NB: as always, Morningstar’s analysis is based on data obtained from the European ESG template [EET]

2. MSCI: less than 2% of SFDR funds align with EU taxonomy

A separate report published by MSCI’s ESG Research unit concludes that less than 2% of SFDR ‘sustainable’ funds currently disclose alignment with the EU taxonomy regulation (TR).

MSCI analysed 13,419 EU funds in total as end-April 2023 (i.e. also reviewing available EET data).

From the 6,603 [49.2%] funds identified as ‘sustainable’ article 8 or 9 products, only 126 [1.9%] actually reported a figure for EU Taxonomy-aligned revenue. Of these, the majority of funds (114) reported zero aligned revenue.  The results were said to be “even more bleak for reported capital and operational expenditure aligned with the EU Taxonomy”.

However, the MSCI acknowledged the EU sustainable investment framework “is only partially developed”, with fund firms “only just starting” to disclose their alignment .

Elsewhere, 88% of article 8 funds and 63% of article 9 funds did not include any taxonomy-aligned investments in their EET reporting. This is said to be “primarily driven by a shortfall in disclosures by underlying companies”.  However, almost 90% of both “sustainable” products disclosed consideration of SFDR PAIs in their investment strategy.

C) UK sustainability latest

1. Frustration over latest SDR delay 

The FCA recently deferred (again) their Sustainability Disclosure Requirements (SDR) rules until Q4 2023.

In response, the head of the UK Sustainable Investment and Finance Association (UKSIF) remarked it was “deeply disappointing to see yet another delay to the publication of the finalised SDR and fund labelling regulations. We see these as crucial in the development of the UK’s sustainable finance leadership and building trust for consumers, and essential to give certainly to the industry on future regulatory requirements.”

A reminder the FCA’s initial set of challenging ESG proposals included sustainable investment Labels, anti-Greenwashing rules, alongside detailed disclosures (not only at product and entity level, but also facing retail investors).  The Financial Times had previously reported the FCA were considering changes, following the Investment Association’s warning they could effectively exclude 60-70% of all retail investment products.

2. GovUK: “to streamline UK taxonomy’s DNSH criteria”

“There are potentially very significant opportunities to streamline, simplify and improve DNSH compliance requirements, without compromising the robust, science-based nature of the criteria.”

Green Technical Advisory Group, 2 August 2023

A consultation on the UK’s green taxonomy will also take place during autumn 2023.

This week, the UK Green Technical Advisory Group (GTAG) issued a detailed report on how a ‘streamlined’ version of the EU ‘Do No Significant Harm’ (DNSH) criteria can be applied to the local taxonomy.

GTAG’s latest analysis concludes five challenges with the EU model, “currently difficult to navigate”, with more than 700 individual DNSH criteria now in place.

They now propose making DNSH “fit for purpose for the UK”, by addressing specific ‘usability issues’, alongside ‘inconsistent structure’ and ‘inflexible disclosure’.  They also confirmed a selective approach (“adopt some and revise some”) facing the EU-DNSH criteria, ongoing.