SFDR, MiFID and the many shades of
In the wake of the ESG gold rush, the European Union hastened to step in and legislate the sustainable taxonomy of investment funds. The SFDR (Sustainable Finance Disclosure Regulation) aims to standardise sustainability disclosures and help institutional asset owners and retail clients separate the wheat from the chaff. The goal of this initiative is to normalise ESG reporting and leverage the underlying power of capital markets to meet carbon emissions reduction targets. Phase one of SFDR was implemented on 10 March 2021 and categorised investment funds in three categories from least to most sustainable (Article 6, 8 or 9).
Figure 1 : Source: Endowus.com
At FARAD I.M., we attach great importance to invest our clients’ money in funds whose strategy pursues environmental and social objectives alongside capital appreciation. Our ESG due diligence starts at the investment fund level by following the European Union’s framework. This is the reason why we exclusively select SFDR Article 8 or 9 funds for our discretionary clients, but this is not our only filter and with a good reason. Last week Morningstar removed more than 1,200 funds with a combined $1.4tn in assets from its European sustainable investment list after an extensive review of their legal documents. This revamping came after a surge of more than 65 per cent in the European sustainable fund universe between June and September 2021 following the implementation of SFDR phase one. Most of the removed funds declared their sustainable credentials under the EU’s “light green” Article 8 section which requires funds to “promote” E or S or both, provided that the underlying companies have good G. The current lack of clarity regarding the European rules and the grey area represented by the SFDR Article 8 create a loophole for asset managers to overstate their sustainability credentials and embark on the ESG frenzy. The necessity to understand each investment fund’s selection and monitoring process when it comes to ESG is paramount to avoid green washing. Sustainable Investing represents an incredible financial opportunity for newly green labelled investment funds and ETFs willing to attract more assets, but first and foremost, ESG investing should be a conviction that market incentives can redistribute capital flows to contribute to all 17 SDG (Sustainable Development Goals) defined by the United Nations – the list of Humanity’s most important challenges.
After acknowledging the fund’s marketing materials and understanding its investment philosophy, our ESG due diligence then filters through vehicles actually selected by the managers. Investors should not limit their analysis to labels at the risk of repeating the errors made in 2008 when investors put blind trust in credit agencies. Never judge a book by its cover: Sustainable Investing is a matter of subjectivity, so it is crucial to read between the lines in order to make up your own mind about what ESG truly means to you and your clients. There are many approaches to Sustainable Investing. Some (self-proclaimed) green asset managers prefer excluding investment in fossil fuel companies, whereas some others opt for an “activist” stance and stay invested to put pressure on management via engagement letters. A similar debate was revived earlier in February when the European Commission adopted a proposal that would allow nuclear power and natural gas to be labelled as green investments under the EU Green Taxonomy.
This decision created a heated debate between those arguing that nuclear energy is needed for the green transition and those criticising that these inclusions are politically motivated. We will not venture into saying which approach prevails, but figures are enlightening. Notwithstanding the bad press about nuclear energy, according to Our World in Data, the death rate from accidents and air pollution per terawatt-hour of energy produced and the amount of greenhouse gas emissions per gigawatt-hour of electricity for nuclear energy is respectively 0.07 deaths and 3 tonnes – both data are very similar to hydropower, wind and solar energy. As a matter of comparison the fatality rate due to oil and the volume of CO2 emissions due to coal are respectively 263 times and 273 times higher than for nuclear energy. What about uranium dirty extraction and radioactive waste disposals? We could also shake up some conventional thinking about radioactive wastes, but nuclear energy is obviously not a perfect solution. “Life is not all green” and it would be hypocrite not to acknowledge that everything around us has been dug up from the ground or taken from nature, but some solutions are relatively better than others.
At FARAD I.M., we do not believe in a Manichean world opposing dirty and clean investors. Our objective here is to show firstly that the EU Green Taxonomy is a dynamic guideline that needs regular monitoring and secondly that there is no “one fits all” solution because every sustainable investment policy has pros and cons. The role of the regulator is to provide a common framework to protect the beneficial owners, but as comfortable as it is to split up investment funds in three boxes : those who don’t care, those who care a little and those who care a lot; we believe there are as many shades of green as there are personal definitions of the new ESG paradigm.
Now that you know where FARAD I.M. stands in the current ESG framework, we can look at the horizon to find out what investors have to get their heads around in in the near future. The European Commission confirmed in November 2021 that the application date of Level 2 of the Sustainable Finance Disclosure Regulation (SFDR) will be deferred by another six months to 1 January 2023. However, companies are still required to disclose on 18 mandatory Principle Adverse Impact Statements (PAIS) of investment decisions at legal entity level by 1 July 2022 and to report on it starting from 2023 (source: ESG Clarity).
In parallel, our British neighbours are following in the footsteps of the EU and creating their own fund categories via the (SDR) Sustainable Disclosure Requirements. The UK is increasing the disclosure and reporting standards for responsible investment products and providers, as well as introducing more explicit expectations of advisors. Since 1 January 2022, UK listed issuers must disclose climate-related risks and opportunities within their annual reports, and from 6 April 2022, TCFD (Task Force on Climate-related Financial Disclosures) reporting will be mandated by law for more than 1,300 of the largest UK-registered companies and financial institutions pending parliamentary approval. If European regulators are well versed on ESG, international bodies like the IFRS Foundation are also getting hold of the topic. During COP26, the IFRS announced the establishment of an ISSB (International Sustainability Standards Board) “to deliver a comprehensive global baseline of sustainability-related disclosure standards”. The next two years will be pivotal in wording a common gospel for “everything sustainable” so as to harmonise the fight against human kind’s greatest challenges (source: ESG Clarity).
If there is only one single date you want to mark on your calendar, this is 2 August 2022, the day from which European advisors will be legally required to introduce sustainability factors into suitability assessments under MiFID II. From August, funds will need to consider reporting on the percentage of their assets deemed sustainable in accordance with the Taxonomy, and whether they consider the “principal adverse impacts” their investments have on the environment, using a number of given criteria. However, advisors will have the most delicate position as they are caught in the middle of asset managers and clients. On the one hand, advisors will have to rely on asset managers’ sustainability disclosures – which currently lack transparency and comparability. On the other hand, they will have to assess their clients’ sensitivity for Sustainable Investing and carefully match it with suitable ESG friendly vehicles, bearing in mind all other investment constraints. At this point, a fund classified as Article 8 today, for example, may not be suitable under MiFID II, hence the need for a thorough ESG expertise. However, the new rules will not be limited to investment and mutual funds. It seems like all financial instruments – either regulated by SFDR or not – will be in the scope of the new requirement from the EU, that is to say ETFs, insurance-based investment products and pension funds will also have to prove their credentials. For those products which are not concerned by SFDR such as shares, bonds, private equity and financial derivatives, investment companies and asset managers will have to conduct their own ESG due diligence.
Figure 2 : Roadmap
As far as fixed income is concerned, we can reiterate our observation made three months ago, the relationship is blurrier over the same timeframe. Indeed, the performance of non-ESG corporate bonds is pretty much in line with that of their non-ESG equivalent if we compare the Bloomberg Barclays Green Bond Index (dotted orange +10.18%) and the Bloomberg Barclays MSCI Global Aggregate ESG (white +9.22%) to the standard Bloomberg Barclays Global Aggregate (dotted yellow +10.08%). However, we can say “advantage green” if we consider another benchmark, because the JP Morgan ESG EMBI Global Diversified index (red) outperforms its non-ESG homonym (dotted green) by 75 bps. Let us recall, however that performance showed can differ dramatically depending on the reference date and the benchmark selected (Source: Bloomberg Finance L.P., 13/01/2022).
With a view to assessing and fostering clients’ commitment to sustainable investing in line with MiFID II, FARAD Investment Management has developed an internal proprietary ESG scoring system, called GreenEthica Sustainable Scoring System (GSSS). This report aims to provide a reliable and objective way to assess the main ESG portfolio metrics with a comprehensive focus on its alignment to the 17 Sustainable Development Goals (“SDGs”). Thanks to GSSS, FARAD IM can produce a synthetic sustainability report with selected key ESG metrics to unveil the real sustainability profile of a portfolio and to compare it in relative terms with a benchmark. Thanks to this easy-to-read ESG dashboard, investors can visualise their quantified contribution to the achievement of the 2030 Agenda for Sustainable Investments of the United Nations.
Junior Portfolio Manager
FARAD Investment Management S.A.