The complexity of SFDR for buy-side firms

Reporting requirements under Europe’s new sustainability regulation pose a major challenge for buy-side firms, but also an opportunity to build an organisation-wide ESG data strategy, writes Mark Davies, partner at Element22.

In line with its objective to become the world’s first climate neutral continent by 2050, the European Union (EU) is implementing a series of regulations to encourage companies to direct capital flows towards green projects and simultaneously prevent greenwashing. Among its policies, the EU’s Green Deal includes the Sustainable Finance Disclosure Regulation (SFDR) which imposes multiple transparency requirements on asset managers to report specific information relating to the degree of sustainability of their financial products and of the companies in their portfolios. It is important to note that following the UK’s departure from the EU, UK-domiciled firms marketing and selling services in the UK are no longer subject to the regulation however, UK asset managers and all other non-EU firms who market their funds into the EU will have to comply. 

The rules for financial market participants to publicly declare how they integrate sustainability considerations in addition to disclosures around policies, risks and compensation, entered into force on 10 March 2021. A second layer, requiring much more detailed ongoing disclosures will become effective from 1 January 2022. This compliance date was pushed back due to ‘unprecedented economic and market stress’ caused by COVID-19, however the industry should be mindful that this does not mean it can ease up on its planning.

While the industry has been afforded a reprieve for the most complex and detailed disclosures, the March deadline is hard set and firms must be making final preparations to comply with this first set of requirements. This will involve acquiring various disparate sources of data and establishing the requisite analytic and reporting capabilities needed to meet the first tranche of requirements under the SFDR.

The disclosure obligations include disclosures at the product level, in particular those made to investors, as well as at the entity level, in the form of publicly accessible information on the entity’s website. In fact, a great deal of this information will have to be obtained from the investees. Hence, efforts to source, collate and report the data are sure to be an unprecedented undertaking which will require considerable allocation of time and resource.

As a fairly nascent sector, it is widely known that ESG investing is beset with data gaps and in many cases the data held within an organisation isn’t actually fit for purpose. For example, a lot of data needed for reporting under SFDR isn’t standardised or is in the incorrect format or structure which can not only make compliance with the regulation challenging, it hinders data transparency, quality, and control within an organisation.    

A further challenge, which will be exacerbated by a lack of standardised data, will be the need to aggregate data across an organisation. For example, a multinational corporation may need to obtain data from across its network of offices in different locations, to have a consolidated view of its carbon emissions. Not only will this requirement present issues for the asset manager but the onus will be on the investees to pull the information together themselves from multiple, cumbersome organisations which undoubtedly is resource intensive.

The EU’s ambitious ESG Action Plan means that more ESG-related directives will be put in place in the years to come, each with their own reporting requirements. In addition to this, there are an increasing number of use cases for ESG data that are equally as important as reporting ESG data for regulatory compliance. For example, there are multiple stakeholders within an organisation such as portfolio construction and risk teams that need the data for monitoring purposes.

With this in mind, investment firms would do well to view this regulation as an opportunity to build an organisation-wide ESG data strategy, to ensure that high quality, consistent information is delivered to all of the stakeholders who need it. Not only will this guarantee regulatory compliance with any ESG reporting mandates, it is sure to satisfy the demands of internal teams who will require access to ESG data for the firm’s own purposes in an increasingly competitive investment management landscape.