European regulators are rowing back on draft requirements in their new disclosure rules on sustainability. And buy-siders are heaving a sigh of relief.

Buy-side firms were critical of the draft legislation, published last April by three European watchdogs, known collectively as the European Supervisory Authorities, and described its requirements as impossible to meet. On February 4, the ESAs published their final report, including a raft of changes from the previous version that buy-side sources say will ease the burden on the industry significantly.

“It is achievable now because those indicators should be able to be captured,” says Will Oulton, global head of responsible investment at First Sentier Investors.

Wherever managers consider environmental, social, and governance (ESG) factors in their investment decisions, the Sustainable Finance Disclosure Regulation (SFDR)—which took effect on March 10—requires them to disclose the impact of their investments publicly. Fund managers will score themselves against a series of principal adverse impact (PAI) indicators—a set of sustainability criteria—and disclose the results on their websites.

In the revised regulation, a series of 32 mandatory indicators for investments in companies has been cut back to 14. In keeping with the original consultation, fund managers will also need to select one additional indicator each for environmental and social factors from a list of options, which has increased with the number of mandatory indicators being altered to optional.

“The first draft missed the materiality point of some indicators that were not so relevant for the industry. So it makes it more focused now,” says Marie-Adélaïde de Nicolay, head of the Alternative Investment Management Association’s (Aima) Brussels office.

The problem presented by the 32 indicators was that companies are not currently disclosing information relating to many of the indicators. Some indicators aren’t applicable to certain companies’ activities, for example, and many companies located outside the EU are not reporting the same level of information that is expected of companies within the bloc.

First Sentier’s Oulton undertook analysis to find data availability among his firm’s investments for the previous consultation paper’s indicators. The data was only completely available for a third of the original indicators, he found, while another third was partially available and one third completely unavailable.

And although data for some of the indicators in the final report will still prove tricky to find, a new provision in the legislation should resolve any lingering issues: it allows fund managers to detail their best efforts in trying, but failing, to get data.

This is a big relief. It will help with, for example, finding out biodiversity effects for a software company

Michael Maldener, Nordea Asset Management

“This is a big relief,” says Michael Maldener, a managing director at Nordea Asset Management. “It will help with, for example, finding out biodiversity effects for a software company. You will hardly get that sort of data from the start because they might struggle to find out what their impact is on biodiversity when they are writing software.”

And fund managers may well feel more pressure from regulators to incorporate the voluntary indicators that are relevant to their investments.

“Although more indicators are now voluntary, there is going to be a regulatory expectation that you pick the ones that are relevant to your portfolios,” says Gavin Haran, head of policy for asset management at law firm Macfarlanes.

The ESAs’ draft regulatory technical standard requires that they also disclose against any other indicators they use to assess principal adverse impacts.

Those indicators may well become mandatory in time when more data is readily available.

“There is a softening of the number of mandatory data points, but they’ve not been taken out of scope and there is an expectation that optional fields will be made mandatory at some point in the future,” says Mark Davies, a partner at data management consultancy Element22.

Scoping out a challenge

Regulators have already fixed a date for reporting one of the data points—so-called ‘Scope 3’ emissions. These are the indirect greenhouse gas (GHG) emissions a company produces throughout its value chain, including—among other causes—the GHG emitted in the use of its products and by its employees’ commutes.

“GHG emission data has been around for 10 years plus. It has weaknesses, but it is fairly easy to get hold of that information,” says Oulton. “The bit that isn’t easy is the Scope 3 emissions—the upstream and downstream emissions.”  

MSCI reports that only 18% of constituents of its MSCI ACWI IMI index, which  includes large-, mid-, and small-cap companies in various developed and emerging market economies, reported Scope 3 emissions as of March 2020.

The ESAs will require fund managers to begin reporting Scope 3 emissions in due course. The regulatory technical standard enters into force on January 1, 2022, at which point fund managers must publish a statement on principal adverse impacts from their investments, but do not need to disclose data based on the PAI indicators. The first reference period for calculating the PAI indicators will be the full year of 2022 and the data must then be disclosed publicly before June 30, 2023.

Scope 3 emissions will be incorporated into the 2023 reference period and so reported before the next reporting deadline, June 30, 2024.

“That gives the industry time to develop the tools around the inclusion of Scope 3 and also enables companies to begin providing that information,” says Oulton.

Clarity and ambiguity

New mandatory and optional indicators for sovereigns and real estate assets—two for each—also provide clarity on how exactly fund managers should incorporate these exposures within their PAI indicators, as not all indicators meant for public and private companies can be applied to these asset types. This is easier for asset managers, as it means they need only disclose the two indicators for each of these exposure types, not the remainder that could be inapplicable.

“Sovereign and real estate assets have received additional and more dedicated indicators and you need to have separate data for these,” says Cecilia Siegbahn, a regulatory adviser at Nordea Asset Management. “That is good because it makes sure that you have relevant data for the relevant asset allocations.”

Conversely, there is still some uncertainty as to how derivative asset classes are treated within the PAI statements. Interest rate and foreign exchange contracts have no inherent link to emissions, for example, which would suggest they should not be included. But Aima’s de Nicolay says there should be more guidance from regulators as to how these are treated.

“It is good to see they have added indicators for sovereigns and real estate assets, but we are still missing guidance on other asset classes such as commodities, foreign exchange and rates,” says de Nicolay. “It is not clear whether you are expected to comply and communicate indicators to asset classes, or whether you should disregard those asset classes altogether.”