How SFDR will Impact Private Markets

ESG data is investment data.

ESG metrics are now a requirement across all investment data management strategies. ESG can no longer be tracked in a silo outside of operational and financial data as investors require timely information about environmental and social investment outcomes. Furthermore, assurance-ready information is becoming a must as new regulations require accurate quarterly and annual reporting.

We see two significant trends emerging: robust and comprehensive data tracking and increased requirements for multiple types of ESG data. New ESG reporting regulations will quickly drive the evolution of ESG data excellence;  investors who are building capabilities to analyze and use ESG data in their fund management processes and decision making will not only have an edge in accurate reporting, they will also have a competitive advantage in the market.

EU reporting directive is elevating ESG as a key investment competency.

The Sustainable Finance Disclosure Regulation (SFDR), which came into effect in March 2021, is part of the European Union’s Sustainable Finance action plan and is intended as a guide to recognizing real ESG achievements and combatting unsubstantiated “do good” claims. The SFDR imposes mandatory ESG disclosure requirements on financial market participants at both the entity- and product-levels. Contrary to common understanding, disclosure will be required even if a firm or product is not ESG focused.

There are both legal and commercial factors compelling non-EU firms to comply with the SFDR. Legally, the SFDR applies to Financial Market Participants and therefore has implications for non-EU actors who market products in the EU. For example, marketing a product in the EU requires compliance with article 6 product disclosures, and article 8 and 9 as relevant (see figure below). From a commercial perspective, the SFDR presents an opportunity for managers to commit to “best in class” disclosure standards, regardless of jurisdiction. Compliance with SFDR standards can help improve firm reputation and meet investors’ disclosure expectations.

We believe that managers that have smart and efficient information flows from source to output will benefit from reduced regulatory risk and compliance costs. Please see Regulation Technical Standards (RTS) for more information regarding reporting requirements, including defining “Principle Adverse Impact” (PAI) and its approximately 60 indicators outlined in the regulation.

SFDR classifies funds in shades of green with differentiated reporting

Although SFDR will be applied to all Fund Managers, many firms offer funds and strategies with different ESG approaches and goals. To accommodate this difference, SFDR enables managers to classify funds as as Article 6, 8 or 9. The general requirements for these classifications are detailed below.

First report is due in 2023 but funds should start recording ESG data now.

Fund Managers must report their Principle Adverse Impacts while complying with the RTS, which outlines specific rules that help keep PAI reporting consistent and enable clients to compare information across funds. PAI reporting includes how funds are promoting ESG through written responses and qualitative data. As of June 2024, funds should record the metrics quarterly and report every six months. Additionally, Fund Managers should also consider how they will report in line with the EU Taxonomy, which defines activities that are deemed “sustainable,” enabling a consistent, science-supported standard.

Getting Started:

1. Start tracking ESG performance.

RTS highlights what should be included in the PAI report; however, the regulators are still working out the final details and some requirements may change. In terms of quantitative data, funds will be required to report 18 metrics and other voluntary metrics if data is available. These metrics mainly focus on environmental and social impacts, with some qualitative and quantitative governance metrics, as well. There are various methods for calculating these metrics.

Here are examples of what a firm can report on:

2. Determine reporting requirements and disclose.

Depending on whether or not a firm considers PAIs and how it has classified its funds (light green or dark green) will determine what they must disclose. A manager will report general ESG integration practices and PAI metrics. Managers will also answer specific “Best Practice” questions on ESG in investment strategies. Common topics include indicators aligned with ESG characteristics, investment strategies, asset allocation, carbon emissions reductions, and top significant investments.

3. Evolve systems and process in line with regulations.

As the RTS states in the “Accompanying Documents” section, many regulatory standards are still being developed, debated, and discussed amongst regulators and financial market participants. Many firms do not know how to classify their funds since SFDR does not state absolute performance requirements or benchmarks managers need to achieve. For now, funds are only trying to improve their numbers from the year before and evaluate their performance relative to peers or the market.

Implementation challenges will remain as SFDR and associated guidance is expected to evolve.

SFDR is an excellent step in the right direction to provide clients with comparable ESG information, but it comes with various challenges. For example, collecting accurate ESG data through a timely and reliable process will initially be complex, as information is not readily available and not subject to the same oversight as financial data. Additionally, measurement standards for social and governance indicators need further development as many indicators are used and there is not the same consensus as for many environmental indicators. For example, the Greenhouse Gas (GHG) Protocol, which is now the measurement standard for both corporate and fund GHG emissions footprints, has been applied for more than 15 years.

How can we help?

Mercatus is an investment data management platform for private market fund managers and asset owners. Reach out to us here.

Quinn and Partners is a management consultancy specializing in corporate sustainability, sustainable finance and responsible investment practices. Reach out to us here.