Much is hanging on the EU’s Sustainable Finance Disclosure Regulation (SFDR), which originally entered into force on 10 March 2021 and the second phase of which entered force on 1 January 2023.
“The implementation phase was already quite complicated,” explains Lisa Klemann, senior associate at Allen & Overy, adding that even though ESG wasn’t something entirely new, in some ways the market wasn’t prepared in the first phase. “We had a lot of discussions when it came to integration of sustainability risks in decision-making processes.”
At the time, she argues, fund managers were taking a “prudent approach”, for various reasons, including at times lacking data to do the relevant checks.
“That has completely changed now because it’s nearly impossible to say that sustainability risks are not relevant anymore,” Klemann says, adding that aspects such as climate change and resource usage cannot be ignored.
She uses an example of a brewery and a tyre company, both located in India: despite two completely different sectors and raw materials, both use significant amounts of water in their production. The World Bank confirms the nation is one of the most water-stressed on the planet; despite accounting for 18% of the world’s population, it only has 4% of its water resources. “So, when investing in an Indian company which is using water as raw material, it’s impossible to say that such an ESG risk is not relevant.”
Areas of expertise
ESG risks are relevant in the context of valuation, but this isn’t always so straightforward. Not only are a number of asset managers still “trying to sort all these ESG-related matters,” but Klemann sees an additional risk in the need to have really specific areas of expertise. “For instance, if you have climate change risks or biodiversity risks, in principle, you’d need to have scientific knowledge [with] your asset manager to really assess, evaluate and monitor those risks.”
As Delano has previously reported, there had also been lack of clarity on funds with a “sustainability purpose” as outlined under article 9, with some funds being downgraded to article 8 because managers are erring on the side of caution in case the funds do not qualify under article 9. As Klemann notes, an CSSF FAQ guide points out that “an article 8 SFDR financial product may only use exclusion strategy as a key element of the ESG strategy, provided it is detailed to allow investors to understand how the financial product’s environmental and/or social characteristics are being met. As explained, this is not possible for an article 9 SFDR financial product.”
Avoiding greenwashing
Klemann cites an interesting article by Kim Schumacher titled “Environmental, Social, and Governance (ESG) Factors and Green Productivity: The Impacts of Greenwashing and Competence Greenwashing on Sustainable Finance and ESG Investing”, in which the author argues that the rise of ESG reporting “has gradually led to a growing disconnect among many financial-sector and corporate stakeholders” but that greenwashing and its variants “do not occur in a contextual vacuum but are strongly linked to the increasing appeal of sustainable finance, ESG investing”, etc.
Klemann adds, “Asset managers often lack the scientific background and the personnel that has this scientific expertise, especially when it comes to metrics and PAIs [principal adverse impacts].”