The SFDR – the EU’s sustainable finance disclosure regulation – is coming fast. Much of the regulation takes effect from 10 March 2021, so it’s high on the to-do list of many asset managers at the moment. Although framed as a series of disclosures, in practice the SFDR is forcing some serious thinking as firms attempt to pin down an area of their investment process that has probably evolved significantly in recent years and is almost certain to continue to do so.
As I work with asset management firms to help articulate their policies, there’s frequently an unspoken tug-of-war between the desire to truly capture the firm’s approach to sustainability and the desire to produce good marketing copy. The best policies emerge from an authentic effort to get to “yes, that’s what we’re doing” rather than to “that sounds good”. Sounding good should be the outcome, not the target.
While SFDR compliance is going to involve a lot of work for most firms, getting to “yes, that’s what we’re doing” needn’t be too painful. Here are some of the keys:
1. Get to the core
At most firms, investment policy and investment process evolve together: the policy emerges from the process just as the process is shaped by the policy. So part of the art of capturing the policy is to work back from the process, to make explicit the why behind the what. But work too far back and the substance can be lost; if the essence of the policy is that “we take ESG factors into account where they are considered to be financially material”, don’t expect anybody to be impressed.
If, however, you are able to identify core beliefs that are both non-trivial and authentically embedded in your investment process, then you’re off to a great start.
2. Acknowledge the dynamism
Right now, the pace of change in sustainable investing is astonishing. Few firms approach sustainability in 2020 exactly how they did ten, five or even two years ago. So even though policy is intrinsically less dynamic than process, the co-evolution described above means that whatever you say today may be out of date sooner than you expect.
3. Take a position on financial vs. non-financial goals
Taken together, the EU’s SFDR and the US Department of Labor’s recent rule on financial factors in selecting plan investments (which applies to ERISA assets) leave little room for ambiguity as regards non-financial goals. Firms can select one of two positions.
The first option is to adopt a policy that sustainability factors are taken into account only to the extent they have financial implications. This makes things easier as far as the US rule goes, but is out of step with the regulatory trend elsewhere and with the increasing recognition of the importance and value of corporate purpose.
The second option is to acknowledge other goals alongside financial outcomes. These goals can be in addition to (and not necessarily at the expense of) financial goals, although this position creates additional documentation requirements when dealing with ERISA assets in the US.
Although the inclusion of non-financial objectives in an investment policy is ultimately a yes-or-no choice, the wider question of purpose is more nuanced: more on that here.
4. Expand your view of materiality
In a previous post on the subject of materiality, I focused on financial materiality. But SFDR broadens that, and one aspect that is shaking things up is the requirement for asset managers to explain how they monitor the adverse sustainability impacts of their investment decisions. In other words, to look at materiality from a social and environmental viewpoint, even where there is no expected financial fallout for the portfolio. Choosing to build your process around purely financial objectives does not get you off the hook; you still need to look into what the sustainability impact is.
The precise requirements are complicated and vary depending on the size of the firm (smaller firms have the option of comply-or-explain) and other factors. But, for most, this is one area where SFDR compliance is likely to go waaaay beyond disclosure of existing processes.
While it’s probably the process, rather than the policy, that represents the biggest challenge here, getting to “yes, that’s what we’re doing” should remain a guiding principle as the policy is formally articulated.
5. Be authentic
The third pillar of ESG policy – alongside purpose and materiality – is an authentic connection to the firm’s investment proposition. More on that here. The point here is that I should be able to tell from your policy whether you are a quant or a fundamental shop, rules-based or judgment-driven, whether you favor proprietary or third-party inputs. Your sustainability policy should give a window into your wider investment process. If it doesn’t, it might sound good, but it probably doesn’t get to “yes, that’s what we’re doing”.
6. Remember there’s more to come
Although the immediate focus for most firms is meeting the March 2021 deadline, there’s a lot more to follow. The SFDR’s regulatory technical standards are expected to kick in from 2022. These remain to be finalized, but seem set to include daunting annual reporting requirements. And the SFDR itself is just one step in a ten part action plan launched in 2018. Behind this plan is a desire to put sustainability at the heart of the financial system. By working on many fronts, the plan is likely to create a network effect of better data, better tools, better understanding and higher expectations and hence to add extra fuel to the growth of ESG investing.
Among the notable developments that are on the way is an updating of MiFID’s suitability assessment requirement to include the client’s sustainability preferences among the considerations that must go into investment advice and portfolio decisions.
7. Don’t create a hostage to fortune
Finally, take care not to allow aspirations and good intentions to slip into the policy, creating a hostage to fortune if, for some reason, the hoped-for action does not occur. “Document, document, document” is only good advice if it’s the right type of documentation. And, while this point applies whenever policies are being created, it’s especially pertinent in a fast-changing environment such as this.
Summing up, the SFDR is forcing asset managers to take a close look at their ESG policies and beliefs. Although a burden in many ways, this is also an opportunity. Well-crafted beliefs create internal alignment and serve as the foundation for ESG integration, operations, communication and client engagement.
But, as I have previously noted, the rapid development of this field means that ESG beliefs are generally less well-established and less ingrained in the everyday workings of the organization than other investment beliefs. With the first of the SFDR deadlines fast approaching, now’s a good time to fix that.
For more information about how Collie ESG can help you to formulate ESG policies that get to “yes that’s what we’re doing” contact us at bob@collieesg.com.