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As the next phase of SFDR disclosure begins, January 2023 marks an important milestone in the regulation of ESG in the EU. With the SEC, HKEX, SEBI and other regulatory bodies around the world also considering similar measures, we appear to be at the start of a significant global effort to increase transparency into the sustainability of financial products, prevent greenwashing and empower investors to compare products based on sustainability risk.
Most asset managers and other buy-side firms have been busy preparing for SFDR reporting for many months. As they and their service providers have gone through the process of translating the requirements into tangible operational steps, there are a number of takeaways worth noting as they will be instructive for future rounds of SFDR reporting and the potential roll-out of similar regulations in other jurisdictions.
Data management
One of the big challenges of SFDR is data management. Buy-side firms must classify their investments based on the EU’s criteria and then make detailed disclosures at both the product and entity level.
In many cases, firms do not currently capture the required data (such as principle adverse indicators, PAIs, which show how investment decisions may negatively impact sustainability factors).
As a result, they are starting to expand their due diligence processes to incorporate ESG considerations. Asking the right questions now will be helpful not only for SFDR, but also for compliance with future requirements.
Of course, the challenge is not limited to data capture. Even if data is available, it is likely to be siloed, maintained in different formats and varying in quality. Recent research by InvestOps found that 30% of buy-side firms do not yet have a solution for integrating the ESG data they consume from multiple sources.
Some firms may hope to complete their initial SFDR reporting using manual or semi-automated processes. However, the large volumes involved (spanning thousands of fields per investment) mean this is likely to be untenable for most in the long term.
To truly operationalize SFDR reporting and avoid tying up resources, firms will need to automate the data collection, validation and reporting processes. This will also help reduce operational risk and deliver high-quality disclosures.
Private assets and proxy data
As many on the buy side expand their exposure to private markets, they face particular challenges due to the lack of available data for alternative assets. While proxy data can help build out initial internal processes and align to internal reporting frameworks (32% of those surveyed by InvestOps said they will take this approach), firms will want to find long-term solutions to replace it with data sourced directly from private companies.
Flexibility and scalability
Detailed reporting rules have been defined for this phase of SFDR disclosures, however, determining the threshold for quality data will be challenging. This is true for ESG more broadly due to the lack of a universal, global standard.
In this evolving environment, it is especially important for firms to have the flexibility to re-evaluate and optimize their compliance with ESG regulations as part of an iterative process.
There is a need for robust data management – both across public and private markets – and this will continue to evolve as firms adapt to regulation. It is important to take time to understand whether your processes and systems for SFDR will offer both the flexibility and scalability to support compliance with similar requirements that are under consideration in other jurisdictions.
We are in the early stages of developing more transparency and consistency across ESG data. By thinking ahead and learning from the experience of SFDR, assets managers and others on the buy side have an opportunity to reap significant efficiency benefits in the future.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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