Fund managers may be storing up trouble on sustainable finance

Fund managers could be accused of ‘greenwashing’, or of underplaying the environmental impact of investment decisions concerning their funds, if they fail to check that the declarations and disclosures they have made to-date will stand up to scrutiny.

The sustainable finance regime

In the EU, the declarations and disclosures fund managers have to make about the sustainability of their funds stem from the Sustainable Finance Disclosure Regulation (SFDR) finalised in 2019.

With the impact of the coronavirus crisis, and regulatory obligations associated with it, demanding the attention of asset managers and other finance firms throughout 2020, there has been a rush within the industry to meet the requirements of the SFDR since it began to apply in March this year. The SFDR has direct effect in EU member states and while it has not been implemented in the UK, many UK-based fund managers especially those active in the EU market, are reporting in line with the SFDR.

The SFDR requires fund managers to make a series of declarations and disclosures concerning the sustainability of the funds they manage. The regulation is designed to increase transparency over the impact funds and other financial products have on the environment, with a view to that driving investment decisions towards ‘greener’ industries, businesses and projects. Since 10 March 2021 fund managers are required under SFDR to publish a sustainability risk policy and to classify their funds, as being, Article 8 ('light green') or Article 9 ('dark green') status or if neither,  by default in compliance with Article 6, which is for funds that do not have a specific ESG investment objective

Among the requirements under the SFDR, fund managers must decide whether they consider the principal “adverse impacts of investment decisions on sustainability factors” or where they do not, set out clear reasons as to why they do not, including information as to whether they intend to consider them in the future. Large fund managers, with more than 500 employees, are obliged, as of 30 June 2021, to consider those impacts and make disclosures in relation to them on their websites.

Among the disclosure requirements, fund managers must make a statement on their website of the due diligence policies they have in place with respect to the “principal” adverse impacts they identify, “taking due account of their size, the nature and scale of their activities and the types of financial products they make available”. There is also a duty to share information about their policies on the identification and prioritisation of principal adverse sustainability impacts and indicators, provide a description of the principal adverse sustainability impacts and of any actions in relation thereto taken or, where relevant, planned, and to specify their degree of alignment to the objectives of the Paris Agreement on climate change signed in 2015 by a number of global leaders, where it is relevant to do so.

Further sustainable finance disclosures must be made in pre-contractual information fund managers must share, as well as in relation to specific funds they operate. Special disclosure requirements also apply where the funds have sustainable investment as their objective.

Although much of the SFDR regime has applied since 10 March 2021, the regulatory technical standards (RTS) are still be finalised and a recent letter from the European Commission has postponed their implementation by six months to 1 July 2022.

The potential to bake-in mistakes

In a rush to comply with the SFDR’s requirements, there is a risk that investment firms have made mistakes in analysing the impacts of their funds on environmental sustainability. Now, as they work towards the 2022 deadlines for compliance under the sustainable finance disclosure regime, there is a risk of baking-in those mistakes.

Our understanding and interpretation of environmental matters is developing at a fast rate. We believe some fund managers may be underestimating the impacts on the environment of investment decisions made ,. In other cases, some fund managers are failing to fully understand that actions they commit to address the environmental impact of investment decisions can themselves result in a knock-on indirect harm to sustainability in another area, which they may not realise far less disclose.

Other developments arising from the growing green finance agenda which give pause for thought include sweeping decisions by fund managers to channel investment away from entire industries such as the traditional energy sector , despite the huge number of businesses around the world reliant on petrochemicals and the sector’s drive to decarbonise.

With every day that passes, businesses learn more about climate risk and what the ‘green’ agenda really means for them. The SFDR disclosure deadlines and the late publication of the RTS meant that the disclosures were done hurriedly and against a background of changing understanding and interpretation. Now there is a risk of baking-in errors and omissions in disclosures already made.

Fund managers are obliged, under the SFDR, to review their disclosures to ensure they are up-to-date. However, we believe a more fundamental review of the basis for the disclosures made to-date and of the potential unintended consequences of actions promised would serve fund managers well and reduce the risk in the years to come of accusations of ‘greenwashing’ and other environmental claims being raised against them. We are already seeing a rise in climate-related litigation and this is unlikely to abate.

Elizabeth Budd was on a panel discussing the environmental, social and corporate governance agenda in investments at the ‘UCITS & AIFMD Dublin 2021, a new era for asset management in Dublin’ conference. Pinsent Masons was the lead sponsor of the 27 April event, which was organised by Informa.