Europe has led the way on sustainable finance regulation with the SFDR. As the US and UK step up their own guidance, some regional divergence means fund managers are customising their approach…
It has been over a year since Europe’s Sustainable Finance Disclosures Regulation (SFDR) was brought into force. Since then, around 1,800 funds have been upgraded from Article 6 (funds which do not integrate sustainability into the investment process) to Article 8 or 9, or from Article 8 to Article 9, according to data from Morningstar’s 2021 review of funds published earlier this year.
Though some fund managers have simply formalised an existing ESG strategy or continued with a business-as-usual approach, others have rebuilt their investment strategy or launched new bespoke fundraising vehicles tied to the categorisation.
The first phase of SFDR has been generally perceived as a success on a global level, but what follows it in Europe and elsewhere is less clear.
In a survey of the industry by Private Equity Wire, around eight out of 10 respondents expected ESG to be an area of greater regulatory focus, within a list of other priorities. But with the inevitable delays in these regulations, there is the potential for SFDR to turn into a fund product label and revert to being a marketing tool, says an advisory source. Subsequent regulations, if implemented incorrectly, run the risk of devaluing the entire ESG proposition, the source adds.
The next stage – or Level 2 – of the SFDR (which should introduce more detailed and prescriptive disclosure requirements under Articles 8 and 9 and principal adverse impact of investment decisions) has been repeatedly delayed, most recently into January 2023.
Climate risk
In the US, the SEC wants to increase disclosure requirements for companies on climate-related risk but has extended the period for public comment up to June 2022 amid a wider pushback. The regulator wants firms to disclose how they identify and manage climate risks including scenario analysis and wants updates on progress towards meeting any climate pledges, including the use of carbon offsets or renewable energy certificates.
In the UK, Task Force on Climate Disclosures (TCFD) rules came into effect in April but under a phased approach, with only the largest UK-registered companies and financial institutions required to disclose climate-related financial information on a mandatory basis. Expansion of the rules is expected in 2023.
Although the SEC’s proposals are aligned with TCFD, a proposed classification approach in the UK through the FCA differs slightly from Europe’s SFDR, potentially adding to the cost and complexity already faced by many fund managers in meeting new regulatory requirements.
The UK’s forthcoming taxonomy – due at the end of 2022 – is also uncertain. It may classify North Sea gas extraction as a ‘green investment’, according to a newspaper report in May citing government sources, while the EU labels natural gas power plants as ‘transitional’.
“The fact is that ESG means something totally different wherever you are,” says Andrew Poole, director at ACA Group. “So that spread of focus is causing GPs concern – ‘If I deal with one thing, does that mean I’m missing out something else?’ They may be running a regulatory triage to keep one regulator happy while irritating another.”
The risk of regional divergence on ESG regulations has been well documented but the impact on how GPs fundraise and deploy capital once rules are implemented is hard to predict. “In terms of ESG regulation, you’ve got to have a certain amount of locality,” says Poole. “So the idea that you can take a global approach on something may not be the right way to do it.”
As with increased disclosure on fees and financial performance, greater standardisation is one way forward and provides a growth opportunity for service providers to the industry. “Fee reporting feels very much more standardised now but the next area that we’re beginning to see a lot more focus on standardisation is around all things ESG-related, and so that will be D&I and the metrics that are being measured there, climate, and emissions across the portfolio,” says Delaney Brown, Head of Funds & Secondaries at large Canadian pension fund investor CPPIB. “There’s nothing yet fully standardised but there’s a lot of initiatives in place to standardise that level of information and reporting.”
Standardisation
As explored in Private Equity Wire’s February Insight Report ‘Creating Values’, more than 100 GPs and LPs globally have now taken part in the ESG Data Convergence Project, which seeks to standardize ESG metrics and provide a mechanism for comparative reporting across the industry. Data is currently being collected across six categories: greenhouse gas emissions; renewable energy; board diversity; work-related injuries; net new hires; and employee engagement. “Standardisation around climate is really probably the big initiative that’s happening right now and over the next 12 months or so,” says Brown, “and that would really be at the forefront of what we’re thinking about.”
According to Marc Moser, head of impact at Lightrock – an early adopter of impact investing with what it describes as a “comprehensive” approach to ESG measurement, around 75% of what the firm does on ESG is standardised, with the remaining 25% customised or tweaked for different regions and their requirements. “We do see quite a lot of differences,” he says. “And we have to actually take the approach to tailor and customise not only geographically, but also thematically – it helps us and makes us more efficient, which is especially important working in impact investment.”
In a survey featured in Private Equity Wire’s ‘Creating Values’ report, almost half of more than 60 responses said financial returns or value creation were the most important factor in their ESG monitoring and behaviour, rather than regulation. One respondent commented: “I think the biggest challenge facing organisations is linking ESG initiatives and strategies to financial returns. It’s one thing to measure these metrics, it’s another thing to accurately predict the financial gain or elimination of loss tied to these actions and metrics.” Blackstone’s head of ESG Jean Rogers even argued that private equity funds have such a level of engagement with their investments that they can get the information they need without spending years coming up with the standard. “There are some universal issues – decarbonisation and diversity,” she said, “but beyond that it really comes down to what strategy you are driving and the data, is it specific? We can’t always wait five years for a framework.”
Wait and see
Some private equity firms are further ahead than others on disclosing their ESG performance and therefore more ready to meet new regulations while others are employing a wait-and-see approach.
“There are firms that are specialising in going out on site, kicking the tires, peeling the paint off, measuring how much lead is in the paint, that is a very detailed way of doing it,” says Poole. “And that might be right for some firms. But it’s finding that right kind of level of matching up with what you’ve got internally versus what’s required. So some firms will be very handily placed but we just we have to wait and see how things come in from regulators.” 
