In September, the European Commission injected some uncertainty into the future regulatory environment for environmental, social and corporate governance issues and impact investing when it issued a public consultation on the EU Sustainable Finance Disclosure Regulation (SFDR). By revisiting the use of the Article 8 and Article 9 categories that impact funds currently fall into, the review could potentially lead to significant changes for the industry.
One problem with SFDR is around its use as a labeling regime, says Patricia Volhard, a partner at Debevoise & Plimpton: “While SFDR is meant to be purely a disclosure regime, for Article 9 funds it really isn’t because all of your investments need to meet certain standards to qualify for that classification. Investments need to make a substantial contribution to environmental or social objectives and at the same time should not do significant harm to any other ESG factors. But that raises questions about how you define a substantial contribution and also how you determine what is significant harm, so it doesn’t really work as a label as it stands.”
The commission’s intention was not for SFDR to serve as “a label of quality or quantity,” adds Volhard. “The idea was to force people to be transparent in terms of what they are doing and to use consistent terminology. They are now trying to find out what the market thinks: should the distinction between Article 8 and 9 funds remain, should we introduce a product labeling regime instead, or should we keep to a disclosure regime and introduce in addition a product labeling regime? We have no idea where the commission will come out, but it looks probable that some kind of labeling regime is coming.”
Volhard says the commission could say, for example, that in order to be classified as an impact fund you must invest within certain parameters, meet certain quality standards and align a certain percentage of your investments to the taxonomy. “My hope is that if they go down the labeling route, which is likely, they don’t replace what we currently have but introduce something optional for those that want to go down that route.”
Impact investors have already dedicated a lot of time and resource to SFDR compliance since the regulation came into effect in 2021. Michael Raymond, a partner at Travers Smith, says: “Ideally what we would want to see in the event of any SFDR reforms is a recognition that we’ve had lots of uncertainty. If we do end up with changes to Article 8, 8-plus and 9 classifications and key definitions, we need grandfathering so we are not disrupting existing funds with any new rules applying on a go-forward basis within the existing framework.
“It is perfectly possible we will end up with a labeling regime. That starts to look a lot like what the Financial Conduct Authority is proposing for UK retail funds, which is a disclosure regime for all products and then product labels that can be used on an optional basis.”
The UK’s FCA has made proposals for retail funds that set out three specific types of sustainable product, distinguishing between those with a sustainable focus, sustainable improvers or sustainable impact. If introduced, there is a good chance institutional investors will ask other sponsors to comply with the same terminology.
Meanwhile, the US Securities and Exchange Commission is taking its own approach. Alexandra Farmer, a partner with Kirkland & Ellis in Washington, DC, says: “Right now the proposed ESG disclosure rules from the SEC are focused on process and disclosures, which is really the same as SFDR. The EU Taxonomy, however, is more about classification of activities, and we don’t have anything like that in the US or see anything that is outcomes-focused coming any time soon.”
The SEC’s focus is very much around transparency on risk and in relation to the investment process, explains Farmer. “GPs are also dealing with some tensions from an anti-ESG perspective, and where the two meet in the middle is in a desire for transparency and an anti-greenwashing focus. That will remain the priority, and the regulatory focus will shift from there depending somewhat on the growth of the impact investing market as regulators seek to address issues that are material to investors.”
“A lot of managers have invested in systems, marketing materials and reporting processes that feed into the existing regime”
Farmer points out that the SFDR has so far led the way on the global regulation of impact, so any potential changes will have a widespread effect. “Most of our US GPs are seeking capital from EU LPs, so they are subject to the SFDR regime directly or, if not, then indirectly through requests from their LPs. Over the last few years, it has been very influential in terms of how ESG and impact programs and strategies have developed, driven by investor expectations around SFDR and what GPs can reasonably commit to.
“This most recent consultation is creating further uncertainty at a time when managers who have spent resources building their programs around existing guidance may prefer to be going into compliance mode.”
Goodwin partner Patrick Deasy also notes a divergence in regulatory approaches between the US and Europe: “The US approach to date has been to say that sustainability and impact are like any other investment strategy that sponsors are looking to promote to investors, so the important thing is that managers are fair, clear and not misleading. The EU, on the other hand, sees the regulatory regime as a means of coalescing capital into the climate impact space by providing a gold standard regulatory regime that investors can take a lot of comfort in and that also seeks to stamp out greenwashing.”
When it comes to impact investing, the direction of travel is toward more rather than less regulation, particularly in Europe, says Deasy.
However, he adds: “My guess would be that the EU and the industry will try to work with what we have got under the SFDR, rather than completely overhauling it, because a lot of managers have invested in systems, marketing materials and reporting processes that feed into the existing regime.”
For now, funds need to focus on providing clarity to investors, says Travers Smith’s Raymond: “What is really important at this stage is being clear with your investors about your ESG and impact proposition, so it is not about your proposition chasing evolving regulation and labeling globally and instead the regulation overlays the manager’s specific impact program.”
Managers may also want to consider how they work with portfolio companies on these issues, says Debevoise’s Volhard. “In order to be an Article 9 impact fund you already have to pass these tests that are quite comprehensive, so you are in good shape. Maybe the next step is to think about getting taxonomy aligned: many clients want to be taxonomy aligned but the companies they are investing in are not there yet on the data. My advice would be to start with Article 9 and work with companies towards getting a certain percentage of the portfolio taxonomy aligned.”