SFDR – a breakthrough in sustainability data

In finance, access to sufficient data is a key part of informed decision making. This is especially true for the rapidly growing area of sustainable investing, where investors are searching for a return on investment that can be measured not only in financial terms, but also in terms of positive environmental and social outcomes. The challenge for investors participating in this important trend is that the rules for disclosure are still developing when compared to more traditional areas of finance.

Progress however, is being made. In March 2021, the first phase of Europe’s Sustainable Finance Disclosure Regulation (SFDR) came into force – a major regulatory change that aims to create a greater level of transparency within sustainable investment. It takes particular aim at preventing the practice of greenwashing, which is when a company or fund gives a falsely positive impression of its sustainability commitments and credentials.

Why should financial participants in Asia pay attention to a European regulation? For a start, it will have a direct impact on any asset manager that is managing a fund domiciled in the EU. But more broadly, it is a strong foundation for a global common framework to measure sustainability among funds. Asian financial centres, such as Hong Kong and Singapore, are also working on their own rules governing sustainable disclosure and it is likely that they will introduce regulations that take a cue from SFDR.

SFDR is an ambitious and wide-reaching set of rules that build on the EU Taxonomy – a regulation published in June 2020 that sets out to provide a precise EU-wide classification framework of those economic activities that can be considered as environmentally sustainable. Asset managers are required to disclose how they integrate sustainability risks into their investment decisions, and to properly categorise their funds when they claim to be sustainable. Firms need to disclose how their investment process considers Principle Adverse Indicators (PAIs), essentially negative sustainability effects that may arise from an investment decision.

The new rules cover a wide range of environmental and social factors, and some governance factors, that form the sustainability spectrum. In addition to PAIs covering greenhouse gas emissions and energy consumption, social metrics are also well represented, measuring the gender pay gap and gender diversity on the board.

The implications of SFDR will likely be felt across the world. Asset owners may come to see SFDR disclosures as the gold standard when making sustainable investment decisions. Asian asset managers could find European asset owners looking for similar disclosures regardless of whether the company is managing a European fund.

The SFDR compliance obligations will make asset managers increasingly require that their global investments provide sufficient sustainability data as a condition for investment. Further European regulations will oblige companies in the EU to provide the necessary information, and we expect that many other countries will in time require their issuing companies to do likewise. The upshot for all parts of the financial sector is that they are going to have to get used to collecting, publishing and making sense of ESG data. This will not be an optional addition to their day-to-day job, but a core responsibility.

SFDR is clearly a step in the right direction, as it will significantly drive the availability of much-needed sustainability data to the investment community. But raw data on its own is just the starting point, as the numbers need to be analysed before they can be used to make investment decisions.

For example, there is an ongoing debate about whether investors should divest entirely from carbon-intensive industries, such as the producers of coal power. Some investors consider the entire coal sector as an area to be avoided. Others think that we can better reach our sustainability goals through engagement – i.e. we should work with and invest in polluting companies that are making strong progress in reducing their carbon footprint. This debate is only meaningful if we have accurate data on the carbon emissions of the companies in question.

When it comes to analysis, fund administrators and custodians are playing an increasingly important role. Perhaps the simplest way to understand this evolution is by analogy. In the same way that fund administrators and custodians regularly report the value of a fund’s asset, the net asset value (NAV), they will also be relied upon as a trusted third party that can offer reliable published data on how sustainable a portfolio of assets is.

We are still in the early stages of this development. At HSBC, we recognise that there is no single agreed methodology on sustainability scores and ratings. So in designing our ESG reporting platform, we have built variability into the system, giving asset owners and managers the ability to choose from three of the leading vendors of sustainable ratings and to see which of their investments need most attention, as viewed through the different lenses of each of the three vendors. This means that advocates for differing sustainability strategies, be it divestment or engagement, are able to make the very best case for their position.

With SFDR in place, the industry will become better equipped with data related to sustainability. Hopefully this European regulation will inspire other parts of the world to implement their own equivalent regulations, thus further expanding the information to hand. More broadly, the financial community has to ensure that it takes advantage of this newly available information to promote sustainable economic activity. Both asset managers, fund administrators and custodians share in this responsibility, and by working together, they will be able to make a real difference to the future of the planet.