The European Securities and Markets Authority (ESMA) has published its Final Report on the integration of sustainability risks and disclosures in the investment fund sector (Final Report).
The Final Report follows ESMA's Common Supervisory Action, which was launched in July 2023 and considered compliance by EU fund managers with:
- the requirements under the Sustainable Finance Disclosure Regulation (SFDR);
- the requirements in AIFMD and the UCITS Directive on the integration of sustainability risks; and
- the ESMA Supervisory Briefing on sustainability risks and disclosures in investment management.
In terms of overall points:
- there was thought to be an overall satisfactory level of compliance with the various regulatory requirements, but also some room for improvement: and
- the Final Report includes a number of vulnerabilities found by EU National Competent Authorities as part of their supervision of fund managers as well as examples of good and below-average practice.
However, there were some other points of particular interest for EU fund managers which are:
- Good governance: The Final Report
stated that one shortcoming observed was that for some Article 8
SFDR funds "there were no processes in place to ensure
that good governance practices were followed in the companies
invested in. Managers did not have criteria for how long a company
could remain in the portfolio if it showed an improvement, while
still being in violation of good governance principles.
Additionally, they did not have criteria for determining when a
breach was sufficiently severe to lead to the exclusion from the
product." This appears to suggest that, notwithstanding
the requirement for investee companies to follow good governance
practices, ESMA does not consider that a decline in governance
practices would always trigger a "fire sale" requirement
to divest. If correct, this could mean that, in certain
circumstances, it should be possible for managers to take a
risk-based view and remain invested with a view to improving
governance within a planned turnaround period. We do, however,
think any such plans or actions should be clearly documented and
calibrated to the relevant strategy.
- Commitments to Taxonomy alignment:
The Final Report is also critical of funds disclosing under Article
8 or 9 of the SFDR which under-commit to Taxonomy
alignment. This could be, for example, because of concerns about
reliable and consistent data. ESMA considers that fund managers
which significantly exceed their minimum commitments to sustainable
investments could be misleading investors by using "a
deliberately unrealistic initial commitment". This seems
an odd statement from a policy perspective as it is difficult to
see exceeding a minimum commitment as misleading investors and it
could inhibit fund managers from pursuing investments which promote
sustainability. We would strongly argue and assert this position,
but it does suggest that "greenhushing" as well as
greenwashing is also a concern of ESMA. This may be relevant for
some funds who are investing in certain types of asset class (e.g.
renewable energy) and where they are actively collecting Taxonomy
data or are otherwise receiving data from European companies in
scope of Taxonomy alignment reporting under the EU's Corporate
Sustainability Reporting Directive.
- Non-consideration of PAIs: There is also increased scrutiny of the explanations for any non-consideration of Principal Adverse Impacts (PAIs) with not all explanations being considered fully satisfactory. Although, slightly unhelpfully, ESMA does not elaborate on the types of explanations that it would find satisfactory, it does set out some explanations which it appears to consider deficient. These include: "the overly extensive reporting requirements, which pose a heavy burden for small companies, to the lack of availability of market information, lack of reasonably priced and readily available data, limited resources for smaller entities [and] investments were too limited to justify considering PAIs". Fund managers using very short form or limited explanations may therefore wish to revisit these.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
