ESG-Driven Amendments to Europe’s Fund Regulations and their Impact on U.S. Managers
- Mar 5, 2021
Over the recent years, environmental, social and governance (ESG) considerations have become an important point of focus for governments, financial institutions and corporations worldwide. While in some parts of the world, this is mostly being driven by investor and shareholder demand, across a number of key regions the growing demand is being backed up by new and evolving guidelines and regulations.
The commitment of the financial services industry to sustainable investing should not be underestimated – by 2017, more than 1,750 signatories from over 50 countries, representing approximately U.S. $70 trillion, had signed up as signatory of the United Nations’ Principles of Responsible Investment (PRI). By the end of 2020, the total number of PRI signatories had grown beyond 3,000. The year 2020 also saw the World Economic Forum release its new ESG disclosure framework, which represents a key milestone in the journey towards establishing a universal benchmark for reporting sustainable value creation.
While in the U.S. recent focus has been on rejoining the Paris Agreement, the European Union (E.U.) has been busy at the forefront of ESG-related regulatory efforts and through its action plan for financing sustainable growth, it intends to realize the objectives set by the UN’s 2030 Agenda for Sustainable Development.
Europe will see various ESG-driven regulatory changes, including amendments applied to various existing regulations. This includes the Alternative Investment Fund Managers Directive (AIFMD), a framework that many non-European fund managers are already familiar with from marketing their funds to European investors. This article will outline the scope and key considerations in relation to a few of the upcoming requirements, including how these may impact U.S. and other non-European managers.
ESG-Driven Regulatory Changes in Europe
The overarching framework in Europe for ESG is known as the European Green Deal, which aims to make Europe carbon neutral by 2050. Stemming from this are various other initiatives. Those focusing on financial institutions include the Sustainability Finance Disclosure Regulation (SFDR), Taxonomy Regulation, Green Bond Regulations and various changes to existing regulations including the AIFMD. All these changes have the overarching aim to reorient capital flows towards a more sustainable economy.
SFDR, effective from March 10, is one of the earliest initiatives to be implemented and applies to all ‘financial market participants’ that are either based or marketing within the E.U. It contains ESG-specific transparency requirements that will need to be disclosed to investors and other stakeholders. The proposed amendments require sustainability risks to be taken into account in organizational procedures, and in the management of conflicts of interest and risk management policies. It also places an obligation on alternative investment fund managers (AIFMs) to consider sustainability risks and factors when undertaking investment due diligence.
In accordance with the new regime, financial market participants and their advisors were required to have reviewed their marketing materials, pre-contractual and website disclosures by March 10, 2021.
The Level I provisions require in-scope firms to:
- Formulate written policies outlining within their investment decision-making process how sustainability risks will be implemented;
- Comply with pre-contractual transparency rules, and have in place the right processes to cater for sustainability risks within investment decision making and operations;
- Describe the impact of the sustainability investments through relevant indicators;
- Ensure up-to-date and accurate publication on their website and other online channels, providing clarifications when information is amended and ensuring that online descriptions of investment targets include the methodologies used to assess, monitor and benchmark them.
In essence, the regulation is very much aimed at providing transparency against greenwashing. In other words, it fights against the use of inaccurate information that misrepresents an organization as being environmentally responsible when it is not.
There are additional requirements at various stages further down the line of SFDR’s implementation, and even more if a firm is above a certain size or is actively marketing sustainable investments. All will require implementation of a process to initially formulate and then provide clear reporting on an ongoing basis.
What is the relevance to U.S. managers?
SFDR applies to all financial market participants – including fund managers – who are based in and/or are marketing within the E.U. As such, there are two ways SFDR could potentially impact non-E.U. managers, including those in the U.S. These are:
National Private Placement Regimes
When a non-E.U. investment manager markets its fund to E.U. investors under a local private placement regime, they will be required to make SFDR-compliant disclosures. It is open for interpretation if such disclosures will be limited to pre-contractual disclosures or if this would include entity-level or website disclosures. The disclosures are presumed to exclude non-E.U. managers who are relying on reverse solicitation.
- Through Relationships with Regulated E.U. Firms
SFDR will apply to European regulated firms and, in line with this, can impact non-E.U. managers in a few ways, including where a non-E.U. manager sub-manages for an E.U. AIFM. In such a case, the non-E.U. manager will presumably need to feed into the SFDR disclosures required from the E.U. AIFM.
It is important to note that the regulation requirements apply regardless of whether the manager manages or markets funds or portfolios with an ESG focus. Managers will need to disclose how sustainability is integrated into their decision-making processes and how their remuneration policy is consistent with such a requirement, while ensuring that their marketing communications are aligned under SFDR. The reporting framework will be structured via a ‘comply-or-explain’ basis, which means that in absence of compliance one must disclose such facts to investors in pre-contractual documentation.
There are multiple requirements that will impact AIFMs over the short- and long-term, not only in terms of their ESG due diligence but also in a much broader way, touching upon risk management and exposure to sustainability risk as well as organizational controls and senior management responsibilities.
It is worth emphasizing the fact that although the principal impact of new/amended E.U. regulations will be felt by those operating within the E.U., they may also indirectly capture non-E.U. managers in certain instances.
This is not simply a check-the-box exercise; such regulations are designed to drive fundamental change and transparency throughout an organization, across multiple levels of operation. Indeed, sustainability laws will have a more far-reaching impact than one may fully realize.
ESG is here to stay and regulation of this area will only increase, both regionally and globally, in the years to come. If a business falls within scope, non-compliance with regulations like SFDR is not an option, and the industry is increasingly seeing non-E.U. managers choosing to opt in to ready themselves for their next fund-raise.
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