Insights: EU ESG Disclosures: It’s Not Easy Being Green

As part of its sustainable finance action plan, the EU is implementing an Environmental, Social, and Governance (ESG) regulatory framework for asset managers, pension funds, and insurers. Rather than a single ESG directive, the new rules are a series of updates to existing EU financial regulations. The new ESG framework will include enhanced ESG disclosures for all asset managers and funds, new low-carbon and positive carbon impact benchmarks, and an official taxonomy to categorize environmentally sustainable economic activity.

Disclosures for All

The three components mentioned above are moving at different speeds and start to come into effect in March 2021. The first component to go live is the ESG disclosure rules that apply to all asset managers, regardless of whether they have an ESG strategy. In April, the European Securities and Market Authority released its proposed rules for the two types of ESG disclosures.

Entity-Level Disclosures

The entity-level disclosure will require asset managers to publicly disclose on their website how their investments have an adverse impact on the the environment and society using a prescribed template. Managers with over 500 employees must comply with the rules, while managers with less than 500 employees have the option to comply; however, if they chose not to, they will have to explain why. When calculating the adverse impact of their investments, an asset manager will have to aggregate all of its investments against a set of 32 factors such as, carbon emissions, impact on biodiversity, gender pay gap, and the human rights policies of the companies in which they invest.

Some in the industry have expressed concerns that the breadth and depth of the entity-level disclosure is so large that it will be nearly impossible for managers to provide the level of detail required. With no standardization, ESG data is already spotty at best, and the entity-level disclosures go above and beyond normal ESG data. “Asset managers are being asked to make quantitative entity-level disclosures about the sustainability impact of their investments, but this data is not yet widely available from investee companies,” says Linda French, Assistant Chief Counsel at ICI Global. “This will make implementation extremely difficult.” Additionally, for companies outside the EU there isn’t a mechanism in place to ensure that they disclose the necessary information.

Asset managers are being asked to make quantitative entity-level disclosures about the sustainability impact of their investments, but this data is not yet widely available from investee companies, this will make implementation extremely difficult

Linda FrenchAssistant Chief Counsel, ICI Global

Product-Level Disclosures

At the product level, managers will need to disclose the sustainability characteristics or objectives of the funds in their pre-sale and periodic documentation. These rules apply to both Undertakings for Collective Investment in Transferable Securities (UCITS) and Alternative Investment Fund Managers Directive funds. The proposals provide details on how this disclosure should be done, along with additional disclosures for funds that have designated an index as a reference benchmark.

For funds that engage in an ESG strategy there are extensive disclosures that are required for their website, prospectus, and annual report. These additional disclosures are for the two categories of ESG funds, often referred to as light green and dark green funds. Light green funds are those where the investment strategy is designed to invest in companies that adhere to general ESG principles. Dark green funds are a narrower cohort of ESG funds that have sustainability as a core investment objective.

One underappreciated element of the new ESG disclosures is the potential extraterritorial impact, the EU ESG disclosures could end up becoming a firm’s de facto global standard

Sean TuffyHead of Regulatory Intelligence, Securities Services, Citi

While the product-level disclosures are more familiar to firms, they are not without their challenges. “One underappreciated element of the new ESG disclosures is the potential extraterritorial impact,” says Sean Tuffy, Head of Regulatory Intelligence at Citi Securities Services. For example, US asset managers often offer UCITS funds that are copies of their US funds. The presence of an ESG disclosure on the European version of a fund may prompt questions from their US investors. The same issue applies to the entity level disclosures. “In effect, the EU ESG disclosures could end up becoming a firm’s de facto global standard,” says Tuffy. “This would be similar to what we’ve seen with other recent EU regulations, like research unbundling.” Given this, non-EU firms that are in-scope of the ESG disclosures

Timing is Everything

The disclosure requirements are set to go live in March 2021, however they won’t be finalized until early 2021. This will give the industry only a few weeks to implement the changes and update all the required documentation with the new disclosures. Further complicating matters is the timing of the disclosure updates. Typically, new discourse updates are done the next time the relevant documents are updated after the regulation goes live. However, the product disclosures are required to be in place on the live date, which could put added pressure on firms’ legal resources as the deadline draws closer.

In addition to the tight timeline, there are concerns about the sequencing of the regulations. “Asset managers will have the legal obligation to report this data on investee companies, but there are no corresponding disclosure requirements for corporate issuers,” notes French. “The sequencing puts the cart before the horse, with disclosure requirements first applying to asset managers, while the EU is still developing ESG disclosure requirements for corporate issuers.” Another sequencing issue is with the requirement for ESG funds to disclose how compliant they are with the ESG Taxonomy, which won’t be completed until 2022.

The ESG disclosure requirements underscore the importance of having a holistic approach to regulatory reporting processes

Fiona HorsewillHead of Digital and Data, Securities Services, Citi

Ready or Not

Even without the timing and sequencing issues, the sheer volume of data needed for the ESG disclosure rules represent a significant challenge for the industry. Firms might want to start preparing their data infrastructure to be able to intake the necessary information and produce the reports in the prescribed formats to meet the deadline, even though the rules aren’t finalized. “The ESG disclosure requirements underscore the importance of having a holistic approach to regulatory reporting processes,” says Fiona Horsewill, Head of Digital and Data at Citi Securities Services. “Firms that take a strategic approach to their data management are better positioned to address the evolving regulatory environment.” To do so, firms could avoid creating standalone reporting solutions and instead implement data management practices that reduce duplicative data. Leveraging sound data management could allow firms to think strategically about regulatory reporting and help them address new requirements more nimbly.

Sustainability is a key pillar of the EU’s agenda, and so far policymakers have stood firm on the implementation date. There will certainly be additional calls for a delay but firms should prepare as if the rules will go live as scheduled.