Guest comment by Jegor Tokarevich and Branko Kukic

In the current environmental, social and governance era, marketing sustainable investments seems worth exploring for many investors. Until 2021 the term “sustainable investment” was unregulated in the EU. As a result, investors could use it in presentations, websites or sales pitches without facing any regulatory consequences or having to consider any kind of standards.

The implementation of the Sustainable Finance Disclosure Regulation (SFDR) in 2021 has changed things dramatically. SFDR sets out disclosure requirements for the financial sector (including non-EU funds marketed to the EU). SFDR also defines the term “sustainable investment” for the first time. Disclosures have to be made when this term is externally used in the prospectus, annual reports, website or marketing documents. From 2023, additional criteria and disclosures for qualification as a “sustainable investment” are expected to become effective via the so-called SFDR Level 2 RTS. Using the term “sustainable investment” with external stakeholders now triggers heavy regulatory

Beyond the introduction of “sustainable investment” in SFDR, EU lawmakers have also developed the term “environmentally sustainable investment” in the EU Taxonomy. Simply put, the EU Taxonomy is a “green dictionary” aiming to inform if a certain activity is considered green based on a set of technical criteria. From this year, the EU Taxonomy is effective for the first two climate goals, climate change mitigation and climate change adaptation. In 2023, the EU Taxonomy is due to be extended to the other four environmental goals. Since the EU is aiming not only for a healthy planet but also happy people, a Social Taxonomy is also under development.

‘Sustainable’ dilemma

While the makers of these various frameworks and definitions may take pride in their work, the industry is left wondering how to translate these requirements into actual investment processes.

The “sustainable investment dilemma” is the hard choice between having a sustainable investment objective under SFDR and/or the Taxonomy versus not having one. In general, both categories of sustainable investments have to be a combination of three criteria:

  • Do something good for the environment (or society under the current SFDR);
  • Do no significant harm (DNSH);
  • Good governance practices/minimum safeguards.

However, the details of these criteria vary greatly from one framework to another. While sustainable investments under SFDR only need to use one set of pre-defined Principal Adverse Impact (PAI) KPIs applicable to rather broad categories such as “investee companies”, “real estate” or “sovereigns and supranationals”, the EU Taxonomy defines very detailed activity-specific key performance indicators in the Technical Screening Criteria.

Another big difference between the frameworks is that PAI KPIs are almost the only granularly defined requirement under SFDR. For other requirements, such as a contribution to environmental/social objectives (apart from the carbon reduction objective that needs to be linked to sustainability benchmarks), investors are able to define the KPIs and thresholds themselves. The same applies for PAI – while PAI are defined, no PAI thresholds or limits indicating that the activity is doing significant harm exist. In other words, there is a lot of room for creativity under SFDR. As opposed to SFDR, the EU Taxonomy is much more prescriptive and defines exact requirements for all three criteria.

Practical implications

Knowing this, would you still like to make sustainable investments under SFDR or the EU Taxonomy, or possibly even under both frameworks?

If you do, the starting point is defining the environmental or social objective you wish to support. Defining the objectives as clearly as possible is key. The objectives will trigger the KPIs that you need to select later. For instance, if your activity will contribute to climate change mitigation, you will need other KPIs if the same activity is supposed to contribute to climate change adaptation under the EU Taxonomy. Under SFDR you will need to define the KPIs that you will use as evidence for the attainment of this objective. Some overzealous managers define too many and/or too abstract objectives which then make it difficult to define the relevant KPIs.

Once the objective is defined, the next step is to identify the required data points/KPIs. The advantage of the EU Taxonomy is that many data points are already defined, although some do leave room for interpretation. Under SFDR you can define your own KPIs for the criteria (1) and (3). This raises the question: what is the right KPI and what is the right limit/threshold of this KPI? For the second criterion under SFDR, the KPI’s are given (PAI), but you will need to define their limits. Selecting KPIs that are relevant for the objective and measurable will significantly support the next steps.

The data collection process is particularly challenging for alternative investments, which are often not subject to any ESG disclosure requirements, and where there is no public source to download the data in structured templates. In the absence of a market standard, managers design their proprietary ESG data collection templates including the relevant data points. Such templates will usually be part of the pre-investment due diligence package as well as ongoing reporting.

Once the assessments are finalised, we know if an investment is sustainable under the EU Taxonomy and/or SFDR. While the external audit requirement is currently under discussion, the collected data as well as the assessment result can now be used for various reports and disclosures. A standardised template can help aggregate the data between the investments in the fund or even at the investor level, comply with the SFDR and EU Taxonomy disclosure requirements and create structured investor reports.

Sustainable investment is hard work; it entails being on top of the regulatory requirements and having clear processes and granular data.

Jegor Tokarevich is chief executive officer and Branko Kukic is a senior risk consultant at Substance Over Form, a London-based reporting services provider for alternative investments