April 19 2022
The Sustainable Finance Disclosure Regulation (SFDR) by the European Union points to a dilemma that financial market participants (FMPs) might also face in the U.S. If FMPs, who primarily focus on small and mid-sized enterprises (SMEs), have to report on the sustainability performance of the companies they work with, they might not be able to gather this information, as most SMEs are not required to report on their sustainability performance, yet. Broadening the scope of enterprises required to report on their non-financial information might be a solution. This is the goal of the Corporate Sustainability Reporting Directive (CSRD).
On March 10, 2021, the SFDR came into force in the EU, introducing new rules for the inclusion and disclosure of sustainability risks and factors by investment managers. The scope of the regulation, which is aimed at FMPs, primarily includes asset managers, funds and fund brokers. With the aim of promoting sustainable investment, the regulation requires FMPs to report numerically on the sustainability performance of the companies they work with, whose shares are therefore included in the investment funds managed by the FMP. Ultimately, funds will be classified as “gray,” “light green,” or “dark green” using a traffic light system, with increasingly stringent reporting requirements to be classified as “green.” FMPs working with blue-chip companies are more likely to be able to collect the valuable ESG data, as these companies are already required to disclose non-financial and diversity information under the Non-Financial Reporting Directive (NFRD). Small- and mid-caps generally do not yet provide this information, so the question FMPs are facing now is how to generate or get this data to inform their investment decisions and classify their financial products.
The good news for FMPs working with smaller companies is that the scope of sustainability risk and factor disclosure regulations are likely to be extended to small and medium-sized companies in the future. For example, the European Financial Reporting Advisory Group (EFRAG) is expected to develop a sustainability reporting standard that is scheduled to be approved by the European Parliament before the end of this year on October 31. This standard, in turn, is laid down in the Corporate Sustainability Reporting Directive (CSRD), which is also planned for this year and is a successor to the Non-Financial Reporting Directive (NFRD). The CSRD would not only require listed companies, banks, insurance companies and companies designated as “public interest entities” with more than 500 employees to report sustainability information. The CSRD would extend this reporting requirement to all companies with more than 250 employees, more than €40 million in sales or more than €20 million in total assets, and to all publicly traded companies. In addition, the CSRD would introduce a digital “tagging” system for storing all ESG reporting at a single access point (European Single Electronic Format, or ESEF).
If the CSRD is adopted by October 2022 as planned, it could alleviate some of the data collection challenges for FMPs working with small- and mid-caps today in the future. This is because the regulation is to be transposed into national law much more quickly than the NFRD was at the time and will already come into force for the 2023 reporting year, i.e., annual reports from 2024. For small and medium-sized enterprises (SMEs), a transition period of three years is planned so that they would only be bound by the new EFRAG standard in their reports from 2026. Until then, the problem remains that FMPs face regulatory disclosure requirements that may go beyond their own CSR and EU taxonomy reporting requirements.
On the topic of the EU taxonomy, it also needs to be noted that FMPs have to report on the proportion of risk exposures in non-taxonomy-eligible and taxonomy-eligible economic activities in their total assets – starting with the reports for the fiscal year 2021. This means that here, financial companies also have to collect data that has not been collected by non-financial companies yet, because the EU taxonomy has just become effective for them this year. While data collection requirements may converge in the future, both FMPs and companies are encouraged to address their data collection and processing workflows sooner rather than later. As FMPs outsource their SFDR reporting to third-party vendors to ensure objectivity, they rely on the third-party vendors’ ability to collect accurate and consistent data. However, to meet the regulatory technical standards published in February 2021, FMPs may need to use two to three data providers, i.e., sustainability rating agencies, to provide FMPs with the data required under the SFDR, including the so-called Principle Adverse Impacts (PAIs), to the FMPs. These are 18 mandatory environmental and social performance metrics that FMPs will have to disclose no later than 2023 when they promote products as sustainable, for example. However, data providers do not currently provide information for all required data fields.
For example, the Carbon Footprint Indicator, one of the PAIs, requires inputs for market capitalization, operating data and carbon footprint data for each operation. Not every market data provider reports data that is granular and coherent enough for FMPs to meet. Of course, data availability improves for blue-chip companies that are already reporting similar ESG data ahead of the more stringent NFRD requirements.
In addition to the added complexity of collecting data from multiple sources, the SFDR requires FMPs to accurately describe their data collection processes. In addition to clarifying and explaining which vendors were used and why, the various possible definitions for field names must also be explained. Justification is also required when switching between data providers. Additional logistical complexity also arises from the requirement to report in multiple languages.
At the heart of effective SFDR reporting is a flexible data model fed from multiple sources. A model in which inputs are easily tracked and metric calculations are dynamic. In practice, however, SFDR compliance means a dual task for FMP leaders: preparing management internally to set up processes and systems to feed data as efficiently as possible, and managing external relationships with vendors and companies. There is also an incentive for companies that are currently outside the scope of the NFRD (i.e., small and medium-sized enterprises) to be proactive with their ESG reporting and go beyond the current regulatory requirements: they can take advantage of opportunities to access capital at a reasonable cost and attract investment from the ever-growing sustainable finance markets.
Looking at the current sustainable-finance regulations in Europe, U.S.-based FMPs focused on SMEs might find themselves in a situation that they have to report on information that enterprises they work with cannot provide (yet). While both financial and non-financial companies are well-advised to establish professional non-financial reporting practices, regulatory bodies should facilitate the collection of ESG data especially for SMEs, which often lack the resources to establish these reporting practices.