Two important pieces of legislation relating to fund managers’ consideration of environmental, social and governance (ESG) factors in their investments will come into force over the next two years, starting in March 2021, namely the Sustainable Finance Disclosure Regulation (the “Disclosure Regulation”) and the related Taxonomy Regulation. These regulations will entail a substantial change in operations for most EU fund managers, as they will require fund managers to incorporate ESG considerations into their investment management decisions, and to explain and disclose to investors (as well as the public at large) how they do so.
The new regulations are relevant to EU private equity fund managers, as well as non-EU fund managers that market to European investors under the national private placement regimes in EU Member States.
1. What is changing for fund managers in March 2021?
In March 2021, European Union (EU) firms will be required to disclose their approach to the consideration of ESG factors in their investment decisions and to make new disclosures for products that take into account ESG factors, in each case, as a condition to marketing and managing funds in the EU. Firms will be required to make much of this disclosure publicly available on their websites. The obligations apply to EU firms that manage and market separately managed accounts as well as commingled funds.
Non-EU managers marketing their funds in the EU are taken to be in scope of these obligations, at least in respect of their funds that are marketed under the national private placement regimes.
There are various “tiers” of disclosure required, depending on the approach a firm takes to integration of ESG factors.
1. Integration of sustainability risks in investment decisionmaking process, meaning at the time the investment decision is made and on an ongoing basis during ownership
All firms will be required to disclose on their website information about their policies on the integration of sustainability risks in their investment decision-making process and remuneration policies. Sustainability risks are environmental, social or governance events or conditions that could cause a material negative effect on the investment’s value. The rules are not prescriptive on the form of this disclosure. Firms will take different approaches, but it is likely that many will make fairly high level statements about their approach to consideration of ESG factors in their investments.
|All firms (firm and product level)
2. Principal adverse impacts - Non-value items Firms are required to disclose, at entity and product level, information about their policies on principal adverse impacts (PAI) on sustainability factors. Sustainability factors are environmental, social and employee matters, respect for human rights and anti-corruption, irrespective of the effect on an investment’s value.
There is currently uncertainty as to the form of the principal adverse impacts statement; draft rules put forward a list of at least 32 “impact indicators” (such as carbon emissions) that all firms must assess and monitor at the initial investment stage, and on an ongoing basis, on a firm-wide and product level.
Many EU private equity managers are able to opt-out of the requirement and are likely to do so, at least on the basis of the current draft rules, as most firms do not obtain the level of detailed information on ESG factors foreseen in the draft rules. Some larger managers are expected to opt-out of the “firmwide” disclosure, but use best efforts to adopt a form of the disclosure on a product-by-product basis. Investor expectations in this regard will need to be monitored.
|Larger firms; opt-in approach for smaller firms (firm and product level)
3. Products that promote “environmental or social characteristics” Managers that actively offer products that promote environmental or social characteristics are subject to special disclosure (Article 8 funds). This level of disclosure ensures extensive information on the approach to ESG considerations. The draft rules require disclosure of information on the sustainability indicators considered, how the indicators are monitored, the methodologies used and a description of due diligence and engagement policies.
Disclosures need to be made at the pre-contractual stage and as part of the annual investor reporting (which will show the degree to which the environmental or social characteristics are attained). Firms will be required to make all the information disclosed to investors publicly available.
Although there is some uncertainty about the level of promotion of ESG factors that entails compliance with this tier of disclosure, it is likely to apply to any manager that describes its product, on its website or in its PPMs, as one that incorporates ESG factors.
|Funds that promote environmental or social characteristics
4. Products with sustainable investments as their objective
Products with sustainable investments as their objective (Article 9 funds) are subject to specific disclosure requirements similar to those for products that promote environmental or social characteristics, focusing on the specific goals, how the goals are measured and the degree to which they are attained.
| Impact funds
2. Investors’ perspective
The Disclosure Regulation provides for different levels of disclosure, and it is possible to “opt out” of certain of the requirements. That said, EU managers should be mindful of the expected preference for EU institutional investors to seek products that are classified as “sustainable” according to the EU definitions, in part due to public opinion and also because of the regulatory requirements to which such institutional investors will themselves become subject. Certain regulated EU investors (such as managers of private pension schemes) will be subject to the Disclosure Regulation and will request disclosure of ESG considerations in standardised form from EU firms in order to meet their own objectives and commitments. For other investors, such as insurance companies, it is expected that similar changes will follow in their regulatory framework (i.e. Solvency II Directive).
3. Taxonomy Regulation: a new classification system to measure performance
The other important piece of legislation is the Taxonomy Regulation which is in part linked to the Disclosure Regulation. Reflecting the EU’s plan to achieve carbon neutrality by 2050, the Taxonomy Regulation initially focuses on climate change issues. It introduces uniform technical “screening criteria” to be applied where a fund either promotes environmental characteristics (see tier 3 above) or contributes to an environmental objective (see tier 4 above). With respect to such funds, the screening criteria of the Taxonomy Regulation must be applied to determine whether and to what extent an economic activity (such as wind power generation, reforestation or building renovation) is environmentally sustainable. The Taxonomy Regulation is effective on 1 January 2022 (in respect of the two climate change objectives) and 1 January 2023 (for the other environmental objectives).
The Taxonomy Regulation requires that with respect to such funds, the pre- contractual information must exactly specify to what extent the product invests in economic activities that qualify as environmentally sustainable and that are in accordance with the technical screening criteria. Because the Taxonomy Regulation provides a common framework for assessing the environmental sustainability of an activity, investors are likely to ask whether a manager complies with the taxonomy, in particular for a product with environmental goals. For products that contribute to an environmental objective, firms must use the standards set in the Taxonomy Regulation to determine whether an activity qualifies as environmentally sustainable or not, and there is some uncertainty as to the approach that managers should adopt where they cannot collect the relevant data from the underlying investments.