SFDR regulation: how to address the ‘explanation’-requirement

The Sustainable Finance Disclosure Regulation (SFDR) EU regulation will have massive impact on the asset management industry since it requires them to report on ESG related metrics. Asset managers will have to collect ESG related metrics from the companies within their investment universe and to calculate and disclose aggregate fund level values. SFDR takes it even one step further: not only does it require disclosure of the fund level metric on an annual basis, but it also requires explaining why the metric has changed over time and the actions the investor took that might impact this metric.

On top of the asset management industry priority list is ensuring that the required data is present when the regulation becomes effective. Luckily, the asset management industry is helped by European regulators: the NFDR (Non-Financial Disclosure Regulation) requires public and non-public companies to disclose the required metrics in an easy to retrieve manner.

The SFDR-regulation includes methodology on how to calculate the fund level metric that needs to be disclosed. The SFDR also requires that the asset managers disclose an explanation of why the metric has changed next to any actions taken to improve the metric. In this article Bas Leerink, Head of Global Implementations Investment Performance, shares his view about the challenges asset managers face in meeting the SFDR requirements.

Explanation of change and actions taken

You could ask yourself what the difference is between the explanation of why the metric has changed and the actions taken to improve the metric. Within the ESG space the actions taken are typically engagement or divestment actions. Where the (financial) impact of the divestment decisions can be measured, the impact of the more frequently occurring engagement is far more difficult, if not impossible, to quantify. Therefore, it is a logical requirement to separate the explanation of the difference in a metric on a fund level, from the actions taken.

Two main reasons why the value of the metric can change

Why a metric has changed over time is a clear question that in our opinion should be answered on a quantitative basis. There are two main reasons why the value of the metric on a portfolio level has changed, namely the metric at the company level has changed over time, or the weight of the company in the portfolio has changed.

You could investigate the reason for a company specific metric to change over time. Some of the required metrics consist of more than one component: E.g., the metric ‘Energy consumption intensity per high impact climate sector’ is defined as the ‘Energy consumption in GWh per million EUR of revenue in investee companies, per high impact climate sector’. This metric can change over time because the energy consumption changes, the revenues changes or the sectors listed as ‘high impact climate sector’ changes. The underlying components are different per metric and are not directly impacted by the investor. Therefore, we assume that a further attribution of the change in metric over time in this direction will not be required.

Components determining a change of weight

Since the weight of a company in a portfolio is the responsibility of the investors, it makes more sense to look into the reasons for a change in weight over time in more detail and disclose this. We can see three components that should be separated:

• A change in weight due to market movements. The share price changes on a daily basis, impacting the weight of a position in the portfolio constantly
• A change in weight due to trades. This is the main portfolio management instrument of the investor and therefore the impact should be separated from the market movements
• A change in weight due to an exclusion from the investment universe. Exclusion is the most direct method to implement ESG in the investment management and therefore should be seen as a separate component from the previous two weight impacting decisions.

In my opinion it only makes sense to look at those values in the broader perspective, namely by comparing the fund level metrics with the metric based on the benchmark universe. That ensures that you can really see the impact of any investment decisions made by the asset manager.

Looking ahead

Expected is that the metrics that the asset management industry is required to report on will evolve over time. The industry should prepare themselves to be able to manage the large amounts of data needed to fulfill the required regulation as well as being in control over the data and the processes. It is therefore important to already take the opportunity to look beyond the current challenge of data-gathering.