What is the impact of the European Disclosure Regulation (EU/2019/2088) (the "Disclosure Regulation") on alternative investment fund managers ("AIFMs") and management companies of undertakings for collective investment in transferable securities ("UCITS ManCos") (together "Management Companies")?
From 10 March 2021, Management Companies will be required to provide information on their websites about their policies on the integration of sustainability risks into the investment decision making process. It is vital for such entities to begin implementing project plans now to ensure that they are in a position to comply with applicable obligations set down under the Disclosure Regulation.
Overview of the disclosure regulation
The Disclosure Regulation, part of the EU Sustainable Action Plan, provides a central schedule of obligations for environmental, social and governance ("ESG") related disclosures in the EU financial services sector. Its aim is to provide investors with certain ESG related information in relation to financial products 1 in order to enable the investors to make informed investment decisions based on ESG factors.The Disclosure Regulation is also central in preventing 'greenwashing' - the term used to describe the process of misleading investors into believing products have ESG components.
Who Is in the scope?
The Disclosure Regulation applies to a) financial market participants ("FMPs") who include Management Companies as well as entities such as pension providers, investment firms and investment advisors and b) financial advisers who provide advice in relation to financial products (ie firms authorised under MiFID to give investment advice and credit institutions). There are also implications for non-EU FMPs, for example, where they market their financial products in the EU.
What does it mean for management companies?
We have set out a summary of the key requirements below:
(A) Website publications
Management Companies must publish on their websites:
- information on their policies on the integration of sustainability risks in their investment decision making process;
- a statement on their due diligence policies with respect to the "principal adverse impacts" of their investment decisions on sustainability factors, or where these impacts are not considered, clear reasons why not and whether and when they intend to consider such impacts; and
- certain information on any ESG-promoting product, sustainable product and carbon product, including data sources and screening criteria and indicators used to measure certain characteristics on the overall sustainable impact of the product.
From 30 June 2021, FMPs with more than 500 employees will be subject to the most onerous of the disclosure requirements. Such FMPs will need publish and maintain on their websites a statement on their due diligence policies with respect to the principal adverse impacts of investment decisions on sustainability factors. They will need to include at least the following information:
- information about their policies on the identification and prioritisation of principal adverse sustainability impacts and indicators;
- a description of the principal adverse sustainability impacts and of any actions taken or, where relevant, planned;
- brief summaries of engagement policies in accordance with Article 3g of Directive 2007/36/EC, where applicable; and
- a reference to their adherence to responsible business conduct codes and internationally recognised standards for due diligence and reporting and, where relevant, the degree of their alignment with the objectives of the Paris Agreement.
(B) Remuneration policies
Management Companies' remuneration policies must include information on how those policies are consistent with the integration of sustainability risks.
(C) Pre-contractual disclosures
Fund prospectuses (for UCITS and authorised AIFs) must include descriptions of:
- how sustainability risks are integrated into investment decisions and the results of the assessment of the likely impacts of sustainable risks on the product's return, or a clear and concise explanation if the risks are deemed not to be relevant; and
- whether and how a product considers principal adverse impacts on sustainability factors (ie the negative impact of investment decisions) and a statement that further information is in the product's periodic reporting (eg annual reports).
There are additional disclosures which apply to certain ESG products:
- where a product, either solely or in part, promotes environmental and/or social characteristics, (an "ESG-promoting product") information on how these characteristics are met (including certain details on any index used);
- where a product has a sustainable investment objective and uses an index (a "sustainable product"), details on how the index is aligned with the objective and how it differs from a broad market index (or where no index is used, an explanation on how the objective is to be attained); or
- if a product has a reduction in carbon emissions as its objective (a "carbon product"), details of how it will help achieve the long-term global warming objectives of the Paris Agreement.
(D) Periodic reports (applicable from 1 January 2022)
Periodic reporting (eg annual reports) must include:
- information on principal adverse impacts on sustainability factors;
- whether and how a product considers principal adverse impacts on sustainability factors (and provide further information in the product's periodic reporting);
- for a promoting product, the extent to which environmental and/or social characteristics are met; and
- for a sustainable product or a carbon product, the overall sustainability-related impact of the product by means of relevant sustainability indicators, or, where an index is used, a comparison of the overall sustainability-related impact of the product with the impacts of the index and of a broad market index through sustainability indicators
(E) Marketing communications
Management Companies must ensure that any marketing communications are consistent with the various disclosures set out above. "Marketing communications" is not defined in the Disclosure Regulation so care is required in preparing a broad spectrum of investor facing materials.
Why act now?
With less than six months to go until the Disclosure Regulation's first major deadline of 10 March 2021, Management Companies will need to start preparing now to ensure they are in a position to comply. All financial products, including those that do not purport to promote any ESG factors, will need a pre-contractual disclosure that sets out the manner in which sustainability risks are integrated into investment decisions and the likely impacts of sustainability risks on the returns of the financial products. Even where sustainability risks are non-applicable, a clear and concise explanation of the reasoning will need to be provided.
What does this mean for ESG products?
ESG was at the forefront of regulator and investor agendas before the COVID crisis. Sustainable finance is a main priority of the current Ireland for Finance Strategy, which runs until 2025 (the "Strategy"). The Strategy, published in April 2019, highlights Ireland's ESG evolution – Ireland issued its first sovereign green bond in late 2018, became the first country to divest public money from fossil fuel companies / industry following the passing of the Fossil Fuel Divestment Act 2018 and has a cluster of renewable energy infrastructure fund managers with €7 billion of assets under management. The Strategy lists that 81% of asset managers already have in place a responsible investing policy and that 50% are investing in sustainability theme activities to fight climate change. In order to meet the ESG evolution, Management Companies are now putting ESG at the forefront of their investment strategies, not just in terms of products but also in terms of their values. There has been a surge of investment in ESG products, with even those operating non-ESG products going through various ESG integration projects and we are witnessing a growth of activity in both well-established and emerging ESG financial products.
Andy Pitts-Tucker, Managing Director, Apex ESG Ratings & Advisory noted that:
"We have seen an increased focus by alternative investment fund managers on sustainable investments, with particular interest in assets in sectors such as renewable energy, low carbon technology and infrastructure as well as biopharmaceuticals. We are also seeing these investors driving a significant increase in the integration of ESG considerations into investment process for more traditional industry sectors. This particularly promising as it paves the way for many more alternative investment managers to who are now recognising how they need to transform their strategies to meet both societal and environmental targets as recommended by governments and regulators."
Achieving compliance with ESG regulations is quickly becoming an essential requirement, rather than an optional one. The previous 'comply or explain' approach now significantly leans towards a sole 'comply' approach, such is the desire amongst investors and regulators to see ESG integration.
This commitment to ESG is a key ingredient for Óskare Capital SAS who recently launched (together with Crossroads Capital Management Limited as AIFM) the first ESG compatible fund with an investment focus on innovative companies and teams in the medical cannabinoid industry - an industry in which investors may not associate with ESG. The fund is now planning to obtain an EU ESG label.A few Member States have labelling schemes in place (see the chart below) and the EU's Taxonomy Regulation has paved the way for a pan-European 'ecolabel' for financial products with the aim of enhancing investor confidence and awareness on the ESG impact of financial products (unlikely to be introduced until 2022).
Alexandre Ouiment-Storrs, President and Managing Partner (Investments) of Óskare Capital SAS, highlights the importance of ESG in the selection of underlying companies in which to invest:
"ESG issues are a key component in Óskare's investment analysis and decision-making processes. However, this is not only a key component for us as investors, but as people also. We refuse to invest in companies that profit from the proceeds of crime, cause addiction or hurt the environment. Our management team's personal commitment to the environment and helping patients access novel therapeutic is rooted deep in their experience as venture capital investors and entrepreneurs in the cleantech, life sciences and circular economy sectors."
Is there enough information to start preparing disclosures?
The Disclosure Regulation empowers the European Banking Authority, European Insurance and Occupational Pensions Authority andEuropean Securities and Markets Authority(together the "ESAs") to deliver detailed draft Regulatory Technical Standards ("RTS") on the content, methodologies and presentation of certain disclosures. The draft RTS were recently the subject of a consultation period that closed on 1 September 2020 and under which Irish Funds submitted a number of proposals. All but one of the draft RTS are required to be submitted by the ESAs to EU Commission the by 30 December 2020, leaving little time for Management Companies to address the requirements in time for 10 March 2021 if preparatory action is not taken now. The draft RTS are highly prescriptive, especially for FMPs with more than 500 employees, and will require extensive information to be sought from investee companies. The draft RTS include a mandatory reporting template, details of the content and presentation of required disclosures and set out 32 mandatory indicators FMPs should always consider principle adverse impacts of their investment decisions.
While we are still awaiting finalisation of the draft RTS and guidance from Central Bank of Ireland on practical implementation, Management Companies should become familiar with the requirements of the Disclosures Regulation, especially surrounding website, pre-contractual and ongoing disclosures relating to UCITS or AIFs they manage.
Next steps to consider include:
- determining whether financial products are currently marketed/promoted as an ESG product, which if deemed ESG products would trigger additional disclosure requirements, and considering how financial products are to be marketed going into 2021, as this will impact the level of disclosure requirements;
- assessing how to gather the information required for the disclosures and developing project plans for updates to website disclosures and offering documentation in the limited time period; and
- developing a roadmap for compliance with the Disclosure Regulations, with a particular focus on the disclosure requirements in force from 10 March 2020.
Management Companies should also keep a close eye on the draft AIFMD Delegated Regulation and draft UCITS Delegated Regulation which aim to integrate ESG considerations into firms' behind the scenes policies and procedures by amending the familiar MiFID II, AIFMD and UCITS regimes. It is expected that the final legislation will be introduced at the end of 2020 or early 2021.
*This article was originally published in the Irish Funds ESG Newsletter 2020 (Will link to article when live)
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