As investor appetite for sustainable investment solutions continues to grow, we are seeing a proliferation of regulations and reporting standards coming to the market globally.
Two of the main frameworks which are being utilised by asset managers are the EU’s Sustainable Finance Disclosure Regulation (SFDR) and associated EU Sustainable Finance Taxonomy and the Task Force on Climate Related Financial Disclosures (TCFD) recommendations.
In this insight, we provide an overview of what these disclosure frameworks currently entail, how we believe they will evolve going forward and how we at AIM are addressing them.
EU Sustainability Financial Disclosure Regulation (SFDR)
What is it?
SFDR came into effect on 10 March 2021. The regulation applies to all financial market participants and financial advisors in the EU, or financial products marketing into the EU.
The regulation covers three broad areas:
• Transparency in relation to sustainability risks.
• Consideration of adverse sustainability impacts,
• Provision of sustainability-related information with respect to financial products
Overall, the regulation is designed to tackle greenwashing and two levels of disclosure are required: entity level and fund level.
We envisage that other regions beyond the EU will follow suit and have already seen this starting. In May this year the US Securities and Exchange Commission (SEC) proposed rules for ESG disclosures, while back in November 2021 the UK Financial Conduct Authority (FCA) published a discussion paper on the classification of sustainable investment products and sustainability disclosure requirements for asset managers. The UK is also working on Sustainability Disclosure Requirements (SDR) and a UK Taxonomy. In Australia, the Australian Prudential Regulatory Authority (APRA) and the Australian Securities and Investment Commission (ASIC) are increasingly encouraging better disclosure of climate related-risks and have released a guide on climate change financial risks. APRA will gauge the alignment between this guidance and TCFD recommendations, however there is not a regulatory requirements to report on climate or sustainability impacts or process. The PRI has recently recommended that Australia’s policymakers update standards and guidance to clarify investors’ duties to address sustainability risk, adopt a reporting framework, strengthen regulatory support for investor stewardship and implement an Australian sustainable finance taxonomy.[1]
In Japan, the Financial Services Agency (JFSA) established its Expert Panel on Sustainable Finance at the end of 2020. Following this, the JFSA published ‘Strategic Priorities July 2022-June 2023’. This includes encouraging disclosure based on TCFD recommendations. TheJFSA has also compiled the Code of Conduct for ESG Evaluation and Data Providers while the Financial Accounting Standards Foundation (FASF) established the Sustainability Standards Board of Japan (SSBJ) that will consider specific disclosure contents based on the International Sustainability Standards Board’s climate-related disclosure standards.
SFDR requires asset managers to disclose the different levels of sustainability integration and focus of each fund they offer.
There are three classifications of funds: Article 6, Article 8 and Article 9.
• Article 6 funds do not integrate any kind of sustainability considerations into the investment process
• Article 8 funds promote environmental, social and governance characteristics
• Article 9 funds have sustainable investment as their objective
How are we addressing SFDR?
At AIM, all of our European funds are labelled Article 9, the highest sustainability classification. While our other portfolios are not classified under the SFDR framework, all of our strategies meet the same sustainability standards, utilise the same investment process, methodologies and generate environmental and social impact.
Our verification process, termed SPECTRUM, is core to our strategies meeting the highest sustainability classification. Our SPECTRUM process is predominantly one of positive selection methodology, which involves deep research to understand impact at the bond and issuer level. We continually review and enhance our process as the market evolves. Adhering to SFDR and classifying the relevant funds has not required any changes to our processes.
Article 9 funds have to provide:
• Pre-contractual disclosures around the integration of sustainability risks and principle adverse impacts (PAIs)
• Periodic impact disclosures
• Fund-level website disclosures
PAI reporting
Consideration of adverse sustainability impacts is addressed through the Principal Adverse Impacts or PAIs. SFDR stipulates 14 mandatory PAI indicators for corporate issuers, two mandatory indicators for government debt and two for real estate assets, as well as a plethora of voluntary indicators. The PAIs represent the most significant negative effects on sustainability factors that are material or likely to be material.
Reporting against the PAIs will be an annual requirement for Article 9 funds. This reporting will commence by reporting against 2022 December year end holdings to be published in 2023. Our PAI statement will report metrics at the issuer level. It quantifies the negative impact of investments.
At AIM we report on the environmental and social impact of our portfolios in our annual Impact Reports. While this focuses on the positive impact at the project level, such as the amount of CO2 mitigated or the number of children immunised through our investments, we also report emissions associated with our funded projects and include reporting at the issuer level, with metrics such as Weighted Average Carbon Intensity (WACI).
This year, we began reporting a selection of the SFDR mandatory PAIs ahead of time for our 2021 holdings. The results are presented in our 2022 impact reports and include metrics such as scope 1, 2 & 3 GHG emissions, GHG intensity and board gender diversity. The suite of mandatory and voluntary PAI metrics and reporting template can be found on the European Commission’s website.[2]
From this exercise we drew three main conclusions.
Firstly, and unsurprisingly, there remains a lack of data availability to comprehensively report against the PAIs at this stage. Coverage rates across metrics are low and some metrics are not yet covered, which means that a PAI statement does not currently provide a comprehensive picture of the investments’ impact.
Secondly, the SFDR requirement is that most PAIs be reported at an absolute level, rather than as intensity figures. While informative, this makes comparing fund-to-fund performance difficult, because the absolute figures reflect the size of the fund as well as issuer performance.
Finally, there are key differences between the mandatory PAIs and recommended metrics under other disclosure framework. For example, a key metric recommended under TCFD is Weighted Average Carbon Intensity. TCFD currently recommends that this is calculated based on scope 1 and 2 emissions, whereas the similar PAI metric, GHG intensity of investee companies, is calculated based on scope 1, 2 & 3 emissions.
Article 9 and EU Taxonomy alignment
The Article 9 precontractual disclosures requests the fund make commitments to minimum allocations to investments with an environmental objective, social objective and to investments aligned with the EU Taxonomy. While this seems like a straight forward requests, it actually can present considerable challenges even for a dedicated impact investor, like us. We only accept investments that have positive environmental or social impact and most of the portfolios we manage do not have specifications as to the portion that should contribute to environmental versus social investments. For this reason, we generally do not specify a minimum in the Article 9 precontractual disclosures as we do not want it to impact portfolio construction. Our portfolios are constructed from an investable universe that is solely made up of impact investments with a sustainable objective, beyond that we do not optimise for any one particular impact.
Committing to a minimum of EU Taxonomy aligned investments presents greater challenges. We will complete an EU Taxonomy alignment exercise, but as we predominantly hold labelled use of proceeds bonds, it will be completed at the funded project and activities level. This means we have to record alignment ourselves based on issuer reporting and cannot utilise the various data products emerging on EU Taxonomy alignment, as these all report the issuer’s alignment. Therefore, we do not have a baseline yet of EU Taxonomy alignment. In addition, committing a high minimum for EU Taxonomy alignment is not necessarily ensuring the best impact outcomes. There are plenty of important impact investments to be made that sit outside of the EU Taxonomy’s guidance, for example the social bonds that we hold.
In summary, we believe there can be very valid reasons for a manager to have a low or zero minimum commitment to environmental, social and taxonomy aligned investments and this does not necessarily indicate poor impact ambition. It is critical to understand asset managers investment process, expertise and evaluation of sustainability objectives.
Moving forward
We will continue to include portfolio-specific PAI reporting in our annual Impact Reports and expect the data to give a more comprehensive account of the portfolios over time. This year we provided an indication of EU Taxonomy eligibility in our Impact Reports and will disclose information about EU Taxonomy alignment next year based on issuer use of proceeds disclosure.
We support the intention of SFDR and the EU Taxonomy to improve reporting against sustainability related metrics and improve transparency on the impact across different funds. We also observe that this regulation and related data infrastructure will require considerable development before it can effectively deliver on this aim. We expect that the best way for this to develop into an effective disclosure regulation is for actors, such as ourselves, to start disclosing against this framework, working with consumers of the information to enhance their understanding and with data providers to refine products that will service this disclosure framework.
Task Force on Climate Related Financial Disclosures (TCFD).
The TCFD was created by the Financial Stability Board in 2015 to improve and increase reporting of climate-related information and published recommendations in 2017. TCFD has four core recommendations on climate-related disclosure, they are: governance and management, investment strategy, risk management and metrics and targets.
Transparency of reporting is a core part of our philosophy at AIM and we have supported the TCFD recommendations since their inception. TCFD has become increasingly mainstream and influential. In 2021, G7 nations have agreed on mandatory TCFD-aligned climate reporting, such as in Japan and the UK, Other countries such as New Zealand, Switzerland and China have also announced mandatory TCFD-aligned reporting. Several other countries have provided regulatory support, such as the Australian Prudential Regulation Authority (APRA) publishing guidance in 2021 encouraging TCFD-aligned disclosures on managing financial risks associated with climate change. Implementation in each country will be different and occur in phases over several years, with reference to other sustainability disclosure initiatives. For example, the European Commission has issued a proposed Corporate Sustainability Reporting Directive (CSRD) that has been amended to include existing relevant standards and frameworks, such as the TCFD recommendations, with reporting requirements beginning in 2024.
How are we addressing TCFD?
Our TCFD report is an opportunity to comprehensively explain who we are and how fundamental climate considerations are to our business: how it is embedded in our governance and investment strategy. It also allows us to showcase the consistency of our green investment and climate disclosure across our assets under management.
Our governance and management structure is inherently sustainability and climate related in support of our mission to mobilise mainstream capital to address the major challenges the world faces. Our commitment to supporting the TCFD recommendations is well aligned with our mission and several of our disclosures have covered some of the key recommendations since their inception. For example, we have reported on climate-related impact performance and risks of our portfolios in our annual Impact Reports since 2017, and physical risk scenario analysis as well as specific TCFD recommended metrics since 2019, such as WACI and total GHG emissions of our portfolios. We include detailed analysis on our WACI results in all our Impact Reports.
This year we will publish our first standalone TCFD report that addresses the four key recommendations in full, giving a complete overview of how we manage our climate risks and opportunities as an organisation. Much of the concepts can be found in many of our public materials but the report provides an aggregated view of the whole organisation across our governance and products to provide material and complete disclosure, we are also excited to share more information on the types of metrics and disclosures we assess to determine climate-risk as well as enhanced issuer-level climate metrics. The report allows us to demonstrate our experience of disclosing on the transition and physical risks of our portfolios, to supplement our annual disclosures on the impact assessment of our portfolios.
Moving forward
International support for TCFD continues to grow, it is backed by over 3,900 supporters across 92 countries in January 2022[3]. The recommendations are increasingly integrated into global efforts to provide sustainability disclosure, such as the International Financial Reporting Standards’ International Sustainability Standards Board (ISSB). ISSB’s objective is to build upon the recommendations and develop a global baseline of high-quality sustainability reporting, However we believe further progress on integration across different initiatives is required as they not consistent and can create confusion and duplication.
Reporting against the TCFD recommendations is relatively straightforward for a climate-focussed pureplay like AIM. Increasingly the underlying quality of the data for the metrics and targets are improving, even if some data gaps and challenges persist. However, TCFD disclosure is only one part of our sustainability reporting. For a more comprehensive view of our organisational structure, integration of climate opportunities and risk management as well as expected positive environmental and social impacts associated with our funds. we encourage investors to review our TCFD report in conjunction with our annual Impact Reports. TCFD disclosure provides a framework to discuss how well we manage our climate risks and identify climate investment opportunity, but we believe our detailed Impact Reports provide a compelling story of our overall positive impacts.
One of the challenges in the increasingly complex landscape of climate reporting is the rise of national, international, and regional initiatives and regulations which can be challenging to navigate. Investors and issuers alike are grappling with increased demands on disclosure from different entities which do not necessarily overlap, even though their goals may be complementary.
We hope to see greater coherence from several initiatives, such as SFDR and TCFD, to simplify reporting, but also importantly to avoid confusion. For example, the carbon intensity of a portfolio under TCFD (ie WACI) is calculated using GHG emissions scope 1 and 2 footprint, whereas a similar metric under SFDR’s PAIs is GHG intensity of investee companies which covers scope 1-3. The difference between these two metrics can be significant depending on the sector composition of a portfolio, however from a bird’s eye view, may appear misleadingly comparable. As several of the regulatory initiatives are under consultation, we are actively encouraging greater harmonisation.
Conclusion
Overall, we see greater sustainability disclosure as a key driver for increased sustainable investment. The next stage for these initiatives will be working on enhanced usability, ensuring they are fit for purpose and covering material climate risks and impacts, as well as simplifying across regimes so the data becomes useful as opposed to abundant.
[1] https://www.unpri.org/a-legal-framework-for-impact/australia-integrating-sustainability-goals-across-the-investment-industry/10033.article
[2] https://finance.ec.europa.eu/sustainable-finance/disclosures/sustainability-related-disclosure-financial-services-sector_en
[3] FSB, 2022 TCFD Status Report