How to trailblaze through the unknown waters of ESG regulation

Man cannot discover new oceans unless he has the courage to lose sight of the shore. — Lord Chesterfield

In his work “The Lusiads”, Portuguese poet Luís Vaz de Camões extolled the epic maritime adventure that was the discovery of the sea route to India. The global expedition, led by the Portuguese explorer Vasco da Gama, is considered one of the most remarkable voyages of the Age of Discovery and, hence, worth narrating. The journey, obviously, meant trailblazing through unknown waters, literally. 

Kings John II and Manuel I of Portugal were deeply committed to this voyage for one simple reason: to establish a sea route that would give the kingdom direct access to the gold of the Indies —that is, spices.

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The pros—a large income to the Crown and the expansion of the kingdom—outweighed the con—the perils in the sea. And so, on 8 July 1497, the expedition was launched.

As you can imagine, back in the day the risks of a trip of this scale were extremely high and indeed things didn’t always go smoothly. Still, on 17 May 1498, Vasco da Gama and his crew reached their destination, docking near Calicut (in the current Indian state of Kerala).

Despite the adversities, the crew kept their determination, curiosity and bravery to achieve their goal, and, along the way, they encountered remote tribes and had unique experiences.  

It might be a bit of a stretch, but asset managers are probably feeling the same way as the Portuguese sailors of the XV century did when it comes to environment, social and governance (ESG) regulation —of course, on a much less epic scale, without having to face disease, unfamiliar lands and an unconquerable sea.

Similarly to the sailors navigating murky waters, asset managers are trying to sail through the regulatory uncertainty. In this blog, we deep dive into the reasons behind this uncertainty, go through the main ESG regulations and attempt to give you some reassurance and guidance on how to navigate these unknown waters.

Why there’s ESG regulation uncertainty

Let’s face it, we are all entering unknown territory when it comes to climate change and achieving net zero. We have never been here before, and so we are trying our best to figure it out. Asset managers are unquestionably going through the same when it comes to sustainable investment and dealing with ESG regulation. 

The main reason for this uncertainty is that ESG regulation is still at its early stages and addressing different needs or scopes. For regulators, such as the Commission de Surveillance du Secteur Financier (CSSF), any regulation—as unclear as it may be—is better than nothing. They can use regulation as a way to raise the market’s awareness on the risks and opportunities of non-financial indicators.

That was also the goal of the European Union: to raise awareness to drive investors and their capital towards sustainable investing. Indeed, given the global challenges we face today that are affecting the world economy —COVID-19, the energy crisis, and climate change— and that need to be addressed, investors want to think beyond the return on investment. They also have to assess their impacts on the planet.

Today, there is a set of ESG regulations in place and asset managers are wondering in which direction it will go and what it will look like in the coming years. Some regulations may disappear, evolve or completely transform, while others might stay exactly as they are. Or maybe new regulations will arise, adding new layers of complexity. 

Hence, asset managers may feel as if they are still going through a trial period. Meaning, they are all doing their best to do something, however that something might turn out quite different in the future. 

Moreover, we understand that being aligned with the EU taxonomy can be rather challenging. And —don’t panic—we believe it will probably stay as it is in the future, but the likelihood of it becoming even more complex, with some additional layers of technical screening criteria as well as new objectives, is high. 

The biggest elephant in the room is, however, the Sustainable Finance Disclosure Regulation (SFDR), mainly because it can be quite difficult to comply with it. So let’s tackle it first.

What’s up with the Sustainable Finance Disclosure Regulation?

What makes asset managers and investors cringe when they hear the acronym “SFDR” is its complexity, which is twofold. On one hand, they aren’t really sure about what’s exactly requested from them. The EU wants investors to be transparent about what they invest in—and we should remember the SFDR is a transparency exercise and not a labelling exercise…‘yet’. 

On the other hand, asset managers shouldn’t choose a bucket and then try to fit in it, even if it’s what we see as a common market practice. Instead, they should disclose information about what they do or don’t do and, on that basis, they will be classified under Articles 6, 8 or 9. Still, there’s a lot of complaining about the fact that there isn’t much guidance on the rules.

That being said, the purpose of the SFDR isn’t to instruct investors on what they have to do —meaning that they have to invest sustainably—, but rather to inform them that if they go for sustainable investment or principal adverse impacts or something else, they should disclose and report on such investments properly.  

Moreover, regulation involves many players, including the asset management, the investors, the activity, and the assets themselves, and this translates into more complexity. 

For better or for worse, SFDR is extremely likely to stick around. However, at this stage, there are still plenty of aspects that need further clarification, and the million dollar question is how the regulation will evolve. In other markets, such as the UK and the US, there will be new similar regulations, which will, in a way, embrace the labelling aspect.

As we see it, the SFDR will eventually become a labelling exercise too. This probability brings even more uncertainty for asset managers. Today, they are trying to comply with the current regulation, but they might need to readapt to any future changes. 

Now, after this explanation, do you share their pain too? We guess so, but the situation isn’t all dark and gloomy, and the answer could be another regulation —the CSRD.

The European Union Sustainable Finance Disclosure Regulation (EU SFDR)

The SFDR is a regulation published in December 2019 by the European Commission as part of a package of legislative measures arising from the European Commission’s Action Plan on Sustainable Finance.

The EU SFDR aims to help investors by providing more transparency on the degree to which financial products consider environmental and/or social characteristics, invest in sustainable investments or have sustainable objectives. This information is now being presented in a more standardised way.

In more detail

The EU SFDR requires specific firm-level disclosures from asset managers and investment advisers regarding how they address two key considerations: Sustainability Risks and Principal Adverse Impacts. 

Concerning asset managers, the EU SFDR also mandates transparency of remuneration policies in relation to the integration of sustainability risks. In addition, the EU SFDR aims to help investors to choose between products by mandating increasing levels of disclosures, depending on the degree to which sustainability is a consideration.

Three different product categorisations result from the EU SFDR, which are:

  • ‘Article 6’ products either integrate financially material environmental, social and governance (ESG) risk considerations into the investment decision-making process, or explain why sustainability risk isn’t relevant, but don’t meet the additional criteria of Article 8 or Article 9 products.
  • ‘Article 8’ products promote social and/or environmental characteristics, and may invest in sustainable investments, but don’t have sustainable investing as a core objective.
  • Article 9 products have a sustainable investment objective.

It’s important to note that these product categories aren’t labels, although many investment firms have treated them as such.

The EU SFDR Scope

The scope of the EU SFDR is relatively broad, applying to all financial market participants and financial advisers based in the EU, as well as investment managers or advisers based outside of the EU, who market (or intend to market) their products to clients in the EU under Article 42 of the Alternative Investment Fund Managers Directive (EU AIFMD).

In terms of products, the disclosures regime applies to Undertakings for Collective Investment in Transferable Securities (UCITS), Alternative Investment Funds (AIFs), separately-managed portfolios and sub-advisory mandates, as well as to financial advice (provided within the EU or by an EU investment firm).

The EU SFDR Timeline

The disclosures, which went into effect on 10 March 2021 were rolled out in two phases:

  • Core disclosures (Level 1) were effective as of March 2021, which apply at an entity level to Sustainability Risks and Principal Adverse Impacts, and at a product level to Article 6, 8 and 9 products.
  • Enhanced disclosures (Level 2) were effective as of January 2023, which apply at an entity level to Principal Adverse Impacts, and at a product level to only Article 8 and 9 products. This requires Financial Market Participants (FMPs) to fulfil their compliance obligations by completing the Annex II or III for pre-contractual disclosures or IV or V for reporting disclosures. On top of that, they all have to proceed to their website disclosures.
The Corporate Sustainability Reporting Directive (CSRD)

The Corporate Sustainability Reporting Directive, adopted in November 2022, is likely to assuage a little the above mentioned uncertainties, and bring clarity to the market. This is because the directive will drive companies —listed and non-listed— and even large Small and Medium Enterprises (SMEs) to disclose and to report on their ESG material indicators and include climate-related physical risks. 

It’s becoming increasingly urgent for companies to disclose this type of information to bring the data into the market, which is another major challenge for asset managers.

The way to achieve this is for companies to comply as quickly as possible with the CSRD and try to develop their corporate sustainability reporting. That would help asset managers to build up and aggregate their data and, thus, bring more clarity.

To clarify, when we talk about data, we are referring to the material ESG-related indicators, but also to impacts in terms of principal adverse impact, and taxonomy. So, there’s a huge responsibility for the asset itself. 

Non-financial undertakings —an undertaking that isn’t a financial institution within the meaning of point (26) of Article 4(1) of Regulation (EU) No 575/2013— should start, as soon as possible, to develop their process and policies and calculate their material indicators to provide data to the market. That applies to both listed companies and private companies.

That said, initiatives such as the CSRD won’t only bring new data, but, most importantly, they will help understand the ESG material risks and impacts and the already available data. That’s why the ESG due diligence process is becoming more and more important, as it allows the assessment and collection of the set of data requested by the different regulations and the chosen strategy(ies).

Corporate Sustainability Reporting Directive (CSRD)

The CSRD was adopted by the European Parliament and the European Council in November 2022.

With it, the existing sustainability matters of ESG (environmental, social and governance) reporting will be expanded and standardised. 

Moreover, it introduces mandatory European Sustainability Reporting Standards (ESRS), based on the European Financial Reporting Advisory Group’s (EFRAG) recommendations.

The revised standards further contribute to:

  • Alignment with existing sustainability frameworks, standards, and regulations in the EU, including final version of CSRD, International Sustainability Standards Board (ISSB) and Global Reporting Initiative (GRI);
  • Harmonisation of the terminology used and structure of the sustainability reporting;
  • Reduction of the disclosure requirements and data points from the original drafts by 40%;
  • Clarification of the concept of double materiality and the approach to materiality including those items that must be reported irrespective of materiality.

The CSRD Scope

  • All listed companies in EU (including listed SMEs*, but excluding the micro-undertakings)
  • All large undertakings, as well as all parent undertakings of a large group, which exceed two of the three criteria during the financial year in two consecutive financial years:
    • € 20 million balance sheet total, 
    • € 40 million net turnover, 
    • average number of 250 employees
  • Companies outside the EU if they generate a net turnover in the EU of more than € 150 million (in the last two consecutive years) and have at least one large or EU-listed subsidiary or a branch that generates minimum revenue of €40 million in the EU. 
*Listed SMEs have the possibility to postpone the first-time application by two years.

CSRD timeline including ESRS adoption

  • June 2023: EU adopts sector-agnostic standards
  • Jan 2024: CSRD requirements start for those in scope of NFRD
  • June 2024: EU will adopt sector-specific, SME and non-EU standards
  • Jan 2025: Other large companies required to report
  • Jan 2026: Listed SMEs required to report
  • Jan 2028: Non-EU companies required to report if > EUR 150m EU revenue with one or more subsidiary or branch

In sum, what to do… for now
  1. Start preparing right now. The Portuguese didn’t underestimate the risks of their voyage and so they prepared as best as they could: they defined a travel plan, equipped their three ships, took with them “high-tech” navigation instruments (for the time) and food sufficient for three years —and planned continuous replenishment along the coast of Africa; they also recruited the best sailors, and before heading full on to India, they did smaller excursions through the coast of Africa to make sure it was possible to navigate around the cape and through the Indian Ocean. When it comes to ESG matters, as we mentioned before, preparation is also key. The pathway will be long and you should be prepared with the right team, expertise, and the best tool(s) and support to help you achieve your ambitions. The sooner you align with both the SFDR and the CSRD —but especially the latter—the better. 
  2. Find the right people and get the knowledge. When navigating through unknown territory, you need people who really know their stuff and you can trust. The Portuguese knew this and so they designated Vasco da Gama as the leader of the expedition and captain of the armada. Besides an experienced crew, they also recruited two interpreters and scribes. Similarly, everyone —from the asset managers to consultants to the regulator— will need to build up their expertise on ESG regulation, but also their scientific expertise to be able to assess the different indicators.
  3. Expect the unexpected. We said it before and we will say it again: the main aspect behind uncertainty is how the regulatory landscape will evolve in the coming months and years. Our advice is to do your best to prepare and be compliant with what currently exists, but, like the Portuguese explorers, keep an open mind and be flexible because the only thing that’s clear is that the regulation will change —we just don’t know yet in which direction and form.
  4. You don’t have to do it alone. You aren’t alone on this discovery journey. The regulation’s complexity and the implementation of your strategy and positioning will ask for a strong expertise. At PwC Luxembourg, we can support you in your ambitions with the regulatory expertise, but also our market knowledge and our operational advice, such as the one requested for due diligence.
  5. Lessons learned. Finally, remember that everyone is in the same boat of learning and discovering. As these are uncharted waters that no one has explored before, it’s important to assess what’s being done and how it’s being done to keep improving the process and the reporting. 

We hope you liked our little metaphor for this blog. The key message we want you to take away from it is that we understand how daunting it can be to sail through the unknown —and unclear—waters of ESG regulation.

Just like the Portuguese sailors did, asset managers, regulators, and investors are trailblazing these waters little by little, without knowing what the home stretch of the journey looks like. And that’s alright.

All that matters is that they keep their resolve, their interest and flexibility to achieve the final goal, which is, in fact, the only certainty they have today: the need to invest in the transition to a carbon neutral economy. 

The consequences of failing to do so outweigh the risks and uncertainty the ESG journey entails. Moreover, we truly believe that this journey will also bring new and unique opportunities for you.

Visit our “2023, ‘ESG-ise’ your Assets” web page for more information about the topic and how we can help you.

What we think
Oriane Schoonbroodt, Sustainable Finance and ESG Strategy and Deals Director at PwC Luxembourg
Oriane Schoonbroodt, Sustainable Finance and ESG Strategy and Deals Director at PwC Luxembourg

The ESG due diligence process is becoming more and more important in order to be able to assess and collect the set of data requested by the different regulations and the chosen strategy(ies). As the Portuguese who discovered the sea route to India, don’t underestimate the risks of the voyage and be prepared as best as you can because it will be a long and complex journey.

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