The new Sustainable Finance Disclosure Regulation [SFDR] came into effect in March 2021. This regulation is developed to drive sustainable investment. The SFDR will have big impact on asset managers, banks and fund brokers. In the past months we have published a blog series focusing on the SFDR, the obligations, the timelines, the definitions and the indicators to help you get your head around the subject. And to ensure you are well prepared for the new regulation.
After the publication of the final Regulatory Technical Standards we have updated this and other blog posts in the series to match the new requirements. We will keep doing this in the future to stay aligned with future developments.
In this article we will focus on the indicators and associated metrics, which are part of the Adverse Sustainability Impacts Statement for FMP’s.
This blog post was first published on December3, 2020 and updated on April 13, 2021.
Complexities related to indicators and metrics
Before we dive deeper into the indicactors and associated metrics, I would like to highlight the complexity of the regulation.
Recently, in February 2021, the ESA’s published their final report and draft RTS. It’s assumed that this draft RTS will be adopted in the near future as the final RTS. However, changes could still be made. Annex I of the joint consultation paper provides an overview of the definitions, formulas needed for calculations and the complete list of mandatory (table 1) and optional indicators (table 2 and 3) which are part of the Adverse Sustainability Impacts Statement.
The NFRD regulation is already in effect and requires corporates within the EU to disclose information on non-financial matters like ESG factors in their annual reports. These rules only apply to large public-interest companies with more than 500 employees. Although the majority of large caps within the EU are affected by this regulation, finding data for small caps could be challenging. The same applies to companies located outside of the EU.
The Taxonomy Regulation came into force on 12 July 2020. However, it will not be applicable in practice until 1 January 2022 at the earliest. This regulation provides standardized definitions and a system to classify whether an investment is to be considered sustainable or not. In addition, several articles of the Taxonomy Regulation will impose additional disclosure obligations under SFDR.
Lastly, the Adverse Sustainability Impacts Statement should be made on entity level (not on the financial product level) and therefore requires extensive data collection and calculations, combining proprietary data and data from multiple providers.
Mandatory and optional indicators
As already mentioned in our previous blog post, there are in total 64 indicators of which 18 are mandatory. FMP’s need to select at least 2 from the 46 optional indicators.
The mandatory indicators are dividend in two main groups: 9 environment related indicators and 6 mandatory social and employee, respect for human rights, anti-corruption and anti-bribery indicators, 2 indicators are related to investments in sovereigns and supranationals and 2 are related to real estate investments.
The calculation of the indicators will require vast amounts of data. In most cases these data come from both internal sources as well as external data providers. By means of an example of a mandatory indicator from Annex I of the joint consultation paper we want to show you the complexities in terms of data collection, combining multiple data sources and making the necessary calculations.
In the example we take the perspective of a UCITS management company which issues funds registered for sale in at least one EU country.
Example of the carbon footprint indicator
Let’s take the “carbon footprint” indicator as an example. The carbon footprint must be calculated using the following metric:
First of all, the UCITS management company needs a complete overview of the carbon footprint for all holdings and all the funds that are managed by them. Their funds can invest in financial instruments from various asset classes. They can invest in, for example, shares or bonds which are directly issued by the investee company (direct holdings). It’s more complex when investments are done in other funds or derivatives like options. The draft RTS requires you to explain how derivatives attain to the sustainability objectives but it doesn’t tell how to include derivatives within the calculations of the indicators.
Consequently for each holding in an investee company the carbon footprint calculation should be done. The sum of the results of all these calculations is the value for this particular indicator.
Components of the carbon footprint formula
Let’s take a look to the different components of this formula:
- The current value of investment: means the value in EUR of the investment by the FMP in the investee company. The draft RTS is not clear which date should be picked when determining the price needed to calculate this parameter. We assume that the last official closing price of the calendar for the specific instrument is required for the calculation of this value. Also there will possibly be the need for fund accounting data and historical pricing data sets for the calculation of this parameter. In addition, the price value must be in EUR and therefore data on (ECB) exchange rates are also needed for this calculation.
- The investee company’s enterprise value: means the sum of the investee company’s market capitalisation of common stock at fiscal year end, the market capitalisation of preferred equity at fiscal year-end, and the book values of total debt and minorities’ interests excluding the cash and cash equivalents held by the investee company. This is data which is traditionally available with well-known data providers.
- The investee company’s scope 1, 2 and 3 carbon emissions are examples of “non-financial” data. Although these can be obtained via well-known data providers sometimes, there are specialized data providers in this field. The complexity with this parameter will most likely be coverage. As laid out before, NFRD requires large companies since 2018 to report on non-financial matters like the scope 1, 2 and 3 carbon emissions required for the calculation of this indicator. However, NFRD only applies to large public-interest companies with more than 500 employees. This could lead to difficulties in obtaining the necessary data, especially in regard to holdings in small- and mid-caps. FMP’s will need to put quite some effort in getting the highest coverage based on their holdings. In addition, because most likely 100% coverage will not be attained by them, they’ll have to disclose information on the efforts they took and the methods they’ve applied to achieve the highest possible coverage.
- Current value of all investments (€M): means the value in EUR of all investments by the FMP. Likewise is the case with the “current value of investment” we assume that you’ll need the last official closing prices of the calendar year for each instrument for valuation purposes. In addition, the price value must be in EUR and therefore data on (ECB) exchange rates are needed as well for this calculation.
What are scope 1, 2 and 3 carbon emissions?
Based on regulation 2019/2089 which amends regulation 2016/1011, the definitions of scope 1, 2 and 3 carbon emissions are:
-Scope 1 carbon emissions are emissions generated from sources that are controlled by the company that issues the underlying assets;
-Scope 2 carbon emissions are emissions from the consumption of purchased electricity, steam, or other sources of energy generated upstream from the company that issues the underlying assets; and
-Scope 3 carbon emissions are all indirect emissions that are not scope 1 or scope 2 emissions and that occur in the value chain of the reporting company, including both upstream and downstream emissions, in particular for sectors with a high impact on climate change and its mitigation.
We think it’s fair to say that performing the calculations as laid out in the draft RTS will be a daunting task for FMP’s. Not in the least because the draft RTS is not clear on some details such as which date to pick for the valuation of holdings and which exchange rate to pick. In addition, the draft RTS provides only little information on how to deal with indirect holdings like derivatives and funds of funds. The draft RTS requires you to explain how derivatives attain to the sustainability objectives but it doesn’t tell you how to include derivatives within the calculations of the indicators.
Based on our analysis of the indicators in the draft RTS, FMP’s will need to think carefully of their data management. Especially because performing the calculations of a single indicator could already require them to include multiple providers of data.
BIQH will continue to monitor any news and updates on the SFDR regulation closely and we’ll inform you via our blog series. Our next blog will be on common data challenges and how to solve those.
We’re always open for a chat and we love discussions, especially when it comes to financial market data. Let us know your challenges, questions and uncertainties relating to the SFDR regulation! Please reach out to me via LinkedIn or send me an e-mail at email@example.com.
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