Regulating the financial transition
Bart Carlier and Sabine Swennenhuis, Mount Consulting – October 2022
Seven years ago, the world signed the Paris Agreement, which is at the core of today’s changes in the financial world. While the United States withdrew from the Paris Agreement in 2019, the European Union was committed to become climate neutral in 2050. This means that between now and 2050, the EU will need to drastically reduce its greenhouse gas emissions and find ways of compensating for the remaining unavoidable emissions, ultimately reaching a net-zero emissions balance. How? The EU Green Deal, a plan consisting of several strategies to reach this goal. And according to the European Commission, the financial sector has a crucial role in reaching this goal.
Sustainable Finance Action Plan
To enforce cooperation of the financial sector, the European Commission has been working on the Sustainable Finance Action Plan (SFAP) since 2018. The SFAP consists of actions that include a set of enhanced regulations. Accordingly, the European Commission subdivided the SFAP into three categories, each with its dedicated goal:
- reorienting capital flows towards a more sustainable economy;
- mainstreaming sustainability risks into risk management;
- and fostering transparency and long-termism.
The regulations EU Taxonomy, SFDR, and NFRD/CSRD are part of the SFAP. These three regulations must together form a solid foundation for Europe’s sustainable finance and, additionally, present the proverbial key for success to the EU Green Deal.
SFDR has the goal of stimulating sustainable investments by identifying sustainable financial products as green products, in contrast to grey products for unsustainable ones. By creating transparency in the market of financial products, investors can compare the sustainability information for investments and make conscious choices for greener products. The main data need consists of environmental, social, and financial (investment-related) data required for the computation of 18 mandatory and 2 voluntary PAIs. While the application of SDFR and the first reference year, 2022, have already started, articles 8 & 9 product disclosures will be published on 1 January 2023, followed by the PAI disclosures on 30 June 2023.
Secondly, EU Taxonomy will strive to consistently make reporting about the extent of sustainable activities of corporations visible with the help of six environmental objectives, which, among others, aim to help companies to become more climate-friendly and protect private investors against greenwashing. These six environmental objectives:
- climate change mitigation;
- climate change adaptation;
- sustainable use and protection of water and maritime resources;
- the transition to a circular economy;
- pollution prevention and control;
- and protection and restoration of biodiversity and ecosystems.
form the most substantial challenge for EU Taxonomy since investee companies must place their activities into buckets themselves. Financial institutions must report taxonomy alignment on 1 January 2024 using reference period 2023.
Lastly, CSRD followed from a revision of NFRD and will have the purpose of mandatory reporting for organizations about sustainability policies and achievements. Like NFRD, it will have five dimensions:
- environmental protection;
- social responsibility and treatment of employees;
- human rights;
- anti-corruption and bribery;
- and diversity on company boards.
However, CSRD will enhance NFRD by introducing the double-materiality standard and mandatory third-party assurance – first ‘limited’ assurance and ‘reasonable’ assurance in the future as the reporting framework evolves. Listed companies must report over the year 2024, non-listed large corporates over the year 2025, and SMEs over the year 2026. The reporting requirements for CSRD will be published in November 2022.
Most challenges that financial market participants might face while complying with the regulation stem from the high need for new data. Since this is true for each of the three regulations, one can see an overlap in challenges for the availability, reliability, and accuracy of data.
Since SFDR requires the most diverse data inputs due to its PAIs, it is expected that collecting data will be the most difficult for SFDR. The most significant challenge that occurs when collecting data for the PAIs is finding reliable, and qualitative data about investee companies.
Ambiguity of Data
Additionally, some of the indicators are vaguely formulated. For example, PAI 14 is referring to “exposure to controversial weapons”, but what is meant by controversial weapons? The challenge for FMPs is to understand what these ambiguous terms mean and to implement this consistently.
FMPs should integrate data sources for SFDR in their processes, while considering the Build-or-Buy decision. Because of the homogeneity of data needs between FMPs, it is expected that data will be sourced from data vendors. Nevertheless, data vendors are simply not able to cover the full scope of investee companies. Consequently, it will be a challenge to fill these “gaps”. Therefore, FMPs should be prepared to find, or produce, the required data themselves and define and implement this data collection process.
Because EU Taxonomy requires predominantly financial data, it is anticipated that quality of data and ambiguity of data are not the main challenge under EU Taxonomy as this data is obligatory for public companies. A challenge concerning EU Taxonomy is the so-called data split towards the environmental objectives, economic activities (gas & nuclear) and capex/opex. Additionally, with the complex data structure that could result from compliance with EU Taxonomy, it is expected that processing data will be the most challenging for EU Taxonomy.
Data granularity and quality
EU Taxonomy uses a classification system that requires investee companies to classify their economic activities. When a financial institution invests in a company, it must aggregate how sustainable the investment is. For direct investments in companies that comply with one environmental objective this is straightforward. It gets more complex when a financial institution invests in several companies that comply with more than one environmental objective. For each investment, the financial institution must discover if the investment is taxonomy eligible. In case of eligibility, they must define whether the investment is taxonomy-aligned or non-aligned. When the investment is taxonomy-aligned, the investee company must define which environmental objective(s) the economic activity fulfils. This is where the challenge emerges because investee companies can split a single economic activity into more than one environmental objective. It is highly likely that investee companies will present themselves more sustainable than they are.
A challenge that specifically applies to EU Taxonomy, is structuring the data so that it can process both direct and indirect fund investments. Naturally, the more investments in a single fund, the more data is required to decide how sustainable a financial institution’s economic activity is. Furthermore, the investments should be aggregated to calculate the weighted average. Since one fund typically holds dozens of underlying investments, one can understand that having a clear, consistent data structure is a significant challenge under EU Taxonomy.
As the data needs and reporting requirements under CSRD are not publicly available yet, the challenges that could arise from its implementation can only be assumed. Nevertheless, what is already known is that the reporting requirements and data needs will increase relative to NFRD. Therefore, it is expected that the challenges regarding data and organizational structure will be similar to SFDR and EU Taxonomy.
Considering the scope of SFDR and EU Taxonomy there will be many departments involved in processing the PAI-related data, KPIs and GARs. The challenge will be to assign and integrate (parts of) the processes to those departments of the company that have sufficient skills and knowledge to execute these. Furthermore, all relevant departments should have access to the same data to ensure consistency. Departments such as Corporate Social Responsibility (CSR), Finance, Risk and Investment management should therefore have clear governance and data management processes in place to effectively source and distribute this data.
While internal alignment already seems a significant challenge, one can expect value chain alignment to be even more burdensome. Even though a lot of the required data can be obtained from data vendors, those data inputs that are not available should be secured from the companies directly. Even though many large companies will be required to report under NFRD/CSRD, it is likely that smaller companies that are not obligated to report, will use their own data definitions and therefore outcomes will become inconsistent.
How can we help
Although the SFAP inevitably will span across many more years to come, the time for financial institutions to act has already passed. Ever since the Paris Agreement in 2015, sustainable finance has been and will still be a hot topic in the sector. Financial institutions located – or operating – in the EU must act now to comply with all the reporting requirements posed by and all the subsequent data inputs required for SFDR, EU Taxonomy, and CSRD.
At Mount Consulting we have extensive experience with reporting operating model definition, implementation of new regulations and establishing a data integration architecture to enable efficient and effective ESG data processing to meet ESG reporting requirements.
At Mount, we are also well acquainted with the centralized ESG data vendor selection process, by assessing the required ESG data service functionalities before reaching out to potential data vendors and conducting a thorough selection process based on business requirements coverage as well as the pricing model.
If the challenges and questions raised in this paper resonate with you, then why not have a chat with us on how we may help you to tackle them?