The EU and the US are implementing new rules to improve transparency on the climate impact of investments. While both plans were developed with the same idea in mind (improving understanding of climate risk and protection against greenwashing), the approaches chosen by each region differ significantly. Today’s economies are tightly interwoven, and fund managers may well be caught by both sets of rules. So how do the two initiatives compare? And what does this mean for you?
The EU was the first jurisdiction to announce its plans. Of these, the Sustainable Finance Disclosure Regulation (SFDR) is key. SFDR introduces disclosure requirements for all firms marketing funds in the EU (whether they, themselves, are based in the EU, or not). The first phase went live in March 2021.
The SFDR is one of three disclosure packages implemented by the EU. The other two are the Corporate Sustainable Reporting Directive (CSRD), which applies to large companies1; and the EU Taxonomy, a framework that identifies which investments are considered environmentally sustainable. These plans are part of the EU Green Deal, an overarching initiative, aiming to transform the EU into a sustainable, resource-efficient, and competitive economy. Transparency on ESG themes in finance is seen as an important condition for that transition.
US ESG Strategy Proposal
The US Securities and Exchange Commission (SEC) was somewhat late to the climate party, but has really pulled up its sleeves, this year. In March and May of 2022, it proposed three sets of rules: one focussing on climate disclosures of public companies (“Climate Disclosures Proposal”); one focussing on registered funds and forbidding misleading names (“Names Rule Proposal”); and one relating to registered funds and investment adviser disclosures (“ESG Strategy Proposal”). After the drafts were published, stakeholders were given time to send in comments. The SEC is now processing these inputs and preparing final versions. The rules are expected to enter into force in 2023 (applying to 2024 SEC filings).
In this article, we will focus on the EU SFDR and the US ESG Strategy Proposal. The development of both rule sets was initiated with transparency around climate-related risks and protection against greenwashing in mind. Both aim to provide investors with consistent, comparable, and reliable information, enabling them to compare ESG strategies, across managers. The resulting regulatory pieces, however, differ considerably, potentially adding complexity for fund managers directly or indirectly active in both jurisdictions. Below, the most important differences and similarities are explained.
Similarities: opportunities in shades of green
- Both US and EU proposals are responses to market concerns. Several investor initiatives have stressed the need for improved climate disclosure requirements. Among these initiatives were the Global Investor Statement to Governments on Climate Change, the Net Zero Asset Managers Initiative and, most recently, the Glasgow Financial Alliance for Net Zero.
- Both sets of rules provide classifications on a range of different shades of green (exhibit 1). The SFDR’s classification goes from “Article 6” (no sustainability objective) to “Article 8” (promotes E or S characteristics) and “Article 9” (with sustainable objective). The US Strategy Proposal grades strategies from “Integration” (somewhat sustainable), through “ESG-focussed” (more sustainable), to “Impact” (most sustainable). Funds ignoring ESG factors, achieve no classification and may find marketing challenging. Please note: the parallel approaches do not mean that the levels are transferable. An Article 9 fund, for example, does not automatically qualify as an Impact Strategies fund; and an ESG-focussed fund under the proposed US regime would not automatically be considered an Article 8 fund, in the EU.
- Both new sets of rules may present challenges for fund managers, but these regulations also offer the opportunity to demonstrate the alignment of investment decisions with ESG practices, a potential point of differentiation from competitors and, hence a marketing advantage.
Differences: mostly in applicability
- The two proposals do, however, differ in applicability. Whereas the EU SFDR affects all financial market participants, the bulk of the US ESG Strategy Proposal will not affect (unregistered) private funds, directly, as it mostly targets registered funds. However, certain parts do apply to private funds and advisers to private funds, specifically its proposed revisions to Form ADV2 and matters relating to marketing and compliance policies. In the EU, on the other hand, all market participants, ESG-focussed or not, will be required to disclose additional information on ESG-related subjects. The funds with the lowest ESG score (Article 6) have fewer obligations than funds that claim to be more sustainable, but still have to make certain disclosures.
- There are differences in terms of granularity of given definitions. The SEC does not define what it means by “ESG” or similar terms, in its proposal. It lets managers decide for themselves which activities they consider relevant. The EU SFDR, by contrast, does give this definition, and it includes environmental, but also social and governance factors. These are defined in the Taxonomy. Environmental factors are already defined in detail, including greenhouse gas pollution, of course, but also biodiversity loss and adaptation to climate change. Social and governance elements are not yet defined in as much detail, but the EU is expected to publish additional definitions, later this year.
- There are differences in the level of detail of the instructions for disclosure. The US ESG Strategy Proposal contains detailed revisions to the Form ADV but it provides only a high-level description of the elements that it expects in marketing material, prospectuses and annual disclosures. The EU’s SFDR, on the other hand, prescribes the required disclosures in much more detail, and includes questionnaires for pre-contractual, periodic and website disclosures. These are provided in the so-called Regulatory Technical Standards.
Start preparing today
To conclude, one thing is clear: in both jurisdictions, fund managers should start preparing for the rules, today. The SFDR is being implemented in phases, the first of which came into effect in March 2021. Since then, financial market participants must comply with the SFDR in general terms. Additional obligations will come into effect in January 2023. These are described in the recently published Regulatory Technical Standards.
The SEC’s ESG Strategy Rule is not expected to enter into force before 2023, and only parts of it apply to private funds. However, fund managers and advisers should now begin to assess how they will be affected and begin laying the groundwork to become compliant before the deadline. Managers who have not taken the time to streamline their disclosure process, in advance, will be left in the starting blocks when the rules come into effect.
For more information on what these developments mean for your firm and your portfolio, please contact Marieke Boudeling.
Read more about the SFDR and the Strategy Rule:
- The EU’s SFDR.
- The full text of the SEC’s proposal for the Strategy Rule.
1 Companies in scope of the CSRD include all listed companies and all other companies that meet at least two of three criteria: (1) 250+ employees, (2) € 40M+ revenue, (3) € 20M+ in assets.
2 Form ADV is the form for investment advisers to register with both the SEC and the state securities authorities. It is made available to the public.