ESG and sustainable funds

With an increasing number of investors looking to invest into funds with sustainability credentials, and fund managers looking to launch and manage the same products, the introduction of a harmonised set of disclosure rules by the EU Sustainable Finance Disclosure Regulation (EU SFDR), was a key step to promoting transparency and understanding whilst partially mitigating the effects of greenwashing. 

At the same time, that brings with it challenges for investors in understanding and comparing different investment opportunities and for managers of the additional regulatory requirements and how they present and report on those to investors. In the UK, the Financial Conduct Authority (FCA) has proposed the Sustainability Disclosure Requirements in its Policy Statement published in November 2023, along with the proposed effective dates for certain provisions.

Developments in sustainable disclosures continue to evolve and we set out below an overview of the latest position at the time of writing. 

Overview – what our clients are seeing 

Funds that are considered 'ESG' or 'sustainable' are now widely recognised in the funds sector and continue to pique the interests of many market participants as investors and their stakeholders increasingly seek to ensure that their investments are aligned with ESG goals, values and requirements. While the market has not been without its challenges, it has been reported that global ESG fund assets reached $3 trillion in 2023, with funds raised over the year at $63 billion. 

We have also seen, among some of the LP clients we work with, an increased focus in due diligence and side letter negotiations on the ESG standards and practices adopted by funds in which they invest, even where they are not investing with a particular ESG or sustainability focus in mind.

We are also seeing a steady increase in interest in regulatory developments in the EU and the UK from our clients and market participants, which we summarise in this article.

A particular focus of our firm is in the real estate sector, and managers of real estate funds will find these regulatory developments particularly important to focus on – it was referenced in our earlier article in an ESG real estate related series. It is reported that buildings account for approximately 17% of the UK's greenhouse gas emissions, and in a broader context approximately 40% of global carbon dioxide emissions come from the real estate sector.

Regulatory developments on sustainability disclosures 

In response to the growing demand for sustainable products, a number of regulatory frameworks have been developed to govern the levels of disclosure required in relation to funds.

In 2017, the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) issued a framework for organisations (including asset managers) to develop more effective climate-related financial disclosures through their reporting processes. The framework sets out overarching recommendations across 4 themes: governance; strategy; risk management; metrics and targets. Beneath those themes sit 11 recommended disclosures in more granular detail on the information to be disclosed.

The EU Taxonomy was later published in 2020, as a classification system which sets out a list of environmentally sustainable economic activities and which provides companies, investors and policymakers with appropriate definitions for activities that can be considered environmentally sustainable. The EU's Corporate Sustainability Reporting Directive (CSRD) was subsequently adopted by the European Council in 2022,  increasing the number of entities that must report and extending the scope of the reporting which those entities must provide.

In addition, the EU developed the European Sustainability Reporting Standards (ESRS) in 2023 as a reporting framework for use by companies subject to the CSRD. The ESRS has sought to ensure alignment with the standards of International Sustainability Standards Board (ISSB), of which the UK is an strong advocate, which were also published in 2023. Both the ESRS and ISSB standards are intended to function interoperably. 

As the world of sustainability disclosures and associated compliance and risk requirements becomes increasingly complex, various international regulatory authorities have recognised the need for a unified set of regulations to streamline disclosures and to assist investors to distinguish between the growing number of sustainable funds launched to market. The EU SFDR is one of the key pieces of regulation on sustainability disclosures, and this article provides some pointers that can be derived from the regulations and insights into the evolving UK position. 

The EU SFDR 

The EU SFDR was introduced in 2021, mandating increased disclosures and requiring specific information to be disclosed about the approach and integration of sustainability into financial products (including funds). The EU SFDR aims to promote transparency, mitigate greenwashing and assist investors to make informed investment decisions. The regulation both supports asset managers in reporting on the products they launch to market and also mandates that they comply with certain standards, ensuring that specific sustainability disclosures, coupled with appropriate explanations, are made at both fund manager and fund product level. 

EU SFDR and funds – a snapshot 

The EU SFDR distinguishes between what are called Article 6, Article 8 and Article 9 funds, as follows: 

The categorisations in the table above seek, in part, to assist investors to better identify the degree to which sustainability is embedded into a fund's objectives, with Article 9 funds being those with the highest sustainability objective and disclosure obligations. Comparative to Article 6 funds, Articles 8 and 9 funds warrant greater disclosures generally, including index benchmarking and explanations as to how the index used aligns with a sustainability objective.

Further disclosure requirements under the EU Taxonomy also apply to Article 8 and 9 funds, which requires asset managers to consider the degree to which underlying investments take into account 'EU criteria for environmentally sustainable economic activities'.  

EU SFDR – Principal Adverse Impacts

Irrespective of categorisation, the EU SFDR requires larger sized asset managers to consider, and make disclosures relating to, Principal Adverse Impacts (PAI) on sustainability factors. A list of PAI indicators has been developed as part of the regulation and includes considerations such as greenhouse emissions, exposure to fossil fuel, energy consumption intensity and other social and employee considerations, against which disclosures are made, detailing actions taken, actions planned and targets set on each indicator. For certain smaller asset managers, if PAI are not considered in disclosures, then the asset manager must give clear reasons why they are not considered under the 'comply or explain' principle.

In a real estate context, a number of the PAI indicators are specifically linked to the real estate sector, including exposure to fossil fuels through real estate assets, exposure to energy-inefficient real estate assets, greenhouse gas emissions, energy consumption intensity, waste production in operations, raw materials consumption for new construction and major renovations, and land artificialization.

EU SFDR Regulatory Technical Standards

From 1 January 2023, financial market participants, which includes non-European fund managers that are marketing their funds in the EEA¹ via the National Private Placement Regimes have also had to comply with European Commission Delegated Regulation (EU) 2022/1288) (SFDR RTS) which supplements the EU SFDR and the EU Taxonomy.

The SFDR RTS specify the details of the content, methodologies and presentation of information relating to sustainability indicators and adverse sustainability impacts, the principle of "do no significant harm", and the promotion of environmental or social characteristics and sustainable investment objectives in pre-contractual documents, on websites and in periodic reports.

UK SDR 

As touched on earlier, the UK has introduced its own sustainability disclosure regime known as the Sustainability Disclosure Requirements or SDR (UK SDR) following the FCA's consultation.

The UK's naming and marketing rules under its sustainability disclosure regime were originally intended to apply to UK asset managers from 2 December 2024, but the FCA has granted limited temporary flexibility for its application until 2 April 2025. 

Certain key differences between the EU SFDR and the UK SDR

Alongside other differences related to the location and profile of the financial institution and fund product, the UK SDR introduces an explicit labelling regime for sustainability-related products, whilst the EU SFDR's Articles 6, 8, 9 regime is a broad categorisation applying across financial products.  

The EU SFDR introduces the prescribed PAI indicators as an added layer of disclosure whilst the UK SDR does not; it encourages non-prescribed key performance indicators (KPIs) to be used, based on industry frameworks and best practice.

Both frameworks, whilst varying in certain respects, seek to weed out the sustainable from the non-sustainable, and support the wider goal of attracting private funding towards responsible investment.

EU SFDR – practical tips for investors 

Investors should review a fund's offering documents for sustainability-related pre-contractual disclosures, periodic fund reports for ongoing disclosures and the asset manager's website for policies or information on sustainable investments and assessment methodologies used.

When comparing various EU-domiciled funds, investors could look out for the Article 6, 8 and 9 descriptions and the 'Keywords' listed in the table above for a fund's general categorisation. For Article 8 and 9 funds, investors could conduct checks against any disclosures made against the EU Taxonomy. Investors could also check if PAI considerations were taken on board and if so, review the specific PAI indicators for further information. Investor due diligence questionnaires could also be updated to take into account developing ESG requirements. Each investor may also wish to consider its own reporting and regulatory requirements and any associated side letter terms it needs to negotiate with a fund's representatives to protect its position contractually.

Recent EU developments

In May 2024, the European Commission published a summary report of stakeholder responses received to its consultation on the EU SFDR, which ran from 14 September to 15 December 2023. Responses on the consultation indicated broad support for the EU SFDR, with suggested reform or improvements to the framework for greater consistency with existing regimes. Since then, the European Securities and Markets Authority (ESMA) both individually, and jointly with the other two European Supervisory Authorities (ESAs), have also published opinions on the EU's sustainability framework, and the ESAs have also published clarificatory Q&As on the application of the EU SFDR. It remains to be seen how the EU SDFR will further develop. 

A set of fund naming guidelines was further issued by ESMA in May 2024 in its Final Report on Guidelines on funds’ names using ESG or sustainability-related terms, which comes into force on 21 November 2024; and the EU Corporate Sustainability Due Diligence Directive  was also formally adopted and entered into force in July 2024. These regimes complement the objectives of ensuring funds are not misleadingly named, and ensuring that asset managers of certain sizes are responsible for considering their own operations and their upstream value chain to prevent, mitigate and bring to an end to adverse environmental and human rights impacts. 

If would like more information on the subject matter of this article, or need any support in this complex area of regulation, please get in touch with the authors.

¹ The EU Member States (Austria, Belgium, Bulgaria, Croatia, Republic of Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain and Sweden) together with Iceland, Liechtenstein and Norway.