How should UK FMPs remain compliant with 2022 sustainability regulations?

With the Sustainable Finance Disclosure Regulation’s (SFDR) first reference period just around the corner, asset managers, banks and fund brokers are working closely with their underlying companies to report on their environmental, social and governance (ESG) impact.

Given the vast amount of information and new data points that must be sourced to measure the sustainability of a given product, asset managers – and, by extension, the corresponding investee organisations – are beginning to feel the pinch.

So, how can UK financial market participants (FMPs) best go about complying with this year’s sustainability regulations? What data is needed for compliance? How should it be accessed and managed? How can technology streamline the process?

Finextra sought answers to these questions by speaking to a clutch of experts in the field, namely: Elastacloud, ResponsibleRisk and Cervest.

Sustainability regulations to watch out for in 2022

In an interview with Finextra, Richard Conway, CEO of Sustainability Studio and Elastacloud, noted that sustainability regulations in 2022 are “working to address one of the biggest topics on everyone’s lips – greenwashing. Not for long will you be able to say you’re green if you can’t prove why.”

This is where the most imminent change for UK FMPs comes into play – SFDR. Introduced by the European Commission as part of a package of measures emerging from the ‘Action Plan on Sustainable Finance’, SFDR aims to drive responsible investment by fostering greater transparency around ESG impacts; both at the entity and product level.

“The run-up to regulations like SFDR started with the EU’s green taxonomy,” explained Richard Peers, founder, ResponsibleRisk. “Becoming law in July 2020, the taxonomy defines what ‘green’ actually means, by providing companies, investors and policymakers with a classification system of environmentally sustainable economic activities. Now, SFDR is making FMPs nail their colours to the mast by justifying exactly why their assets fall into the ‘green’ bracket.”

It is important to recognise that there are varying ‘shades’ of green, which reflect the extent to which a fund promotes sustainable characteristics. This spectrum is formalised by SFDR through three key articles – six, eight, and nine – which gauge the extent to which fund managers are assessing the green credentials of the companies in their portfolio.

Here is the basic criteria:

• Article six: Funds that do not integrate any kind of sustainability into the investment process. This may be stocks that are excluded by ESG funds, like tobacco or coal producers.
  
  
• Article eight: These funds are seen by the investment industry as ‘light green’, and promote environmental or social characteristics. The companies in which the investments are made must adhere to strong governance practices.
  
  
• Article nine: These funds are seen as ‘dark green’, and therefore have, for example, sustainable investment or a reduction in carbon emissions as a specific objective.

There is, however, a snag. The first reference period (June 2022) for SFDR does not sync up with another key sustainability regulation that is on the horizon: the European Union’s (EU) Corporate Sustainability Reporting Directive (CSRD). Requiring banks, insurers, and listed companies to disclose information on the way they operate and manage social and environmental challenges, the regulation is unlikely to oblige large organisations to do much reporting until 2024.

As Conway pointed out, “the key challenge for fund managers is accessing data on small to medium-sized enterprises (SMEs) – not so much on the HSBCs of the world. Yet, SFDR is asking fund managers to be very clear on all they’re doing now. So, if you’re a small capital fund manager, how do you square CSDR with SFDR? What will be the outcome of this timeline misalignment?”

Hopefully, the lack of regulatory synchronisation will not cause fund managers to shy away from SMEs because they can’t fit them into their SFDR mandates.

To be considered alongside regulations are frameworks such as the Taskforce for Climate-related Financial Disclosures (TCFD). Like a management handbook, it shows how governance, strategy, risk management and metrics should be run it – acting as a pre-cursor to the operational-level SFDR.

“By April 2022, aligned climate risk reporting will become mandatory for more than 1300 public and private UK companies,” said Partha Bose, head of capital markets, Cervest. “UK companies with over 500 employees and a turnover of more than £500 million will be required to publicly report on financial impacts associated with climate risk exposure to their business. By 2025, all UK businesses will be subject to these disclosure requirements.”

Since 2017, increasing numbers of UK organisations have voluntarily reported their climate-related financial risks under TCFD. These will be in a strong position to resource their SFDR execution. Others have recently started preparing with internal ‘trial run’ reports aligned to their ESG initiatives.

The compliance process

Despite the asynchronicity of upcoming regulations, compliance remains an imperative. Naturally, the process will depend upon the regulation itself and entity in question.

Complying with SFDR

SFDR states that sustainability impacts must be identified and disclosed at both the entity and product level. As mentioned earlier, it is vital to justify why a fund falls into article six, eight, or nine. Ultimately, the intention is to boost transparency by making asset managers be clear about why they feel they fit into a particular article.

“Article six is the lightest touch. It covers funds that do not integrate any kind of sustainability into the investment process,” said Conway. “Articles eight and nine, however, are where it gets interesting. A surprisingly large number of products could be classified as dark green.”

For article eight, FMPs must provide additional information on how environmental or social characteristics are promoted, which includes disclosing the degree of taxonomy alignment of underlying economic activities. Article nine, meanwhile, requires FMPs to explain how sustainable investment objectives are achieved, and provide disclosure on alignment with the EU Taxonomy Regulation.

This compliance process will require asset managers, banks, and fund brokers to source considerable amounts of ESG data on underlying companies, which they may not have accessed before. It will have to be specific, and directly address the disclosure criteria.

Complying with TCFD

The TCFD framework, meanwhile, suggests that banks should provide the metrics they use to assess the impact of climate-related risks on their lending activities over the short, medium, and long-term.

However, “it is not specified what these metrics should be,” pointed out Bose, “but suggests they should relate to credit exposure, equity and debt holdings, and trading positions. Banks lending over the longer term (i.e., more than five years) also need to provide the percentage of their assets that are carbon-related.”

For a complete picture of climate risk that enables them to properly report and support adaptation planning, banks will want to assess asset-level climate risk across different global emissions scenarios (including business as usual, 2040 emissions peak, and Paris Agreement-aligned), and across multiple geographies and time horizons.

It’s worth noting that transition risks have already forced banks to write off stranded assets, and accelerating climate extremes guarantee that more material risks are on the horizon, added Bose. Mandatory disclosure will nudge banks and other organisations to understand and segment climate risk – perhaps for the first time ever. Climate intelligent organisations will also want to quantify those risks at the asset level, as a key step in adaptation planning.

It’s also vital that companies are aware of what the current regulation doesn’t cover. TCFD reporting is mainly focused on net zero and mitigation, but physical risk from climate change can have a massive financial impact. Companies that integrate their emissions strategy with climate change adaptation measures are going to be better prepared for the coming decades.

“It’s likely only a matter of time before specific adaptation guidelines are added to the TCFD framework,” argued Bose. “In fact, the current framework highlights physical risk in specific guidelines for banks.”

The challenges of gathering and disclosing data

Whatever the sustainability regulation, disclosure can represent a significant administrative and financial burden for FMPs.

According to Greenomy, in order to comply with new sustainability rules, companies and institutional investors will have to invest €2.1 billion over the next five years. Unfortunately, there is no single solution on the market that can deliver the granular data needed for compliance.

“It goes without saying that managing climate risk is an emergent and unfamiliar challenge for all businesses,” said Bose. “We can’t look to the past for examples on how to manage it. We don’t have examples of what has worked and what hasn’t that we can apply now. We’re breaking new ground, and that requires new ways of thinking, new methodologies, new metrics and data.”  

Here are three key challenges that FMPs should be aware of on their compliance journey:

1. Sourcing the data

There are many challenges that will come with SFDR compliance, depending on the kind of fund you're managing, which articles you intend to adhere to, or what your target market is. A key challenge for the upstream investor, though, is often accessing the data itself.

“Many listed companies simply do not have it because they don’t have the necessary technology or climate knowledge in house – and there’s no pressure for them to,” claimed Conway. “If you looked at all of the FTSE AIM 100 constituents right now, you'd find that around 80% of the data is missing. What companies need is an effective cloud data platform, that not only enables effective information capture, but highlights key analytical insights which recommend areas for improvement.”

As such, UK FMPs will have to start playing a supportive role with their underlying companies, in order to help them source the data that is required.

2. Validating and managing the data

Once surfaced, FMPs must ensure the data is trustworthy. This can be a time-consuming process; manual reporting is often fraught with human error.

“Data collection is bound to be a challenge for banks,” said Peers. “Historically, they have worked with financial data, but now they’re being asked to extract non-financial, ESG data. Banks, in turn, have approached corporates for disclosure, but the issue with that is self-reporting. How can the information be verified?”

To make matters worse, even if the data is verifiable, it will often need rationalising so that it is organised and workable.

“A key challenge is the condition of the data itself,” noted Conway. “If you've got disparate data sets all over the place, things can get very tricky. Again, a cloud platform that can help fill data gaps is key.”

Fund managers are not always set up for tagging and normalising vast datasets. A considerable operational effort is therefore required to prepare for the 2022 disclosure process.   

3. Finding an agile approach

Another key challenge is the need to be agile in the face of new or emerging regulations and frameworks. Every time a new sustainability directive lands, new data points must be extracted. This forces FMPs to be flexible in their approach to data management and adapt at speed to new requirements.

Speaking to the specific challenges that come with TCFD disclosure, Bose commented: “Although the TCFD reporting framework includes industry-specific guidelines, in reality, it’s a framework without a framework. It includes a broad list of recommendations but offers no standard way of reporting. Banks are left to make their best guess on how to report. And if every bank uses its own reporting methodology, there can be no like-for-like comparisons between reports.”

Indeed, TCFD-aligned climate risk reporting entails disclosing the governance structure behind climate risk disclosure, and the strategy for mitigating and adapting to climate risk over the long-term. This is a lot for organisations to get in place, especially in unfamiliar areas, such as climate scenario analysis.

Streamlining compliance with technology

Now that we have explored the challenges around regulatory compliance, it is time to shed light on the solutions.

As ever, technology is an enabler. According to Bose, “over 80% of decision-makers recently surveyed by Cervest said they are investing in new technologies, hiring specialists, and training existing staff in an effort to fully understand the risk to their assets in preparation for climate-related financial disclosure regulations.” 

Using technology to discover, analyse and report risk is a more effective and time-saving approach for reaching a ‘good data in, trustworthy intelligence out’ mechanism: “Look for automated solutions based on open, shareable intelligence built on the latest climate science and machine learning – and importantly one that is based on a unified dataset where everyone shares the same asset-level view,” advised Bose.

Here are some case studies which highlight how technology can be leveraged to support the compliance and disclosure process:

1. Extracting data: IoT

Elastacloud utilises Internet of Things (IoT) technology to extract specific ESG data required by entities or analysts. By embedding physical objects with sensors and software, they can be connected to other devices and systems via the internet for an efficient exchange of information.

Darshna Shah, Elastacloud’s lead data scientist, described to Finextra how the firm applied IoT in a proof of concept with housing association company, Notting Hill Genesis: “We installed IoT sensors into their buildings, to create a three-dimensional, digital twins of the structures. The platform showed us in real time exactly what was happening within those buildings, from a temperature; carbon intensity; and predictive maintenance point of view.”

Interestingly, while Elastacloud were demoing this project, they spotted a water leak occuring live. With their predictive model, they showed how in the future, such events could be pre-empted and fixed before additional costs are incurred.

“This case study shows that for a small company across multiple sites, IoT is a really manageable way to measure carbon footprints in real time,” noted Conway. “ESG reports from corporates can sometimes take a couple of years to surface – we’re getting 2021 ones now, and we'll be getting them over the next four or five months. With this technology, we can move the story forward by extracting data, and adjusting on the fly. We have also developed location models that leverage natural language processing techniques to semi-automate ESG metric extraction.”

Indeed, this use case proves that asset managers do not necessarily have to wait for an ESG report. The face-to-face active ownership engagement can be avoided, and processes can still move forward.

“You may not want to go to that level of detail,” added Conway, “but I know plenty of analysts that do. This technology doesn’t just enable smaller companies to report and disclose for sustainability regulations, but it circumvents the time lag often associated with ESG reporting.”

2. Rationalising the data: Artificial intelligence

Fortunately, technology can also be leveraged to help FMPs manage and rationalise ESG information, so that it is ready to be disclosed.

Some solutions such as Cervest’s artificial intelligence (AI) initiative – EarthScan – are emerging which help FMPs package the kinds of data needed to align with TCFD.

“EarthScan gives an FMP access to a catalogue of over 220 million assets, while also allowing them how to upload their own asset information,” explained Bose. “From here, an FMP can create a portfolio of assets, and discover, analyse and act on their climate risks.”

This technology then enables FMPs to build reports across multiple timescales, emissions scenarios, and hazards, in alignment with TCFD guidelines. With editable fields, reports can be customised to ensure details such as internal governance are included.

“With this shareable view of climate risk, on their portfolios or specific assets, FMPs can use these insights to strengthen in-house reporting, add to their risk reports and fully meet UK regulatory disclosure requirements,” noted Bose.  

Indeed, basing reporting on unified data sets from a single, independent source eliminates ‘walled gardens’ and promotes transparency and accountability, enabling banks – for example – to see portfolio and asset-level risks for any of their holdings. It also facilitates apples-to-apples comparisons between different banks’ reports possible.

With the deadline for mandatory disclosure rapidly approaching, banks really have no choice but to take action, argued Bose. Creating an internal ‘dry run’ report with the help of AI is a good starting point.

That said, AI is an extremely versatile technology. Elastacloud, for instance, deploys it to deliver solutions such as climate risk modelling, emissions reduction recommendation systems, and route optimisation for waste management.

3. Taking an agile approach: Customised data platforms 

From a long-term success point of view, any technology-based solution should allow for flexibility into the future. This way, FMPs will not have to re-write the book every time a new piece of reporting framework or taxonomy lands.

“Measurement on an ongoing basis should be accommodated for, because SFDR will eventually ask companies to accurately gauge the impact of projects,” noted Conway.

Indeed, the key is not to just dump data or scores at the doorstep. Customised dashboards and big data intelligence is needed to support capital allocation and project prioritisation decisions.

The end-goal

The science to understand climate risk has been around for decades, but it’s been too fragmented and complex to be useful for business and banking decision-makers. Fortunately, advanced frameworks have made it possible to harmonise and present climate data in a way that makes it readily available and useful for businesses to use in their adaptation planning and decision-making.

“Sustainability reporting in the UK covers a wide spectrum of ESG issues,” summarised Bose. “The ESG landscape has rapidly evolved over the last decade, fuelled by green-mindedness among investors and customers, and a growing realisation that climate change presents a serious financial risk to our global economies.”

The emergence of further reporting frameworks and taxonomies, however, speaks to a broader challenge within sustainable finance. With new regulations comes new data points – and the industry-wide pursuit of a central reporting framework gets more futile.

“At some point, a line in the sand must be drawn, so that the sector can get up to speed with the implementation of a universal reporting and taxonomic framework,” argued Conway. This will fast-track the movement toward the greening of the financial system, which, after all, is the end-goal of directives such as SFDR, TCFD and CSRD.

“Ultimately, we need to reach a point of regulatory and reporting consolidation, whereby the ESG data of an entity in the palm oil industry in Asia, can be compared to a pharmaceutical company in Switzerland, for instance,” said Peers. “Investors can then slice up the information and make decisions based on their risk appetite and environmental conscience.”

Against this backdrop, it’s imperative that FMPs begin to factor climate into their financial risk planning, including operational, credit and liquidity risk – all the while leveraging technology to provide the flexibility needed to withstand the changing winds of regulation.