A small step, a major milestone
Prasad Gollakota

A small step, a major milestone

Prasad Gollakota

18th July 2022

The core premise of sustainability disclosure regulation.

A small step, a major milestone

Stamping out greenwashing lies at the heart of the EU’s Sustainable Finance Disclosure Regulation (SFDR), and represents a milestone in creating benchmark standards to support the sustainability claims of financial market participants such as asset managers, insurance companies and pension funds. The SFDR requires portfolio managers to attribute a level of sustainability for each investment strategy or product they offer. There are three tiers of sustainability:

  1. Funds and products that do not integrate any kind of sustainability assessment into their processes. These funds are referred to as non-sustainable under article 6. In the market, these funds are known as ‘brown funds’.
  2. Funds and products at the other end of the spectrum under article 9, which have sustainability as their core objective and driving force. This is akin to impact investing. In the market, these funds are known as ‘dark green funds’.
  3. Funds and products in the middle of these two extremes, which promote environmental or social characteristics. This captures ESG screening and sustainability-themed approaches, and is covered by article 8. In the market, these funds are known as ‘light green funds’.

Early reports are that the vast majority of Environmental, Social and Governance (ESG) funds and products of mainstream asset managers are expected to fall under article 8. However, this classification exercise has not been an easy one, and certainly not without critique. One criticism is that the disclosure rules are relatively onerous as they require collection and processing of data which is not financial in nature, such as greenhouse gas emissions and records on human rights. It has also been criticised for being vague and open to interpretation.

To me, these criticisms are healthy and actually validate the SFDR. After all, the SFDR represents a structural shift in the way financial markets participants present sustainability claims, and such criticisms prove it is real. What’s at stake is very real for many asset managers -- funds and products not classified as optimally as the market would like are going to miss out on investor money, and potentially close or never launch.

This journey, however, has only just begun. Weeding out greenwashing in the financial services sector will be an ongoing game of cat and mouse, and the SFDR is round one.

Faithful and verifiable disclosure is not a new concept

Accountants have known this for decades, if not centuries. The original intent of International Financial Reporting Standards (IFRS) was to harmonise reporting of financial statements for all stakeholders. The fundamental characteristics of financial information is to be relevant and a faithful representation of the state of affairs of an entity. Moreover, such information should be comparable, verifiable, timely and understandable.

Sound familiar?

In essence, IFRS is a regime which is intended to minimise ‘asset-washing’ or ‘profit-washing’, that is, presenting a picture of the health of the financial affairs of the company (higher net assets or profits) which is not a faithful representation of reality. Despite its clear intention, IFRS has been gamed over and over throughout the years, with parties masking finance leases, hiding special purpose entities, or misrepresenting current and non-current liabilities.

A recent intriguing case is Wirecard, the ‘Enron of Germany’, where profits were materially inflated until the accountants found a gaping and unexplained hole of €1.9bn in the balance sheet. Despite this, and many other scandals, the accounting profession has been resolute in its efforts to continuously improve the quality of financial information and processes to ensure such information is consistent, timely and accurate for the benefit of all stakeholders.

Perhaps unsurprisingly given the direction the world is going in, the IFRS has also announced the creation of the International Sustainability Standards Board (ISSB). The ISSB will deliver a comprehensive global baseline of sustainability-related disclosure standards to assist international investors with global investment portfolios. This is a massive step in the global drive for ESG disclosure given the SFDR is only applicable to financial market participants within the EU.

The end justifies the journey

Sustainability champions in the market can learn from the accounting profession. Any bumps in the road to minimise greenwashing is no reason to deviate from the mission. Imagine a world where IASB gave up, and there were no harmonised financial statements across comparable institutions.

Efforts and attempts to minimise the occurrence of greenwashing are invaluable even if there are teething issues in the early days, or the occasional rogue disclosures along the way. The mere existence of SFDR will ensure the vast majority of asset managers are dissuaded from highlighting the sustainability merit of a product or fund without the data to back it up.

The EU’s proposed Corporate Sustainability Reporting Directive (CSRD), which will impose ESG data standards on all listed companies and large unlisted companies, will be immensely helpful to investors in meeting SFDR requirements, as current corporate ESG disclosure is patchy.

As mentioned already, this is round one. The SFDR will continue to iterate over the years. The accounting standards are a good precedent for this.

Share "A small step, a major milestone" on