Teething problems: Data difficulties overshadow inaugural sustainability disclosures

The first compulsory periodic reports under the EU’s Sustainable Finance Disclosure Regulation (SFDR) are due on June 30, requiring investors to complete and publish a template on the sustainability profile of their investments held during the 2022 calendar year.

The template, known as Annex I, prescribes 14 core principal adverse impact (PAI) indicators that investors must report on, as well as a list of voluntary indicators. The mandatory fields include carbon footprint and emissions to water, as well as social indicators such as board gender diversity.

There are two primary challenges, and while not difficult to understand, they are difficult to address. First, much of the data that would fill the PAI indicators is challenging to source and often unstructured. Additionally, regulators have moved the goal line for compliance several times.

“It is extremely important to get this topic right, and it is potentially an excellent way to clarify the intentions of asset managers and ensure alignment with investors. But it could also become a headache. Right now, we are somewhere in between the two,” says Karine Hirn, chief sustainability officer at East Capital Group. “It feels like we’re constantly running, but the ball keeps being kicked just out of reach. Of course, you don’t want to lag behind, but it doesn’t make sense to be too far ahead of the pack either. Because you don’t want to waste resources on research and implementation when these details could still easily change.”

Hirn has a deep understanding of the challenges of sourcing ESG data. With investments in emerging and frontier economies, Hirn says the Stockholm-based asset manager could not have weathered 25 years in the industry without a firm handle on topics like corporate governance risk, the quality of owners, and minority shareholders’ rights.

“We wanted to quantify ESG risks and opportunities. But when we looked into how we could do that, we felt that there was no proper coverage of the companies we were investing in from ESG vendors,” Hirn says.

To be fair to the data providers, the paperwork is also piling up for them. Eric Weitzman, senior director for regulatory solutions product development at FactSet, says it is not uncommon for him to receive 80 emails a day from a single client with questions about the PAI indicators. “It’s often a scramble to plug in the missing data elements. I regularly hear, ‘Uh-oh, we didn’t account for this type of security,’ or ‘We’re missing an enterprise value on X,’” he says.

At the same time, many companies still do not regularly disclose information on their sustainability profile. In the EU, the current corporate reporting scheme in place for ESG (the Non-Financial Reporting Directive) only applies to the roughly 12,000 listed companies that employ over 500 people. And even they are not required to disclose all of the data found in the PAI indicators.

For funds investing in private companies—particularly those in less developed markets—the likelihood of getting reliable data on the PAI indicators is even lower.

“Things like human rights and supply chain are particularly tricky. Some companies will have great data; others will be terrible. And then you get into places like China—can you have an Article 8 China fund? I’m not sure you can,” says an ESG professional at a large asset manager, referring to a fund under SFDR that “promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices.”

Funds that cannot source ESG data from a vendor or directly from their investees run up against a lack of guidance on precisely how the numbers should be crunched.

Peder Michael Pruzan-Jorgensen, co-founder and director of specialized sustainability consultancy Raison Consulting, explains that PAI indicators do not come with very detailed accounting protocols. “For some of the indicators, it’s not entirely clear what is actually being asked for,” Pruzan-Jorgensen says.

As a result, funds may have to avail themselves of the N/A option for some fields in Annex I, at least for this first set of periodic reports. “I think we will see that many of them only have partial data. They will not have full datasets from their investees,” Pruzan-Jorgensen adds.

Hirn agrees with this assessment, adding that some asset managers may resort to conjecture. “There’s very little information out there on some PAIs, so there will be estimates instead. I suspect that there’s a bit of wild guessing going on,” she says.

Green machine

With the reporting deadline looming, it is easy to lose sight of the bigger picture. The SFDR is only one cog in an elaborate legislative mechanism that is slowly clicking into gear, and will soon start churning out ESG data.

The EU Taxonomy, which came into force in July 2020, defines environmentally sustainable economic activities. It is a key reference point for both the SFDR and the Corporate Sustainability Reporting Directive (CSRD), which will soon widen the net so that more than 50,000 EU companies will have to report on their PAI indicators, among other things.

The idea is that the EU Taxonomy, the CSRD, and the SFDR will work in concert to drag in more and more entities from the peripheries of the market. While many companies with fewer than 250 employees will remain exempt from reporting obligations under the next stage of the CSRD, they will likely still have to put in place data collection, consolidation, and reporting processes as a consequence of having investors that need to consume that data for SFDR disclosures.

“Those three frameworks combined are going to raise the bar on both corporates and investors in a lift that I don’t think we’ve seen at any moment in corporate sustainability. And of course, it’s also causing a number of challenges for everyone involved,” Pruzan-Jorgensen says.

Faced with this proliferation of data, some firms have turned to vendors for help. There’s a swath of providers that offer a service that scrapes data for PAI indicators from public sources such as annual reports, websites, and income statements. This can reduce a lot of the legwork when it comes to filling in Annex I.

Chantal Mantovani, product manager for regtech and fixed income at technology provider Confluence, says the PAI indicators can prescribe 50 to 60 data points for some investors. “Each of these points is a matrix because it has to be available also at the fund level, where the fund is just one security within the broader portfolio.” When a fund’s holdings include a fund of funds, the workload is doubled.

But vendors typically provide an ESG profile for the issuer, whereas funds hold only securities, not the entire company. Confluence’s data management layer can translate a metric provided by any vendor from the issuer level to the security level. It can also provide a full look through on mutual funds and ETFs, deconstructing the instruments in the fund in order to re-aggregate the constituents from the bottom up.

The challenge is particularly acute for private markets, where investees may not have historically had the data collection or the policies in place to effectively report on the various indicators.

“Public markets rely extensively on third-party providers. And where data does not exist, these providers may send questionnaires to their investees and ask them to fill in the data. But when you look at private markets, many of them are not covered by these vendors,” Pruzan-Jorgensen says. Instead, some funds with investments in private markets are attempting to collect the data from their portfolio companies (PCs) directly. “They may use an ESG data management platform to facilitate the data collection from companies, but such platforms mostly just assist data reporting from the PC to the fund. The PCs still need to find a way to collect credible data internally,” he adds.

For such firms, it is often greenhouse gas emissions that raise the most questions, according to Pruzan-Jorgensen. Calculating a footprint is a big undertaking, which requires a thorough understanding of scope three emissions. A report by MSCI found that the provider’s ESG ratings-coverage universe could provide a scope three emissions PAI indicator for only 27% of companies, compared to 95% for scope one.

Smaller investees in private markets tend to lack the personnel for such calculations as well as the leverage to get good data from their multinational suppliers on things like capital investments or transport. Increasingly, firms are signing up to carbon calculators to get an estimated footprint, Pruzan-Jorgensen says.

Nor do the softer data points pose any less of a challenge. One of the most difficult PAI indicators to get right is violations of the UN Global Compact principles and the OECD Guidelines for Multinational Enterprises, according to FactSet’s Weitzman.

“Those guiding principles are not binding laws. How do you violate something that’s not a law? We all have to interpret what that means. Say you have four vendors: Each may have a definition and a clear methodology, but you can still get four different numbers on whether a company has triggered that violation or not based on if a lawsuit was filed, if there was an accusation, if the company admitted wrongdoing,” Weitzman says.

Some funds use dozens of different vendors to get the most exhaustive view of their portfolio available. But this only creates a new problem: How do you consistently piece together a set of indicators produced using dozens of different methodologies?

For Mantovani, the amount of possible permutations arising from one of the ways that a single metric can be interpreted, implemented, and proxied makes this a uniquely intractable challenge. “This might just be the most complex problem to solve in the whole industry. When you start playing with different vendors, you say, ‘Is this correct, or is it this?’ This one says 3 million, this one says 3.5 million. Should I be conservative? Should I average the results? Maybe this was derived in a different way to the other?’ Imagine this on a much larger scale, with different vendors, different portfolios, and different asset managers within the broader industry. There’s a lot of mess, a lot of confusion,” she says.

Reading between the lines

As previously noted, the availability of data is not the only obstacle that beleaguered fund managers will need to negotiate by June 30. With scarce guidance from regulators, asset managers are struggling to interpret what are the precise requirements on them.

“At a meeting just a month ago in Sweden, people were still debating whether we should use the end-of-year data or quarterly data for PAIs. The outcome could be quite different depending on which one you use, but people simply don’t know,” East Capital Group’s Hirn says.

It is also unclear how derivatives and green bonds should be accounted for, and whether some PAI indicators should give absolute numbers or proportions relative to peers.

Meanwhile, funds are still waiting for regulators in different countries to issue Q&As and clarify lingering uncertainties.

For the first set of reports, the PAI indicators table will also come with a column for explanations, allowing funds to show their approach. “We’re likely to see a lot of explanations for the first year, showing that best efforts were made even where data was unavailable. And I think the regulators are going to be pretty lenient for this first go-around,” FactSet’s Weitzman says.

ESG and compliance professionals will be cheered by the news in May that lawmakers from the European Council and the European Parliament struck a provisional agreement on a future European Single Access Point (Esap). The platform, which should be available from 2027, will serve as a central digital access point for information reported by both companies and investment products in the EU. SFDR data is set to be included on the platform from January 2028.

In the meantime, however, funds must get thoroughly acquainted with the current system and all its quirks. The number of PAI indicators is only set to proliferate. In April, the European supervisory authorities jointly published a consultation paper promising to “extend and simplify” the SFDR. Among a host of proposed changes, the paper puts forward two new PAI indicators, which industry insiders say are likely to be adopted.

East Capital Group tries to keep ahead of the curve by assigning ESG momentum scores to holdings, taking into account ESG topics where there could be a change in the next 18 months. Even with a proactive approach and much of the data to hand, however, Hirn finds that the SFDR reporting can be very time-consuming. “My biggest frustration is that it’s hard to find time to do other things which I think would have more real-world impact—such as active ownership and engagement. Instead, a lot of effort goes into this reporting,” she says.

Europe is still a long way from having a common and achievable set of reporting standards among investors for sustainability considerations. The SFDR disclosures in June are bound to reveal huge variations in the quality and depth of ESG data sourced by different firms. But expectations are key: However patchy the results, June 30 will represent a starting point in a gradual process of industry alignment which is, after all, a world first.

Hirn concurs. “I think we need to wait—practice makes perfect. It will get easier. Definitely. … I hope.”