The European Commission is putting a blanket ban on the reporting of derivatives as visible elements of sustainable investment products from next year under recently adopted rules.
The move is likely to be a blow to any fund that currently uses futures, options or swaps as part of a sustainable investment strategy.
A synthetic ETF that tracks an ESG index, for example, will have to report zero sustainable investments while a similar product using physical replication of the index will be able to report 100% sustainable investments.
“It is a strange decision to say all derivatives are excluded without exception,” said Olivier Van den broeke, a senior associate at law firm Baker Mckenzie in Antwerp. “It seems that the European Commission has taken an overly prudent position by carving out all derivatives, while there are good arguments to be made for including derivatives when they are intended for hedging purposes of investments in taxonomy-aligned economic activities.”
Last Wednesday the EC adopted long-awaited technical standards of the Sustainable Finance Disclosures Regulations (SFDR), setting out the exact content, methodology and presentation of the information to be disclosed.
These revealed that physical securities, included securitised assets and infrastructure, could be included in pre-contractual and periodic disclosures to clients in a pictorial representation of the fraction of sustainable elements within a strategy.
But there is no place in the top half – the numerator – of the fraction for derivatives. The official text said: “Due to the lack of reliable methodologies to determine to what extent exposures achieved through derivatives are exposures to environmentally sustainable economic activities, such exposures should not be included in the numerator. The denominator should consist of the market value of all investments.”
“I think it’s almost culpable to exclude derivatives from all relevant disclosures”
Ulf Fullgräf, director of Hamburg-based Alpha Centauri
Ulf Fullgräf, director of Hamburg-based Alpha Centauri, which runs a climate smart long/short low carbon strategy, said the Commission’s thinking didn’t make sense to him.
“If you leave out derivatives, investors might be exposed to unintended or hidden risk factors,” he said. “If for example a fund chooses to hedge carbon exposure by shorting energy stocks via a sector future, it is the identical position economically to an underweighting or exclusion. In this case, two funds with a comparable economic exposure will produce different reports.”
Fullgräf said that climate risk is investment risk. “I think it’s almost culpable to exclude derivatives from all relevant disclosures.”
Craig Bisson, a partner at law firm, Simmons & Simmons, in London said that the approach taken by the final text went against the advocacy of the derivatives industry.
“The exclusion may disincentivise the use of sustainability-linked derivatives in affected products – as their use would have a negative impact on the Taxonomy-alignment ratio,” he said. “In turn, this might reduce the availability of funding for Taxonomy-aligned investments.”
Bisson said the European Supervisory Authorities (ESAs) have previously acknowledged that their position on this is “out of an abundance of prudence”.
Bisson and Van den broeke both reckoned there was hope that the ESAs will revisit their position on this in due course, once relevant methodologies have gained traction and acceptance, “but that may be some time off,” said Bisson.
Van den broeke said that for his clients, such as asset managers launching funds in the Benelux region, there is currently still a great deal of legal uncertainty around the practical implementation of SFDR and how it is likely to be enforced.
“There are many grey areas of the law. Even the FSMA – Belgium’s financial regulator – doesn’t have all the answers yet,” he said.
The European Parliament and the European Council now have three months to object to the standards the Commission adopted, after which the technical standards will become official legislation.