This article is sponsored by Gravis Capital Management
Working with evolving regulation requires a spirit of collaboration. Created as a tool to improve transparency for sustainable investment products to facilitate investors comparing funds, and to prevent greenwashing, there are many ways that LPs and GPs can work together to maximise benefits from the Sustainable Finance Disclosure Regulation and EU Taxonomy (together, the ‘Regulations’).
LPs are actively approaching GPs seeking investment products with a more sustainable focus, while many GPs, after initial enthusiasm, are taking a conservative approach, avoiding overcommitting while a detailed application of the Regulations to infrastructure is developed. As the Regulations set out separate, interlinked frameworks, supplemented by detailed regulatory technical standards, they have become a maze to navigate – both for GPs making disclosures and LPs looking to allocate capital and meet their own reporting requirements.
“In formulating and reviewing disclosures, GPs and LPs must consider the complete investment chain”
The Regulations have marked a sea change for GPs focused on sustainability-aligned funds established or marketed in the EU, requiring integration into the asset management process with cross-discipline collaboration needed to meet regulatory and LP requirements. GPs, having completed their fund offering memoranda ‘SFDR Annex 2’ – including the requirements, or scoring basis, for assessing whether potential investments meet the fund sustainability requirements – are now advanced in the ‘level 2’ requirements, collating data this year to report how each fund has done against its sustainability objectives. They have also considered ‘principal adverse impact’ and ‘do no significant harm’ disclosure requirements.
Some LPs are now subject to their own regulatory requirements to invest in sustainability-focused funds, and need to report on them, requiring GPs to report transparently to LPs.
Navigating the maze
Challenges include that the Regulations were adopted at different points in time, seeking to apply to all asset classes, albeit with greater consideration of multiple asset classes in the Taxonomy. Further guidance on application in the regulatory technical standards, which are in part still being developed, will aid both GPs and LPs.
Another difficulty for investors in infrastructure is determining if, or when, funds may fall within SFDR Article 9 – having sustainability as the fund’s objective and making sustainable investments – as opposed to SFDR Article 8, which covers a broader range of funds promoting environmental or social characteristics with no, or some, sustainable investments through to the threshold with Article 9.
What is a sustainable investment?
A simple question. However, SFDR and Taxonomy have slightly different definitions of sustainable investment. Some GPs have developed their own definition of sustainable investment, making it challenging for LPs to get a clear sense of comparability between funds.
The EU’s ambition of increasing sustainable investment transparency is to be lauded, but it would be too easy to solely focus on the challenges that GPs and LPs currently face in navigating the evolving regulations. It is important that GPs and LPs collaborate with each other and the regulators in improving the current regime and making a success of it.
Data comparability is key
True comparability will require data-focused criteria with clear parameters of project outputs and protections from doing harm. There is currently too much room for interpretation within existing disclosures which tend towards statements. This is where initiatives like the ESG Data Convergence Initiative play an important role in helping to agree on standardised sets of ESG metrics and comparative reporting mechanisms that can be applied throughout the entire supply chain of the investment process.
Global data analysis providers have all moved at speed to develop systems for analysing and assessing funds focused on sustainability. The Regulations include an element of good governance in addition to environmental and social disclosures, which causes an issue for some infrastructure funds, in particular debt-focused funds. To assess good governance, questions may be employee related, for example around gender and racial diversity. If you have no employees, does ‘not applicable’ result in a nil score for this question? Many providers are working closely with GPs and LPs to refine their assessment tools to aid in data comparability across asset classes.
Understanding the entire investment chain
In formulating and reviewing disclosures, GPs and LPs must consider the complete investment chain. For example, investment opportunities in batteries that require high-risk raw materials sourced through a supply chain several steps removed from the transaction documentation in the country of implementation represent a sustainable investment predicament, despite their contribution to transition efforts.
The Taxonomy focuses on the responsible recycling of materials, but less so on best practice in procurement. Moving towards sustainable procurement practices requires investors to ask questions to drive change.
GPs should draw on LPs’ expertise
LPs can really help GPs develop their responses to these disclosures. There are many LPs with a long history of ESG focus, including pension funds, national and supra-national investment banks and funds that can constructively influence thorough and detailed disclosures and processes which recognise the blend of impact factors required to make incremental progress on sustainability focused investments.
This collaboration process should happen both as part of LP due diligence processes and in wider industry forums.
On the flipside, GPs and regulators must continue to educate investors that the SFDR was not conceived as a labelling regime. The classification of a fund as Article 8 or Article 9 should not be determinative for allocation purposes. It is quite likely that some of the most impactful changes will be delivered by Article 8 funds creating value through investing in transition assets or greening their underlying assets over time.
Engaging with policymakers and regulators
The EU framework continues to evolve, and GPs and LPs have a real opportunity to shape its future direction. Take the Social Taxonomy that is being developed: this is of real importance in the renewables and infrastructure sector, where we are seeing an increased emphasis on delivering a just transition that considers the creation of new job opportunities and the mitigation of job losses in polluting industries.
There is also an opportunity to further refine the existing framework.
A collaborative approach
The SFDR and Taxonomy are showing a great deal of promise that they can become useful tools for regulators, LPs and GPs, but more consistency and clarity is needed. In the meantime, LPs and GPs have much to gain from working together to align their understanding of data and to standardise and condense information requested from portfolio companies. This will ultimately enable GPs to deliver the investment strategies that LPs demand and deliver financial returns and positive change.
Net-zero transition funds serve an important purpose, but can fall into a regulatory blind spot
The European Securities and Markets Authority has indicated that impact funds focused on transitioning assets from “brown to green” may not be Article 9 funds. Article 9 requires investing in investments that already qualify as sustainable. Whilst formal guidance on this point is awaited, this also raises important points in the infrastructure investment space.
Gravis has been investing in nascent infrastructure sectors for over a decade, being an early investor in offshore wind, Anaerobic Digestion and battery storage, for example, and has recently commenced work on a net-zero-focused fund that will invest in infrastructure that accelerates the transition to net zero across the areas of the economy with the greatest emissions. These include energy transition, transport, circular economy, food production, carbon sequestration and carbon capture and storage.
Wind energy, using miscanthus to create sustainable packaging, converting biogas to green hydrogen, and battery storage – on the face of it, these are sustainable investments, once operational. Where assets are being transitioned to a new purpose, such as projects to repurpose oil wells for CO2 storage, these investments appear akin to retrofitting buildings, and are only classed as sustainable once in repurposed operation.
However, in Germany, financial regulatory authority BaFin has accepted some real estate funds focused on retrofitting as disclosing in accordance with Article 9. There is no indication yet of the Luxembourg and Irish regulators applying this approach to funds that transition assets. Consequently, many GPs investing in infrastructure and transitioning assets have decided to disclose in accordance with Article 8 and monitor investments and regulatory developments, with the potential to disclose in accordance with Article 9 once assets are operational, or have transitioned.
GPs want to avoid the reputational risk, and potential regulatory risk, of moving from Article 9 disclosures to Article 8 disclosures. Transparent communication with LPs will demonstrate the benefit of investing in transition-focused funds.