Investing tradition has it that portfolio managers focus their attention on strictly financial metrics. EPS, debt to equity ratios and dividend yield are a few notable ones, but investment advisors also tend to keep a keen eye on macroeconomic indicators such as EURIBOR rates or quarterly labour data.

On 10th March 2021, financial market participants woke up to new mandatory Environmental, Social and Governance (ESG) disclosure obligations imposed on them by the SFDR. These regulations are meant to break with this tradition, shedding light on the fact that a sustainability dimension must be added to the classical financial considerations.

More than two years have now passed since the first implementation round of the Sustainable Finance Disclosure Regulation (SFDR) and some investors are still not sure whether they should care.

IR magazine reported earlier this year that a study conducted by product provider GraniteShares showed that more than half of the 1,070 UK-based retail investors (51 per cent) did not pay attention to ESG ratings and 15 per cent of them were not able to quantify the impact of said ratings.

The evidence in favour of sustainable investing keeps rolling in, however. On July 2022 Reuters reported how “stock funds outperformed across global markets” over the previous five years “if they were weighted toward companies with positive environmental, social and governance (ESG) scores.” Investment giants JP Morgan are adamant that “smart ESG investing could help boost portfolio returns.” The company explained how “companies that outperform on ESG factors (so called ESG leaders) often become more competitive than their peers by more efficiently using company resources, effectively managing human capital and strengthening supply chains.”

Investors whose funds are invested in climate change sensitive portfolios should also be wary. A 2021 study that appeared in Nature found that 90 per cent of coal and 60 per cent of oil and natural gas must remain untapped if global warming is to be capped at 1.5 degrees Celsius above preindustrial levels. The implication for investors is that as the world divests from polluting activities in alignment with the Paris Agreement any investments in fossil fuel companies risk the prospect of significant losses as assets tied up to these companies end up stranded.

As always, transitioning is never easy, especially since there are various disclosure levels and categories that financial practitioners must keep in mind. Level I of the SFDR requires firms to “describe the manner in which sustainability risks are integrated in their investment or assurance advice and the result of the assessment of the likely impacts of sustainability risks on the returns on financial products they advise on.” If firms deem sustainability risks not relevant to them financial advisers are required to “include a clear and concise explanation of the reasons therefore.”

Sustainable Investment experts Robeco explain in their website how SFDR classifies companies in three categories:

• Article six funds: those that do not promote their environmental social or governance (ESG) characteristics.
• Article eight funds: where a financial product 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.
• Article nine funds: where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark.

More requirements followed. As of 2nd August 2022, financial market participants are required to take into consideration and integrate clients’ preferences on sustainability in addition to the usual risk appetite metrics. On 6th April 2022 the European Commission introduced technical standards that must be used by financial market participants when disclosing information related to sustainability under the SFDR. These requirements, known as SFDR level two, started to apply on 1st January 2023.  The aim of this second phase is to protect investors against potential greenwashing. 

In its Supervision Priorities document, the Malta Financial Services Authority (MFSA) listed Sustainable Finance as a “High-Level supervisory priority for 2023.” In the report, the MFSA noted that a working group has been established in the field of climate change and sustainable finance.

With respect to banks, they will be “expected to integrate climate change and environmental risks in their governance and risk management approach.” The MFSA will also be asking them to “set out key aspects of their plans for integrating climate change and environmental risk into their governance and risk management approach. “When it comes to the capital markets and investments sector, the document details how the “MFSA is monitoring developments with respect to green bonds, which have a material role in financing assets required for the low-carbon transition,” as well as “monitoring of compliance with the SFDR and the related technical stands.”