SFDR and the New Principal Adverse Impact statements

This blog is about the new SFDR (Sustainable Finance Disclosures Regulation) requirements coming online next week in the EU and the Principal Adverse Impact statements that financial market participants are being asked to prepare.

But first, there is a detour that we’d like to take by examining problems and solutions in a broad sense.

Opportunity and Edges

Opportunities exist at the edges of things. In the context of Climate Change, the edge is already here. We are living in it every day, witnessing the effects of a global climate “weirding.”

The opportunities in this edge are plentiful: is there a better way to reduce carbon intensity? Probably. Hundreds of solutions are being explored simultaneously, luckily,  all around the world. Which ones will catch on? Which ones will scale? Difficult to predict at this point.

In the context of social change, current American events are VERY “edgy.” A contested election, multiple active mass protest movements, political divisiveness online and in the actual government. Again, hundreds of solutions are being explored, from the increasing number of highly paid D&I executives to the newly established councils and hiring programs for underrepresented groups.

Recent examples from inside Big Tech point to the friction created when employees tasked with creating change make more change than the company bargained for. But of course, change can be painful, right?

Solutions are the End, not the Beginning

The world is very “solution-oriented” right now. In the US, we are playing catch-up with the Paris Climate accords. The SEC recently expressed interest in additional regulatory frameworks for carbon intensity assessment. How will companies get there? Step-by-step, innovation will continue to fuel the solutions industry.

But if we pause for a moment in all this array of problem-solving, there is a moment where we can ask this question:

How much do we actually know about the problems?

Can an investor today accurately invest based on boardroom diversity, for instance? That could be a tremendous thematic effort at changing companies from the top down. But you can’t do that today. Only partially. It’s a hopeful solution to a specific social problem, but not enough companies report board diversity information, at least, not in an easy to consume sort of way.

In fact, do you know how many of the Fortune 500 report detailed demographics of their employees? The answer is less than you think. In our analysis, around half report this detail.

Insufficient Knowledge of Problems Makes Progress Challenging

At this stage, no solution to diversity in the workplace and equity in employment can accurately measure its progress. We don’t even have accurate statistics reported at scale about workforce diversity. As an investor, how can you measure success towards that goal if you don’t know the starting point? How can you even establish a plan?

It is a problem that there is a lack of information. As a metaphor: To apply first aid, you have to determine the cause, location, extent of the injury. Today we have a backpack full of splints and bandages, but we don’t even know how many wounded there are. So to speak.

Reality Exists Even If Data Does Not

Can an investor today accurately invest thematically in large companies that are climate positive? Not possible because most large companies do not disclose audited environmental impact statements. Those who do produce disclosures post them to their websites, where they are lumped in with other marketing collateral.

Climate change is not a perception problem. It is an actual problem. Whether or not we know the number today or estimate it, there is an actual number representing a company’s carbon intensity.

Today, investors have their pick of these kinds of numbers, ratings, analytics, proprietary reports. So many, too many to count, more being developed every day. They get prepared and sold to investment companies, but the transparency is sorely lacking.

Where does the data come from for these ratings? How many metrics analyze the same CSR report and come to different conclusions? How many providers analyze the same basket of companies and rate them very differently? Rating dispersion and transparency are significant problems in ESG data today.

Revenue is Complicated  – but Consistent

It is not difficult to find out how much revenue a large company generates. It may have been difficult at one point, but market demand and new technology have made it relatively easy, even to compare across different companies and industries.

There are potentially millions of data points, if not more, required to report annual revenue for a multinational corporation accurately. Every sale, every product line, every billing date, these all factor into that one number.

However, the methodologies that produce that number are audited. Well established, agreed upon, maybe slightly different between different industries, but at least the methodologies are firmly defined. If two different auditors approach a company’s GAAP-compliant financial filings and come to widely different results, that’s a problem.

Increasing Quality ESG Disclosures

Which brings us back around to the original purpose of this blog, to look at the new SFDR and Principal Adverse Impact (PAI) statement regulations in the EU. Starting next week, financial market participants will be tasked with finding out the answers to some of the questions posed above.

The PAI requirement is actually a great place to start. How much do we know today about ESG related impacts of investments? If you invest based on any number of available ETFs or Index funds that track “highly rated” companies, you know a lot less than would be ideal.

The SFDR requirements are putting a lot of responsibility on financial market participants, creating all kinds of problems. How do you represent as a ratio the extent of wastewater pollution that negatively affects biodiversity in your basket of companies? That’s a problem.

What Do We Know, and How Do We Know It?

So you can’t measure the success of a solution until you can measure the extent of a problem. Which companies report which data, which global taxonomy was used? What is the quality assurance process? What is the level of transparency into the underlying holdings?

The problem only becomes more complicated when discussing companies with many lines of business. One company may have renewable energy powered data centers at scale but may source materials or labor for other products in highly problematic ways. That company could end up in a green index, even though the net impact is to destroy important ecosystems further, or contribute to externalized opaque labor practices.

Or is it? We can’t assess the net impact because sufficient audited disclosures with rigorous taxonomies and transparent methodologies do not exist. Yet.

The Status Quo is Changing Quickly

That does not mean that nothing exists. Quite the contrary, a considerable amount of data exists today on these issues. The problem is that most investors are one step removed from that data through the means of a green index or a sustainability report.

Directly assessing the actual nature of your investment impact according to some far away exemplary ideal of a well-audited ESG report filed with a regulator, is not the only solution available today.

How We See It

At idaciti, we are fully committed to working at the edges of things. We use an XBRL-first methodology to approach problems with a technological lens. We can provide answers to some of these questions, as they exist today. And we can also provide a better idea of the problems themselves – because we are not looking only for solutions.

Our backpacks are also filled with splints and bandages, but we know the first step is to assess. Assess the problems accurately, and you can remove roadblocks on the path to a more sustainable future. Transparency is baked into our framework because we primarily source information from official SEC filings and never provide a data point without metadata that gives its exact location in the source document.

Please feel free to comment on this post; we’d love to hear what you think. These are rapidly changing times, and we are actively engaging in them. More diversity of opinions and perspectives can only help to see where problems still exist. And only then, can we solve them, together.

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