In April 2021, the Sustainable Finance Disclosure Regulation (SFDR) was proposed and accepted in the European Union. This regulation mandates the disclosure of information about sustainability of the products offered by financial institutions. In this blog our colleagues Rafael and Joost briefly discuss the SFDR and its implications for Private Equity organisations (PE’s).

The main question to start this discussion with: are current ESG methodologies sufficient to comply with the SFDR?

This does not seem to be the case. The aim of this regulation is to further integrate sustainability in the broad community of investors. The ‘conventional’ ESG methodology seems to be insufficient in two different aspects: primary impact statements and double materiality

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  1. Primary impact statements
  2. Double materiality
  3. Now what?
Rafael LCA

Rafael
Junior Sustainability Expert

Joost LCA

Joost
Founder
Chief environmental compliance

What are these primary impact statements?

The primary impact statements are part of the Principal Adverse Sustainability Impact Statements (PAIS). These mandatory indicators are divided in two main groups: 

  • 9 environment related indicators and 
  • 5 mandatory social and employee, respect for human rights, anti-corruption and anti-bribery indicators. 

In addition there are:

  • 2 specific indicators related to investments in sovereigns and supranationals and 
  • 2 specifically related to real estate investments. 

On top of these mandatory factors, financial market participants (FMPs) are required to choose two additional indicators:

  • One environmental indicator out of a list of 22
  • One social indicator out of 24 listed indicators. 


Currently, data to disclose the information demanded by the PAIS are mostly absent within companies interesting for PE’s. ESG has focused on the data available ‘out there’ with big data analysis. Now, under the SFDR and CSRD this data will have to be created bottom up, from the companies itself. Hedgehog Company creates this data using organisational footprinting within these companies.

Hence, these PAIS will bring structure in the current maze of ESG methods. Currently, any ESG consultant handles different categories and weighting factors in their E, S and G quantifications.

ESG

Double materiality?

Current ESG methods focus largely on the risks imposed on the organisation by ESG factors. Double materiality entails that the effects of the organisation on the environment needs to be calculated and disclosed in reporting. For example, the formula for calculating the carbon footprint of an FMP, stated on the right, is as follows [1].

To calculate its complete portfolio footprint, the FMPs benefit from data disclosures in their portfolio. For PEs, for example, this means environmental monitoring like organisational footprinting for all their investee companies. With these monitoring programs, in combination with a clear sustainable strategy, PEs can realize a headstart on SFDR compliance for themselves and CSRD compliance for all their investee companies.

Carbon footprint of portfolio

What happens if you, as a PE portfolio manager, ask for our support?

For all FMPs, generating the necessary data to comply with the PAIS can seem nearly impossible. The LCA team of Hedgehog Company consists of experts on performing organisational LCAs in both SMEs and corporates. Hence, especially for PEs we are the perfect partner in becoming compliant with SFDR and becoming a sustainable investment company.

In addition to SFDR compliance there are more benefits to be achieved. There is more and more consensus on the notion that environmental performance increases financial performance [2]. Our continuous monitoring system ensures we can effectively thrive corporate’s sustainability performance in your portfolio. In this way we can stimulate the enterprise value before the investee company is sold. A win for the climate and a win for the investors! 

Moreover, generating these sustainability data points creates the relevant parameters for investors to be able to engage in active ownership. The investors in your portfolio have access to real sustainability data of the companies in your portfolio. Not the ‘average, big data points’ generated by ESG ratings. 

Finally, we achieve better environmental performance for investors in the portfolio without having to change the configuration of the portfolio. After all, kicking-out bad performers from your portfolio does not lead to a reduced investment risk as a result of climate change; outside your portfolio, such companies will continue with their business as usual. Hence, for PE it is better to stimulate their investee companies in the transition towards sustainable performance to reduce perceived investment risk [3]. Check also for more information our PE page here.

1. https://www.esma.europa.eu/sites/default/files/library/jc_2021_03_joint_esas_final_report_on_rts_under_sfdr.pdf

2. https://www.blackrock.com/us/financial-professionals/insights/sustainability-letter.

3. https://www.blackrock.com/institutions/en-nl/insights/portfolio-design/turning-climate-risk-into-opportunity