Exegesis is usually reserved for religious scholars trying to extract the last drop of meaning from sacred texts. Most of the sacred texts of the ESG are accompanied by detailed instructions on how to understand the words. Not so with two lines of the SFDR Article 6 – the clause containing an opt-out for investment product providers to avoid handling sustainability risks. Given the number of reactions we received to our article of 26 June, it appears there is a need for further clarification.
Particularly since about half of the investment funds in Luxembourg have no intention of transforming themselves into Article 8 or 9 Funds.
The Article 6 opt-out clause contains the wording that if sustainability risks are “deemed not to be relevant”, no specific steps need to be taken to mitigate or avoid sustainability risks.
Publishing a “clear and concise” explanation for not handling the risks is sufficient.
The two words “deemed” and “not relevant” are important. But they are not explained in the Hadith of the SDFR, the SFDR Level regulation 2022/1288. So let us try with some triangulation.
The verb “deem” refers to the act of regarding or considering in a specific way. It often implies a judgment or evaluation that has been reached after some level of thought or consideration. Such deliberative reasoning is a process of carefully thinking through all the aspects of a situation, often with an emphasis on logic and rational thought. It may involve weighing evidence, considering different viewpoints, and predicting potential outcomes.
The concept of “not relevant” in SFDR Article 6 aligns with the concept of “immateriality” used in risk management.
Immaterial risks are those considered to have minimal impact or significance within the specific context of the investment fund’s objectives and outcomes. Similarly, risks deemed “not relevant” within the context of SFDR are those that are considered of minimal significance, ie. immaterial, and may not require explicit disclosure or dedicated management efforts.
While the terms “not relevant” and “immaterial” are not explicitly synonymous, they share the underlying idea that some risks may have minimal impact or relevance within the specific context of an investment fund.
Whether a specific (type of) risk is not relevant or immaterial is based on a systematic assessment process that considers factors such as the potential impact on financial performance, stakeholder expectations, reputation and regulatory requirements.
In conclusion: to opt out of managing sustainability risks, a fund provider needs to engage in a systematic and deliberative process to determine if sustainability risks are immaterial to a given financial product.
Describing this process leads then leads to the “clear and concise” explanation required in Article 6. Unfortunately, that is another wording where no guidance has been published (please DM us if we are wrong).
Because the SFDR was presented before all the technical details were made clear, many organisations have treated its implementation as an exercise best handled by marketing, compliance and legal staff.
Portfolio managers and risk specialists have been thin on the ground in shaping ESG implementations. This may explain why the Article 6 opt-out clause is widely considered a get-out-of-jail-free card for many fund providers who do not want to deal with ESG. At. All.
To those unfamiliar with the first principles of risk management in investment products, there are some basic steps involved:
- Identify the risks.
- Evaluate their impact on the investment in case the risks materialise.
- Estimate the probability of the occurrence.
- Assess the overall impact, financial and otherwise on the investment, by combining the severity and the probability.
If – after going through these steps – the risk or risk category may be deemed immaterial, and hence it can be deemed “not relevant”.
This could very well be no less than the content of the “clear and concise” statement a product provider needs to present when opting out of managing sustainability risks otherwise required in Article 6 of the SFDR (as well as in the AIFM regulation 2021/1255 and the UCITS directive 2021/1270).
It is not complicated. Unless of course you have never managed a portfolio or worked as a risk manager. In that case, you may need assistance from people who know about portfolio management or risk management to reach the goal.
Contact Katia Ciesielska, Carsten SALEWSKI, Frank Dan Jensen or Kim Asger Olsen to hear how Origo Consulting can help you.
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