By Shayla Colon
June 14, 2023
Real assets managers and other private market participants are stumbling upon hurdles as they attempt to comply with Europe’s sustainable disclosure rule regime.
Since the European Securities and Market Authority developed the Sustainable Finance Disclosure Regulations, or SFDR, framework, last decade and came online with a first phase of deadlines in 2021, managers have struggled to ensure they’re compliant.
An analysis from the European Association for Investors in Non-Listed Real Estate Vehicles, or INREV, conducted an in-depth survey of 10 investors and managers and found that many believe complying with these rules “takes considerable mental agility.”
While managers said the framework is a push in the right direction, they also expressed fear that SFDR, in its current form, could have a variety of “unintended and potentially detrimental” consequences for real estate and the pace of decarbonization efforts, the report stated.
Managers also have great concern over the “cost burden” of SFDR compliance, as well as the legal and management resources required to integrate new systems, the INREV paper said.
As a result, SFDR has been a challenge for most managers and funds in the market, said Tamara Close, founder of Close Group Consulting.
Market participants initially welcomed the regulation in hopes that it would make environmental, social and governance, or ESG, evaluation schemes easier to compare for real asset funds, she said. However, managers soon found that gathering data for the disclosures can be an obstacle, particularly as it applies to real estate.
The industry is trying to make its concerns known. Managers and other industry participants on an SFDR working group recently authored a paper outlining the most pressing issues real estate managers face to achieve disclosure and potential solutions. The group includes members from several industry organizations, including INREV and the Association of Real Estate Funds, and has individual working group members hailing from the real estate arms at Nuveen, PGIM and DWS, as well as Apex Group, a fund administrator.
The group highlighted challenges such as differing calculation methodologies, inconsistencies with energy performance certificate ratings, uneven treatment of energy-inefficient assets and confusion around what should be considered to measure exposure to fossil fuels.
For instance, disclosures regarding exposure to energy-inefficient assets concentrate on a “snapshot” of the current operational sustainability of underlying assets, rather than an asset owner’s desire or progress to transition them, according to the paper.
“Typically, a building would be sold when this program of activity is complete, and therefore the manager who undertakes this activity would not be recognized as engaging in sustainable activity,” it said. “On account of the real estate investment lifecycle, this means that any core plus, value add or opportunistic real estate asset would not be likely to be categorized as a sustainable investment.”
Consequently, the regulations don’t “promote investment capital toward this necessary transition,” and instead encourage managers to dispose of existing inefficient assets without improving them, the paper stated. The group’s members advocated for improvements to the framework that recognizes how investing in real estate can spark investment to make assets sustainable under SFDR.
The group also said the regulation’s definition of “inefficient” real estate was “overly complicated and unworkable,” with a separate methodology applied to buildings constructed after Dec. 31, 2020.
Many legacy assets don’t have reporting systems or lease terms that require sustainability data. The asset class, therefore, needs mandates to encourage data disclosure, particularly focused on embodied emissions rather than just on operational emissions, the working group advocated.
Another obstacle making SFDR burdensome is how the industry has been using the framework, Close said.
While SFDR was intended to be a product disclosure designation, rather than a fund label or certificate, some managers are using it as a marketing or status appraisal tool. For instance, managers may portray funds qualifying under SFDR’s Article 9 compliance level as better than those qualifying for Article 8 classification, or both better than Article 6 funds, she noted.
And many limited partners, or LPs, similarly are saying they will only buy into Article 8 or 9 funds.
Moreover, fund managers are buying inefficient buildings and transitioning them in a manner that would fit under Article 8, even though the work might reduce emissions in more impactful ways than Article 9 funds, Close explained.
Such examples leave managers concerned they are not being rewarded for their actual sustainable effort, she said.
Misaligned SFDR incentives are also causing some managers and owners to sell underlying assets with limited sustainable potential, often to less sophisticated buyers that can’t retrofit assets, thus masking the decarbonization challenge to transition them, INREV said.
In addition, recent rule changes have led some managers to shift gears away from Article 9 and reclassify funds as Article 8 vehicles, INREV’s report stated.
The regulation’s reliance on entities to “mark their own homework” in that way could breed greenwashing instead of inhibiting it, one interviewee told INREV.
The trend of re-classifying funds from Article 9 to 8 is on the rise, according to Robert Bluhm, a sustainability officer for Universal Investment. Even as managers want to be more transparent, they struggle at times to get the necessary data for reporting, Bluhm said. And such data uncertainty presents a “reputational risk” to managers if the disclosure isn’t properly done, he noted.
And while many of these complications can be pegged to real estate, it’s likely what the working group and others are expressing could be “equally applicable in infrastructure and so on,’ said Melville Rodrigues, a member of the working group and real assets head of advisory at Apex Group.