ESG data availability is one of the main challenges investors face against the reporting requirements under the SFDR and the EU Taxonomy. As such, some investors might be turning towards proxy data to align their funds as sustainable under the EU Taxonomy.
However, the European Commission has set rigid rules around the usage of proxy data and this article aims to guide investors through these rules as we delve into the permissible uses of proxy data.
The often repeated trope “if you cannot measure it, you cannot manage it” underscores one of the major dilemmas facing ESG regulation and assessment.
As opposed to financial data which lives in well defined and regulated financial statements, ESG data (thus far) has been highly inconsistent in the way it is presented, let alone measured.
One of the often understated goals of ESG regulation is to encourage corporations and financial institutions to be more transparent about their exposure to ESG risk, as well as their impact on ESG metrics. Before ESG regulation can be effectively implemented, the markets need a baseline of data availability.
In the EU, the Non-Financial Reporting Directive (NFRD), which will be replaced by Corporate Sustainability Reporting Directive (CSRD) in 2024, seeks to create this baseline of data by expanding the regulatory framework on non-financial disclosures to a broader range of businesses.
Despite the expansion of available and standardized ESG data, the regulations still miss a substantial percentage of the market.
The mismatch between available information and required reporting is most clearly evident for Private Equity (PE) firms who invest in firms who do not fall under the disclosure requirements elucidated in the NFRD or future CSRD.
Working with our clients we have found PE firms and portfolio companies struggling with the data collection systems required to satisfy the regulatory requirements under the Sustainable Finance Disclosure Regulation (SFDR) for Article 8/8+ and Article 9 funds.
The lack of readily available data has prompted some funds to use proxy data to identify performance against the Technical Screening Criteria, both substantial contribution and Do No Significant Harm (DNSH) assessments of their underlying assets.
Proxy data, in this instance, is used to supplement these assessments when the ESG data is not made directly accessible or available by the underlying company.
But is the usage of proxy data admissible under the new EU rules? And if so, in which circumstances?
The European Commission (EC) has clarified that indeed while proxy data is permitted under certain circumstances, there are strict criteria to follow, and investors should carefully consider whether their proxy use is permissible.
In short, the Commission permits financial market participants (FMPs) to use estimated data for underlying investment companies that do not fall under the mandate of NFRD and are exempt from reporting against the EU Taxonomy. The Platform on Sustainable Finance (PSF) uses the term “equivalent information” to refer to the Taxonomy-permitted estimate date. Therefore, “equivalent information” can only be used by investors aiming to report on their portfolio companies that are SMEs or non-EU based.
This is not a green light to apply proxy data across the entire reporting spectrum. Despite the lack of available information, the Commission is quite clear that FMPs can use “equivalent information” only for certain elements of their Taxonomy assessment.
In the next section we will break down the Taxonomy reporting requirements by sections (substantial contribution, DNSH and MS). This is meant to provide clear guidelines on where and when proxy data can be used, and when it will not stand up to regulatory scrutiny.
The most important rule for substantial contribution is that all the information used to determine substantial contribution must come from the company reported data. The PSF has identified three different scenarios for how investors can align with Taxonomy if the underlying company has not reported on their alignment. It is important to note that the PSF has advised that whenever data is proxied, that the user must take a conservative approach and not attempt to underreport on emissions or other scientific metrics.
The PSF conducted a market scanning exercise and has identified four ways of how the FMPs are using proxy data for DNSH alignment and has provided guidance on whether these practices should be permissible.
For example, the PSF advises against using environmental controversy scanning or local and national environmental laws as the sole identifier for DNSH compliance. While environmental controversies and non-compliance with local laws can be a good indicator for not meeting the DNSH criteria, it is not enough to prove full DNSH alignment.
Furthermore, the PSF advises that any ESG score models or DNSH tests should be supplemented with the information on the methodology used and backed with a due diligence conducted on these firms. For example, for qualitative assessments within the DNSH, FMPs can review the company's policies, management systems, monitoring, reporting, and other sources to establish DNSH alignment, given that proper due diligence processes have been applied.
We recently published an article on how investors can align their underlying portfolio companies with the MS standards, where we similarly discussed the use of proxy data in determining MS alignment.
To recap, investors should carefully consider the national law or international framework they want to leverage as a proxy for compliance with the MS.
If the whole scope of the MS requirements are in line with the proxy framework, investors can use it to confirm MS alignment. The figure below describes application of data collection and reporting requirements for the four core pillars of the MS framework.
In summary, while proxy data is regulatorily permissible under certain circumstances, the types of proxy and estimated data vary depending on their use case (substantial contribution, DNSH, and MS).
Therefore, investors should carefully assess whether:
a) they are allowed to use proxies (once again, estimated data is only allowed for firms not under mandatory disclosure regulations)
b) their estimated data is thoroughly assessed to ensure an accurate depiction of the company under assessment.
So, when in doubt, investors would be wise to rely on a more conservative assessment to ensure full compliance. If you are looking for detailed information on getting your fund aligned with the EU Taxonomy, check out our full guide for investors.
If you want to ensure a smooth collaboration with your portfolio companies on ESG data collection, while having a solid overview of your SFDR and EU Taxonomy reporting requirements, Briink's reporting platform can help you save the day.
Get in touch to request a trial.
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