EU Sustainable Finance Disclosure Regulation (SFDR)
AP2’s approach to the Disclosure Regulation
In 2018, the EU launched an action plan to increase the share of sustainable investments, promote a long-term approach and make sustainability more transparent, with the overall goal of making the EU carbon neutral by 2050. As part of this, the EU issued a number of regulations to strengthen the action plan. One of these is the Sustainable Finance Disclosure Regulation (SFDR), which came into force in March 2021. The main objective of the Disclosure Regulation is to increase transparency on sustainability issues and to enhance comparability between financial market players with regard to the integration of sustainability risks and the consideration of negative impacts on sustainable development in their processes.
Första, Andra, Tredje and Fjärde AP-fonden (AP Funds) are not directly covered by the Disclosure Regulation, but since it is part of the AP Funds’ mission to manage their assets in an exemplary manner through responsible investment and responsible ownership, as well as to report on how that goal has been achieved, the AP Funds will in the coming years develop the reporting, mainly on their respective websites, in line with the Regulation.
How AP2 integrates sustainability risks into the investment process
According to the SFDR, sustainability risk “means an environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment”.
AP2 considers both financial and impact risks in accordance with the EU principle of double materiality, which is taken into account throughout the Fund’s approach to sustainability risks.
The Fund has integrated climate risk management in its asset management and has a risk process with methods for identification, assessment and management according to the asset class in which climate-related risks arise.
AP2 considers sustainability risks in all investment processes, to ensure efficient management of risk and an exemplary asset management.
In accordance with the TCFD, climate risks and opportunities are divided into two groups: transition risks and physical risks. Transition risks are subdivided into regulatory risks, technological risks, market risks and brand risks. Physical risks are subdivided into acute risks and systemic risks. On the opportunity side there are resource efficiencies, energy, products/services, markets and resilience. These climate risks are part of the existing risk categories that the Fund already takes into account, such as financial risk, operational risk and impact risk. The purpose of categorisation is to make it easier to highlight, manage and communicate the risks to which the Fund is exposed.
There are various types of climate risk and they affect the Fund in different ways. The risks can be seen as financial or operational risks, and analysed on the basis of this classification. Fossil reserves are one example of a climate risk factor that affects financial risk. The risk is that, as a result of the transition to a more fossil-free world, assets risk losing value, which would cause the value of companies holding these assets to depreciate. This can be viewed as a climate risk, but becomes apparent as a financial risk.
The most common sustainability risk factor under operational risks is reputational risk – the risk that investment activities undermine confidence in the Fund’s operations or the pension system as a whole. In addition to the division into financial and operational risks, during 2021 AP2 introduced impact risk, as the third category of risk. An example of impact risk is when an investment risks causing harm to people or the environment, without necessarily having any effect on financial or operational risk. If impact risk is high, the Fund finds it difficult to achieve its objective of exemplary asset management. The risk of the Fund contributing to illegal deforestation through its investments is one example of this type of risk.
The identification, assessment and management of both transition risks and physical risks are adapted to the different asset classes in the portfolio. The first step in the risk management process is risk identification, which is handled by each portfolio manager. The Fund continuously works to improve and integrate the identification of climate risks. Risk assessment and risk management are also performed by the portfolio manager, with the support of sustainability analysts.
Read more in the Fund’s TCFD and TNFD report.
A portfolio in line with the Paris Agreement
Climate issues are integrated into the Fund’s analysis and decision-making processes for all asset classes, where relevant. The ambition is to develop the portfolio in line with the Paris Agreement. The starting point for the Fund’s climate work is to both reduce the financial climate risk and contribute to the transition. AP2 outlines its approach to climate change, explaining the reasons and methods for its work on climate issues on its website and reports. The Fund aims to have a net zero emissions portfolio by 2045.
Climate change is expected to have a significant impact on long-term returns. Integrating climate considerations into risk assessments and investment decisions is therefore becoming increasingly important.
How AP2 identifies, prioritises and addresses the main negative impacts on sustainable development
Climate-related risks
Climate risks have a unique position among sustainability risks, as the consequences of climate change are both extensive and complex. Major climate change can occur suddenly when a critical point is reached, and can also trigger a domino effect with further negative consequences. The transition to net-zero economies will involve major societal changes.
Financial climate risks can be divided into two groups: transition risks and physical risks. Transition risks are divided into regulatory risks, technological risks, market risks and brand risks. Physical risks are divided into acute and systemic risks.
Since neither physical climate risks nor transition risks are fully priced, such sudden changes can have a significant impact on the valuation of various assets.
In 2013, AP2 began analysing financial climate risks for fossil energy companies and then proceeded with coal-based power companies. An important starting point for this work was that the climate-related risks facing companies are not correctly priced by the market.
Since 2019, physical climate risks have been included in the Fund’s overall return assumptions, which form the basis for the selection of the strategic portfolio.
With AP2’s internally managed global equities and corporate bonds meeting the criteria for the PAB since 2020, the Fund has completed the analysis of climate-related financial risks for fossil energy companies and coal-based power companies.
Climate change has the potential to create financial instability, which would have serious negative consequences for the financial sector and the wider economy. Therefore, AP2 considers climate change to be a systemic risk. This is one of the Fund’s investment beliefs. This means that the Fund develops its portfolio in line with the Paris Agreement. An example of this is the introduction of indices based on the EU Paris-Aligned Benchmark. The Fund is also committed to bringing about positive change through dialogue with companies and decision-makers.
Human rights risks
AP2 is exposed to the risk of adverse impacts in several situations, including its role as an employer, a supplier customer, a counterparty to other financial institutions and an asset owner and asset manager. The Fund has previously assessed the risks of potential negative impacts that it may cause itself or that may exist with its suppliers. However, the Fund’s assessment is that the most serious negative impact to which it may be linked is in its role as an asset owner and asset manager. AP2 has therefore placed a particular emphasis on integrating human rights issues into its investment decisions.
AP2 has identified potential and actual risks related to the above roles in order to assess them from a severity perspective. Potential risks refer to situations where there is a risk of an adverse impact occurring and where the Fund works proactively to prevent an adverse impact. Actual risks refer to situations where a negative impact de facto affects individuals and groups and where the Fund works reactively to minimise the negative impact.
An important step in this proactive approach is to identify potential risks associated with the Fund’s holdings. During the past year, AP2 developed a quantitative model that can identify human rights risks in different sectors, countries and portfolio companies. The risk assessment is based on the risk to human rights, and not on the Fund’s activities or financial risk. The aim of the model is to facilitate, based on severity, the prioritisation of where the Fund should focus its preventive measures.
AP2’s Human Rights Policy Statement
Report on Human Rights 2023
Active corporate governance to manage sustainability risks
The background to the Fund’s work on corporate governance can be found in its overall mission. This includes AP2 being a responsible owner.
An initial success factor for acting as a responsible owner is identifying the areas where the Fund’s initiatives are deemed to have the greatest potential to influence and achieve the greatest benefit. In the next stage, there should be realistic possibilities to focus resources on these areas. On this basis, AP2 has formulated:
- Ten corporate governance principles within which the Fund considers it important to have a position and act accordingly towards companies. The principles are based on the assessment that the greatest risks from a corporate governance perspective relate to a company’s shareholder protection and its effective governance.
- The corporate governance strategy that describes how the Fund, in the next step, chooses to influence those companies where the risk is deemed to be high in one or more of the principle areas. The main tools for an institutional manager like AP2 are voting, dialogue and collaboration with other institutional owners and through joint initiatives.
- Targets and metrics to quantify as far as possible the achievement of objectives and, at best, the impact attained. The latter is considerably more challenging and therefore has a longer time frame.
Corporate Governance Policy
Voting Guidelines
Screening and exclusion
Twice a year, all the AP Funds’ shareholdings are screened to see if any company is in breach of any international convention.
If AP2 has reason to suspect that one of the companies in which the Fund has invested is seriously and systematically acting in breach of an international convention to which Sweden is a party or has declared its intention to become a party, the facts of the case must be investigated. This includes a dialogue with the company in question. If the suspicions are confirmed, the company will be requested to provide an explanation and develop an action plan. In its assessment of the case, AP2 must take into account the nature of the incident and any measures taken (or to be taken) to ensure that the incident does not recur. If the contacts with the company do not produce a satisfactory result, the Fund shall, after an overall assessment, decide whether the company should be excluded. The Fund may also decide on exclusion if it considers that the circumstances are of such a serious nature that exclusion is warranted, even though no violation of a convention has occurred or can be demonstrated.
Since 2014, the AP Funds’ Council on Ethics has introduced a time limit of four years for reactive dialogues, which are conducted with companies where convention violations have been verified by external experts. If the objective of the dialogue is not achieved within four years, the Council on Ethics recommends that the AP Funds divest the company. According to the legislation applicable to the AP Funds, the Funds must have common guidelines on the assets in which the Funds should not be invested.
AP Funds common guidelines on which assets funds should not be invested in
Activities in which the Fund does not invest are:
- Cluster bombs
- Landmines
- Nuclear weapons
- Coal (more than 1% of sales)
- Oil (more than 10% of sales)
- Gas (more than 50% of sales)
- Power companies (if more than 50% of revenue comes from burning fossil fuels)
- Tobacco and cannabis (does not apply to cannabis used for medical and scientific purposes)
Dialogue Guidelines
For the Fund, which is a long-term and committed owner, dialogue is the most important tool to bring about change.
It is not only through investment decisions that AP2 can promote sustainable development, but also in communication with the outside world. To start with, it is important that the Fund is transparent and clear about how it works with and integrates sustainability into its management. Not least, it is important to discuss and collaborate with other similar players. It is also important that the Fund, in its role as owner, clearly communicates its approach on sustainability and promotes greater integration of sustainability in the companies in which it invests, both directly and through external managers. On the one hand, it should contribute to a positive return as companies and external managers increase their sustainability profile and thus reduce sustainability risks, and on the other hand, it should contribute to positive effects for the world at large, such as reducing environmental impact. However, the dialogue should not only address sustainability issues in a narrow sense, but should also include corporate governance issues. Sound corporate governance in itself should contribute to sustainable development. Dialogues with companies take place both in asset management and within the framework of the AP Funds’ Council on Ethics. It is important that the level of ambition is well balanced with the Fund’s limited resources, so that they are used as efficiently as possible.
In the Fund’s fundamental equity management, analysts and portfolio managers engage in extensive dialogue with many companies on a wide range of issues. This is where the Fund can act to encourage companies to improve their sustainability performance and reporting. The Fund also maintains a dialogue with all external managers and promotes greater integration and focus on sustainability in their organisations and portfolio companies.
Dialogue is defined as dialogue between AP2 and companies with the intention of acquiring knowledge, influencing or exchanging perspectives concerning a company’s climate/environmental strategy, corporate governance, social issues or other issues that affect its business.
The Fund’s dialogues are primarily driven by the Fund’s investment team for Swedish equities, the Head of corporate governance, sustainability and corporate governance analysts.
Dialogue takes place mainly through formal letters to boards and/or company managements, as well as meetings with companies.
The Fund primarily engages in dialogue with companies where:
- The Fund is a major shareholder or bond owner
- The dialogue concerns an important issue for the Fund
- The Fund has an understanding of the issue and a constructive solution to propose
- The Fund believes that the dialogue can lead to changes that create value for the Fund.
The Fund shall express an opinion at Swedish general meeting if there are unanswered questions that the Fund wishes to raise. If the Fund votes against a proposal from the Board of Directors or the Nomination Committee, this is justified at the meeting.
A selection of the Fund’s foreign holdings shall be informed after a general meetingas to why the Fund has chosen not to support proposals from the Board. Dialogue with foreign companies on ethical and environmental issues is primarily conducted by the AP Funds’ Council on Ethics. Dialogue always precedes any exclusions based on companies systematically violating conventions to which Sweden is a signatory.
The Fund also presents shareholder proposals at general meetings when this is considered to be a valuable tool to influence companies.
The Fund will also maintain a dialogue with external managers and promote greater integration and focus on sustainability in their organisations and portfolio companies.
Reference to International Standards
The AP Funds’ approach to dealing with negative impacts on sustainable development is based, among other things, on the conventions to which Sweden is a signatory. It also builds on other commitments and initiatives, such as:
- The OECD Guidelines for Multinational Enterprises and Corporate Governance
- The UN Global Compact (UNGC)
- The UN Guiding Principles on Business and Human Rights (UNGP)
- The Principles for Responsible Investment (PRI)
- The Task Force on Climate-Related Financial Disclosures (TCFD)
Principal Adverse Impact (PAI)
The concept of Principal Adverse Impact (PAI) is part of the SFDR and is defined as: ”Negative, material or potentially material effects on sustainability factors that result from, worsen or are directly related to investment choices or advice provided by a legal entity’.
The SFDR framework contains 18 mandatory indicators for greenhouse gas emissions, biodiversity, water, waste and social indicators that should be taken into account (comply or explain).
In addition, there are voluntary indicators: 22 climate and other environmental indicators, as well as 24 indicators related to social and labour issues, respect for human rights, anti-corruption and anti-bribery issues.
AP2 will develop the reporting in the coming years.
How AP2’s remuneration policy relates to sustainability risk integration
The AP Funds’ mission is to generate a high return while keeping risk low. The investment strategy shall be based on the impact on outgoing pensions and shall take into account the solvency requirements of the outflows from the Funds. It is important that Funds enjoy public confidence and act responsibly. The AP Funds must also manage the funds in an exemplary manner through responsible investments and ownership.
Both sustainability and responsible action are high priorities for the Funds. A proactive approach to environmental, ethical, social and corporate governance issues is the means to achieve the objective of a sound risk-adjusted return. Remuneration of employees should encourage high performance and behaviour in line with the AP Funds’ missions and comply with the Swedish Government’s guidelines for terms of employment in the AP Funds.