Ep. 45 Who’s shepherding all this EU ESG rulemaking?

Published: 09 November 2022

The Long-Short is a podcast by the Alternative Investment Management Association, focusing on the very latest insights on the alternative investment industry.

Each episode will examine topical areas of interest from across the alternative investment universe with news, views and analysis delivered by AIMA’s global team, as well as a host of industry experts.

The Long-Short this week spoke to Bloomberg’s Nadia Humphreys who has spent the past two years advising the European Commission on the coherency of its various ESG-related regulatory regimes with a focus on transparency and data consistency.

Nadia offered an insider’s perspective on the rule-making process from her role as co-rapporteur for the platform for sustainable finance, on the data and usability workstream and lifted the lid on the group’s key requirements on how to harmonise all these frameworks.

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Hosts: Tom Kehoe, AIMA; Drew Nicol, AIMA

Guests: Nadia Humphreys, Bloomberg

Interlude: Sharon D'Agostino, AIMA


Tom Kehoe, AIMA  00:02

Welcome back to The Long-Short. I'm Tom Kehoe.

Drew Nicol, AIMA  00:06

And I’m Drew Nicol.

Tom Kehoe, AIMA  00:07

And this week, we are returning to the highly debated issue of ESG, or environmental, social and governance, which still dominates financial discourse, ranging from whether ESG is even the most appropriate description of the strategy, to whether in some quarters of the world investors are doing the right thing by incorporating ESG risks in their investments. Drew, you're just back from our Global Policy and Regulatory forum in Paris. How was that? Did the topic of ESG come up?

Drew Nicol, AIMA  00:32

Yes, ESG came up a lot, but, it was really interesting to hear directly from regulators present on all the main issues facing the alternative investment market today. And it's always fun to spend time with our members as well, especially when you get to go to Paris. But on ESG, I think one of the key takeaways, for me at least, was some of the European regulators, giving the very simple message to fund managers not to panic at the prospect of some of the new reporting requirements that were being considered. And through forums like AIMA’s working groups and our advocacy work, we have apparently been absolutely crystal clear in expressing the anxiety of the industry. And the regulators essentially said back to us to be calm and reassured, that any reporting rules coming in would be proportionate.

Tom Kehoe, AIMA  01:20

And so, let's take this conversation forward further. We have the perfect guest today with Nadia Humphreys, who's primarily part of the Bloomberg Sustainable Finance Solutions division, but she's speaking to us today in her capacity as co-rapporteur for the platform for sustainable finance, on the data and usability workstream for the European Commission. Nadia, welcome to The Long-Short.

Nadia Humphreys, Bloomberg  01:46

Thank you so much for having me.

Drew Nicol, AIMA  01:47

So, we often raise issues of inconsistent and scarce data when it comes to ESG. And this is very much a global problem. But the EU is probably the most active in taking steps to rectify this primarily through regulation. Just before we jump into the meat of this, could you just give us a brief overview of where we are now from the regulatory landscape, especially as it applies to fund managers?

Nadia Humphreys, Bloomberg  02:12

Yeah, I mean, Drew, I'm going to pick up on your word brief and try and do my very best service to it. But there is a lot happening right now. And you know, anyone can be forgiven for not really tracking fully what they need to do, and when they need to do it, and quite frankly, how they need to do it. So, there are a number of requirements, I think they can be tough to navigate, I'm sympathetic to those that are trying to, but it is certainly worth familiarising yourself with what you have to do, particularly as it affects those companies that have sustainably linked financial products, and those companies who do not. And so really, sustainable disclosures, and we're talking to the financial community here, they could be made either in documentation related to the financial products that will be pre-contractual or post-contractual, so periodic updates. But there's also an expectation that on a manager’s website, they start to publish, and in actual fact, when we look at legislation, it's not only for the manufacturer of the product, it's a requirement to a distributor of a product, and ultimately impacts the financial advice given to any end consumer, even impacting into the retail sector.

Now, most of it has the basis of transparency, so their disclosure regulations, you know, are really explaining what the ingredients of the fund are, and trying to create some kind of common narrative of what sustainability is. There are, at the moment, lots of very different narratives, and very different claims of sustainability. And so really, what we're trying to do here is say, can we create consistency? A little bit like food labelling? Potentially, can we get to a point where we have, you know, an indication of what is good and an indication of what is bad, although I think that is still evolving. And then can there be free choice? Can people make decisions about what they consider to be a sustainable product? Because those ingredient lists are good enough. And in a nutshell, very simply, that's where I would put it. Now, a lot of people, therefore, when I say that, think, okay, this is just reporting. I'll give it to my operations team, I will outsource it. But, actually, a lot of the regulation is going to impact at a policy level of an organisation. And when we hear that when we speak, not only to hedge funds, to asset managers, but also credit institutions and banks, there is a requirement to start to feed this into decision-making. So, when we look at data, data is not just a reporting problem. Data is also a decision-making problem as it relates to regulation.

Tom Kehoe, AIMA  04:53

And Nadia, we spoke at the top of your introduction, and referenced you as co-rapporteur for the platform for sustainable finance on the data and usability workstream for the European Commission. So, could you describe to us a little bit about the work that you're doing there?

Nadia Humphreys, Bloomberg  05:10

Yeah, absolutely. So, the role of the very first platform concluded on the 31st of October. So, there is an open call at the moment for anyone interested in joining the platform. The platform itself has a statutory duty. So, it is actually ingrained into the taxonomy regulation, specifically under article 20, there are a set of requirements for this platform. And every two years that platform is reformed of a variety of technical experts. Now, in my role for the last two years, as you've mentioned, co-rapporteur, was looking very much at data and usability. And so, the requirements that we were trying to satisfy were to advise the commission and to some extent, work closely with the supervisory authority. So ESMA, EBA, and EIOPA, and give them direction on a few things.

Number one is market observation. So, to be the voice of the market, that would be a non-financial company or a financial company, trying to grapple with what the rules are, and trying to explain where there are implementation and usability issues, maybe interpretive issues. Now, whilst we in legislation were regarded on the taxonomy, what people will be aware of there are other things. So, there's the sustainable finance disclosure regulation, there is the corporate sustainability reporting directive over the horizon, so mandatory ESG reporting for companies. There are MiFID II suitability requirements. So, this complicated framework of different pieces of legislation, and actually in our remit, is to give advice more broadly on whether that is coherent and working, and can we give some advice there? We also wanted to look with the Commission at whether money is flowing into sustainable products, we wanted to look at the use and adoption of the taxonomy, what does the reporting look like? Is that reporting accurate? And so that really is the remit of the group.

One thing I would point out because we have published a report, we're giving advice to the Commission, we are not necessarily giving implementation advice to the market, and so, it's very clear. We hope we suitably emphasise that in the report. We're trying to represent the market to the commission, not necessarily telling the market what they have to do to implement the regulation.

Drew Nicol, AIMA  07:41

And just to pick up on that and something you said before very broadly when we're talking about reporting requirements, as far as I understand, it's generally an issue around quantifying market risk or investor protection in some capacity. So, when you're having these conversations, the sort of direction of travel for these conversations, is it around one or two, or both of those issues? Because, in my mind, if you're talking about a lot of the data that's being required under the ESG umbrella, doesn't seem to be directly to do with market risk, but it's sort of a new category that we haven't seen before.

Nadia Humphreys, Bloomberg  08:23

Yeah, Drew, it's a really good question. When I boil it back to what's the objective of these pieces of legislation? I think, overall, if there's a budget deficit in the transition to a sustainable economy. And so, we need tools that direct capital to sustainable outcomes to help achieve net zero. So, what we really should be doing is saying, number one, what does the transition look like? How do we measure that? And how do we measure what good is? So, there is a tool like the taxonomy which tries to do that. Now, how do you then mobilise capital? Well, one way of doing that is through transparency, if you believe there is sufficient demand in the market for sustainability, that demand will drive supply and that supply has to explain itself with a narrative to net zero, then that's a really good framework to start to build. Now, when we start to unpack that, how does that work in legislation?

Well, let's go to the demand thing originally, imagine I'm an asset owner, I would have had to expressly come to you Drew and say, I have sustainability preferences, what products can you offer for me, for example, I want a decarbonising product. And then you would package and create one to satisfy my need. What MiFID II has done as introduced in August is changed that. You now have to come to me, even if I'm silent and say, Nadia, do you have any sustainability preferences? That change in the shape of conversation is more likely to lead to, well, actually, yes, I do have some preferences. How can you tell me that the product you're selling is fit for my sustainability preferences?

Now, then there's the guidance on how you do that. And there's some concern in terms of that guidance. If you tell me what percentage taxonomy alignment I want, do I know what I mean when answering with a number? So, for example, if we look at some of the kind of major indices, not necessarily ESG, indices, just major indices, we're looking at 5-6% taxonomy alignment, roughly. It's a small number. Now, if you're asking me, do I have sustainability preferences? And you are asking me, Nadia, what percentage of sustainability do you want? And I'm probably going to say, you know, north of 50%, I want something that is sustainable. And you say, well, you know, the highest level I can give you is 5%, I'm not going to be happy. So, do I understand that metric? And what that metric means? That's one problem.

In the other question that you touched on, you talked a little around risk, it's not so much risk, it's more harm. So other ingredients in there that I disagree with. If I am fundamentally against certain things, do I have transparency that you are not investing in those things I don't want in my product? So, there's another piece of the conversation which is around harm. Are we investing in things that I object to and should we be excluding those things? And so really that’s the framework. And when we start to provide advice to the commission, really, we are providing advice to say, is it satisfying your objective? Is it enough of a carrot that says, we’ve set up a system where demand is clear, where consumers that are asking for things in their financial product, get clarity that the financial product actually contains what they're looking for. And is there a consistent narrative in the market where people can make good judgments between products? And then if there is, ultimately that demand will drive supply, and then that will finance the transition because there's more demand for transitioning sustainable outcome products. Does that long-winded way answer your question?

Drew Nicol, AIMA  12:13

Definitely. Thank you.

So, we first met actually, earlier this year at AIMA’s ESG event in London, and you were on a panel that, among many other things, discussed how managers were navigating the frontier of ESG, investing and tackling new areas of concern, which is an incredibly broad topic that you took on that. For anyone that wasn't in the room. Can we just revisit that question and just sort of finish setting out the foundations of where we're at today?

Nadia Humphreys, Bloomberg  12:44

Yeah. And maybe Drew it kind of lends itself well, to the answer I've given. So, if we say does demand exist, I think some of the metrics I shared were, looks like it does. And I'll, I'll give you some that I think I shared at the conference. If I look at the composition right now of the European ETF market, I'll use that as my framework. Right now, the sustainable finance disclosure regulation defines a sustainable product, or something called an article eight, or an article nine product. And then if it has no real sustainability preferences, right now, the language people are using is article six. So, if I just look at composition, there are a couple of ways I can look at composition, one could be assets under management, just shy of a quarter of assets under management, as of last month, where in these articles eight and nine products, three quarters were in these articles six products. If I look at by count of products offered, it's roughly the same, it's maybe more like a third and two-thirds.

Now if I look at flows, so my point is on demand, what am I seeing? So, if I looked at all the data from 2021, what we were seeing was that 51% of flows, were going into these articles eight and nine products. That's an impressive trend. Now, you might say 2022, has had a few headwinds from an ESG perspective, and maybe demand is drying up. When I looked at the data. About a month ago, what I saw was, that's not true 58% of flows year to date, and 2020 are going into those articles eight and nine products. So, the point of demand clearly exists.

Now, the second thing we were talking about in the panel was okay, that's great. And we want the transparency that these products are actually sustainable, and there are frameworks by which you narrate that. Now, if we go back to the point on taxonomy, one of the interesting points here is there was a piece of sell-side research pointing to the fact that high taxonomy alignment is overweight in these articles eight and nine products. In fact, it's between 200-300% overweight. And what taxonomy alignment will do is it'll tell you a top 10% best-in-class climate mitigation. Now, Nadia, what does that mean? That means, for example, if I'm buying vehicles right now, the requirement is a tailpipe emission of fewer than 50 grams, not a lot of hybrids are going to achieve that. So really, we're looking at zero-emission vehicles. So, if I'm a car manufacturer and I make money from zero-emission vehicles, the percentage of revenue I make in that is what is considered to be my taxonomy alignment.

Now, similarly, I report another metric, which is capital expenditure. So how much money am I investing to improve the output of zero-emission vehicles in my production process, I can give you that metric as well. And that capital expenditure is hopefully going to be a larger number. That's the number you look out for in transition. Now, when you look at the good activities, the taxonomy clearly states renewables are good, but not blanket good. So, one of the things you might look at, for example, is hydropower. Hydropower isn't just blanket taxonomy aligned. You don't want to have closed-loop systems that are affecting biodiversity downstream and water supply downstream because you're pinning all the water upstream in order to power the hydro plant. So, there are criteria related to hydropower, there's criteria related to biomass. And so, what we're starting to do, particularly in a data space, and as it relates, specifically to the hedge fund market, is you can start to identify things pre-becoming taxonomy, and like how near or far a company is from meeting these testing criteria. And if you're able to use data to give you those signals, you know of something that is going to be valuable and demanded by these articles eight and nine products. We have flow, so we know that there are investors who want to hold these products. So, you can start to use triggers in data through the regulation, even if you're not in scope for it, to really start to make some intelligent decisions about what to hold. And I think that the signals that exist in data are the things that are really interesting to the hedge fund market.

Sharon D'Agostino, AIMA 17:04

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Tom Kehoe, AIMA  17:51

Nadia, on the panel of AIMA’s ESG event earlier in the year, you mentioned a new report that you are working on platform recommendations on data and usability. That report has been published a couple of weeks ago, and there's a chance that not everyone has read the report in its entirety. So, it will be great for our listeners if you would be able to take us through some of the main takeaways.

Nadia Humphreys, Bloomberg  18:17

Of course, I can! I think it's about 178 pages, and it's certainly quite technically dense. I wouldn't recommend anyone digests it in one sitting, piecemeal would make sense. It's broken into seven main parts. The top is the introduction, and the bottom is recommendations for a future platform. So, if we look at kind of the middle chunk, what does that contain? Well, it contains just shy of 65 recommendations to the European Commission. And we've obviously said the European Commission can't take all recommendations and act on them at one point. So, we've broken them into high, medium and low.

One of the things we have done, and I do want to stress is it's not about the importance, every recommendation is important. It's just about priority. So, there's a near-term need for things that are actually legislated that people are reporting on today that we need to fix. There's midterm, so there's a 2024 review period and legislation and we're making some recommendations there. And then there's longer-term and longer-term would-be things like working with the UN High-Level expert group on things like emerging market finance or working with the international platform for sustainable finance on harmonising taxonomies that are growing across the world. That would be what we're calling low because it's a bigger piece of work that will take time to execute, it is not low because it is not important.

If we break out what each of those chapters is, so we start off with the data chapter. And what a data chapter is doing is market observation. What have we seen? Where are the usability struggles? What's the shape of reporting today? Are all companies who have to report reporting? About 50% of those who we think have to report have started. We're also seeing some encouraging signs that you don't really have to report until January on things like taxonomy alignment, you only have to report eligibility. But 50% of those that are reporting eligibility are already reporting alignment. So, they're doing it a year early to try and get ahead of the reporting.

What we've also started to witness is you are allowed in your financial product, when you don't hold European stock, to report on international companies, so to proxy to the taxonomy. Now, the supervisors call that term ‘equivalent information'. And one of the problems with 'equivalent information' is it doesn't have any guidance. So how do you know if you're proxying an international company to an EU regulatory framework that you're doing it right. And so, what we've done in the report is we've highlighted to you, what we see people doing, and we have given you a platform for opinions. So, we've given you a platform opinion about what we think is good practice, and what we think it isn't. And as I said at the start, we're not saying implement our advice, we're suggesting this to both European Commission and the ESAs, and then they will provide the implementation advice to the market.

The next thing we do is then start to look at reporting frameworks, there are a few what we call fatal flaws that we're asking for the commission to fix. And then we look at the 2024 review period, and that would be things like extending the taxonomy, to cover reporting on derivatives, extending the taxonomy for banking into the trading book KPIs, fees and commissions reporting, or extending the taxonomy into public sector finance, for example. So, we give some recommendations there.

And the next chapter comes on to verification. Now, verification is politically debated. One of the problems in verification is, we believe there were signals starting to emerge that said, for your financial data you would have audit firm one, and for your ESG data, you would have audit firm number two. Now really, in a nutshell, our recommendations are, it's not an audit firm one, and then audit firm two thing, that will double the cost for everyone. It is a skill set. And arguably, a human could carry both skill sets. Certainly, an organisation could carry both skill sets. And so, we're making a recommendation there those skills are appropriate, that guidance and methodologies are appropriate, that allows auditing firms to do their jobs.

Well, we then come on to part five, which is just the whole coherence of the Sustainable finance framework, we've noticed some issues, things like understanding of terminology, the same words are used in different pieces of legislation, and they mean different things. So, for example, the word ‘do no significant harm’ in the taxonomy that means something different to an SFDR. So, we're highlighting that terminology is an issue and should be consistent. We highlight sequencing issues, there's a lot of reporting required of financial firms when the data isn't yet available for them to do that, in a clear, consistent and comparable way. So, we highlight sequencing issues. We also highlight some kind of coherence. If we look at what an active fund manager is supposed to report, versus what an index or benchmark provider is supposed to report. ESG datasets are different. So, if you are therefore comparing an active fund to a benchmark, you're not even looking at a common set of ESG datasets. So, we make some recommendations there.

And then very finally, we look at international. So, we are aware of roughly 25 International taxonomies in various stages of development across the world. What we don't want is a dual reporting burden if, for example, the UK taxonomy is executed, we don't want UK firms to have to report under the UK regime and also have to do another report under the EU regime for EU invest investment products. So, what we're saying is there should be a framework of equivalence where a UK firm can report under its taxonomy, and that value can be accepted by a European investor as taxonomy aligns for the purpose of their own reporting. So that in a nutshell is the recommendation in the report.

Tom Kehoe, AIMA  24:18

Thank you, Nadia, we'll include a link to where you can find that report for our listeners.

Drew Nicol, AIMA  24:24

So I just wanted to sort of use this opportunity of having you here to put something to you from our own research that we're working on. And that is based on a survey that we've done of our members and some interviews with various investors and managers around the world. Just to sort of condense the sentiment that has been expressed to us in a few different ways is that the market broadly and especially in Europe, although somewhat in the US as well, is moving away from the quite crude tools of exclusion lists and divestment. and maybe moving something a bit more nuanced, especially when it comes to areas like energy stocks and how they've performed this year which may have given people pause for thought. And the general shift seems to be towards engage don't exclude. Meaning that firms are looking to reward firms for becoming more sustainable, as opposed to just shutting the door to large areas of financing that they may have been concerned was happening up until last year.

Do you agree that the market is sort of shifting in that way of becoming more sophisticated in their approach to just having a black-and-white ESG standard? And if you do agree, then can you give any insight on what is driving that?

Nadia Humphreys, Bloomberg  25:43

Yeah, Drew, this is a really, really hot topic right now. And I think it's a good one for us to be having a debate around. Maybe I could answer in two parts. One is referring you to a small platform material, specifically to something called minimum safeguards. And then maybe in a second part, I can share a bit of my personal perspective.

So, if I start on minimum safeguards, there's a paper written by a separate working group of the platform or minimum safeguards that looks at things like social controversies. And we debated a lot, you know when would be a signal to divest? And if we think about controversy, and let's think about it in the shape of, you know, a news story or NGO activity, at what point should that signal a rumour versus a truth? And if you are going to legislate that people are not allowed to invest, you need to do so on more than just a rumour. So, if you then take it a step further, and you say, look at the point at which an organisation is fined and found to be guilty of some social negligence, should you therefore not hold that company? Now, problem number one is, that the legal system is often very much post the problem having occurred. The second thing is that at the point at which the fine is given, there may have been a series of remedial efforts to fix whatever the underlying problem was, guilt is found, and the fine is made. But subsequently, that organisation has never been better.

So where really are the exclusion or divestment triggers on a controversial dataset. We debated that a lot. And actually, one of the places that we landed on, and you can read this in the report, is thinking through social supply chain issues. So large listed companies are probably going to have deep in the supply chain, some link to some issues. And really, what we want to encourage is that those large listed companies are engaging in their supply chain, finding out where they have issues, and then looking at a time-bound remedial effort, working with their suppliers to fix those problems. If you think about the fact that large companies might move away from certain suppliers, what that probably means in a social context is you move away from investment in high-risk geographies. And that could be incredibly harmful. So, what you want to do here is encourage people to really dig into where they have problems and try and fix their problems. So, when you're providing rules to the investor community, how do you do that? How do you say, what is good human rights due diligence? What is expected of an organisation? What data points do I need to look for? Now that is really challenging, and I think the report tries to do a good job of explaining and I would recommend you read it, I couldn't give service to their work in a short couple of minutes. But that's probably the place of debate. We shouldn't be divesting, we should be engaging and fixing.

Now that the second part of that question relates to maybe things like fossil fuels, which I know is also kind of on the tip of people's tongues, should I not be investing in a fossil fuel company, if I am thinking about, you know, a future world in which carbon is reduced. One problem there may be that, and the taxonomy I think seeks to address some of this, those large fossil fuel companies probably hold some of the secrets and keys to investing in renewable energies. Investing in electric vehicle infrastructure, for example. Now, I would want to invest in a company that is thinking about building out renewable energy capabilities or building out our electric vehicle charging infrastructure. And so those activities in the taxonomy are considered to be aligned even if those activities come from a company that has an affiliate business line that is in oil and gas.

So, a lot of a narrative on a fossil fuel revenue-based exclusion, and we touched on this in our report, I would query. I would actually say the metric that is more important here is fossil fuel-based capital expenditure. I mean, if you're investing in building out new gas pipelines, that could be a problem. But if you're investing in a company that itself is investing in building out renewable energies, that is less of a problem. Now we do see reports out in the media, these companies are investing in fossil fuel-based companies. And that's a bad thing. I certainly agree with some of the more recent reports around debt, and the use of proceeds of debt. But I think that's probably where I would conclude, Drew, on my opinions around that.

Drew Nicol, AIMA  30:55

So, we've maybe been a little bit negative up until now in terms of just focusing on the flaws and the gaps in the dataset. I wanted to end on a slightly more positive note and just flip the question because I had a really interesting conversation this week at our event with one of our members in the digital asset space, who was telling me about some of the incredible things that are going on around tokenisation, and the use of blockchain technology to provide some incredibly granular data on ESG factors. And the example he gave was that when you're talking about the commodity sector or land, or you know, anything related to that, you could have ratings attached to securities that not only ranked a forest or piece of land and whether it had forest or woodland, but down to the biodiversity of that land. So, it wasn't just some of the great pine forests that you see here in the UK, but something that really was contributing to sustainability. And then that's incredible if you're thinking about where you're getting timber from or other commodities, and really having a good answer to that maybe very broad question of, is this good? Or is this bad? And having no data really to support that. So that does sound quite pie in the sky to me now, given where we are, and maybe still at the early stage of this journey around standardising data and bringing up the general understanding. But, are you optimistic that we will soon see this level of granular data applied across the board? And are you excited by blockchain and other sorts of data-providing tools and organisations springing up that can really service this demand?

Nadia Humphreys, Bloomberg  32:41

Drew it's a really great question, and actually one that will be very timely with COP27. My enjoyment last year was in meeting all the startup organisations, and all the clever ideas. There is certainly an evolution about to take hold in terms of good quality data via satellite imagery on methane leakage or carbon emissions, as you say, be that biodiversity link dataset, I think the richness of data will absolutely improve. Probably a place I'm a little bit more excited about is that financial markets might play a hand in valuing natural capital. Now, what do I actually mean there?

At the moment, if you look at a lot of net-zero commitments that organizations are making, it is a net value, so it recognises they will continue to emit carbon, but they will offset that carbon in some way. Now on a voluntary market, offsetting that carbon has been subject to a lot of scrutiny. What is a good quality offset? Can you offset this by planting trees? How do you calculate the carbon pulled out of the atmosphere as a result of those trees? How long do you hold those trees for etc? Now, if you have a financial system that number one regulates the quality of an offset in some way, and really interestingly, you have that net zero demand, I need to buy these offsets. The really exciting thing is if you've got a financial market structure around that, those offsets carry true value, and play it long term, you may find that Brazil is very happy with its rainforest, because that has a real financial value to them as an asset. And so, I think if we can fix at least that part of the market where we are truly valuing natural capital, I'm very excited that that could be a way of designing the future in sustainable investing.

Tom Kehoe, AIMA  34:43

A very upbeat message to end today's episode. Nadia, thanks so much for your time in joining us on The Long-Short. We're sure we'll have you back again in the future.

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