The Sustainable Finance Disclosure Regulation (SFDR), also known as Disclosure Regulations, came into force on 10th March 2021, imposing new transparency and sustainability-related disclosure requirements to the financial services sector. Despite a recently announced delay and reduction in the number of disclosures that organisations are required to make (32 down to 15), financial service providers will still be required to make ‘principle’-based sustainability disclosures from this month onward at both product and corporate level.
What is the EU Sustainable Finance Disclosure Regulation?
SFDR is a new regulation requiring financial service providers and owners of financial products to assess and disclose environmental, social, and governance (ESG) considerations publicly.
The regulation is directed at Financial Market Participants (FMPs), including firms who oversee financial transactions (e.g. fund managers or pension providers) or advise on investment strategy (e.g. banks and investment firms) and their products (e.g. investment and mutual funds, insurance-based investment products and advice, and pensions).
Which financial market participants are impacted by the new regulation?
Although the regulation is driven from the EU, it will directly impact:
- EU regulated FMPs
- Non-EU FMPs with European connections
- Non-EU investment managers managing a European Economic Area (EEA) fund
- Funds acting as delegates of an EEA investment manager
- Funds managing segregated mandates for a client located in an EEA member state
- UK FMPs when providing services into the EU post-Brexit
The SFDR has not been retained in UK law during the Brexit process. However, a UK-specific regime similar to the SFDR will be developed between 2021 and 2022, according to the ELFA (European Leveraged Finance Association). Currently, if a UK firm is providing services into the EU, it is considered likely that the SFDR will still need to be adhered to as best practice and to facilitate access to investors.
A firm that has no European connections, no marketing in the EEA, and whose European clients do not require the firms’ compliance with the SFDR because they have their own regulation, e.g. in the reverse solicitation process, may be exempt from the SFDR. However, best practice and market expectations may still influence their approach to ESG reporting.
What must firms disclose?
The SFDR disclosure obligations are divided into three categories:
1. The principal adverse impacts of investment decisions on sustainability factors
Obligated firms must disclose the potentially negative consequences an investment decision may have on sustainability factors and how they are mitigating the impacts. These sustainability factors include environmental aspects, such as energy performance and water usage, as well as social aspects like employee matters and respect for human rights.
One specific environmental example is biodiversity. Firms will need relevant ESG Key Performance Indicators (KPIs) that enable them to disclose any investments or investee companies which do not assess, monitor, or control the pressures corresponding to drivers of biodiversity and ecosystem change.
The first reporting period for principle adverse impact indicators starts in June 2021, with the requirement to report starting in June 2022. It is not yet certain if these dates will be impacted by the delayed Regulatory Technical Standards (RTS).
Large companies or the parent undertaking of a large group (with over 500 employees) must publish this information on their websites. Firms with less than 500 employees can use a comply or explain rule, meaning that they can either explain their adverse impacts and subsequent mitigation strategies or explain why these are not considered.
By the end of 2022, these disclosures will also be required for financial products.
2. Considering sustainability (ESG) risk
From March 2021, firms will need to disclose where an ESG event could negatively impact material investment and align their remuneration policies with sustainability risk management. This involves firms stating how their remuneration policies are consistent with the integration of sustainability risk into key investment decisions. Firms will be required to publish an updated policy or statement detailing how the policy is consistent with integrating sustainability risks on their website.
3. Product-specific obligations
Where a product is categorised as an Article 8 or Article 9 product (see below), additional disclosures need to be made. These will eventually be enforced by the delayed Regulatory Technical Standards (now expected in January 2022).
- Article 8 products: financial products where the primary objective is not sustainable investment but promote, among other things, environmental or social characteristics.
- Article 9 products: financial products with sustainable investment as its core objective.
How do firms need to report?
FMPs can adhere to their disclosure obligations through three reporting channels:
- Mandatory website disclosures. Firms can disclose in detail both the remuneration policies that integrate sustainability risk management into investment processes and due diligence activities addressing the principle adverse impact of investment decisions on sustainability risk on their website.
- Pre-contractual disclosures. Mostly for financial products, firms must disclose the integration of sustainability risk management of the product, for example, in marketing materials and private placement memorandums.
- Periodic reporting to investors. This involves reporting the adverse impact of investment decisions on sustainability risk directly to their investors.
What is the impact of the regulation?
The regulation aims to reduce greenwashing and the overstating of green credentials. The European Commission found in an assessment of 344 “seemingly dubious claims” on the environment that nearly half (43%) were false or deceptive and 37% included purposely vague and misleading statements like “eco-friendly” and “sustainable”. Not only will the SFDR help organisations to focus on ESG risks during the investment process, but in addressing an existing gap in mandatory rules for ESG disclosure, the SFDR aim to spark a behavioural change for FMPs.
The SFDR follows a wave of new policies preserving investor value by stimulating greater investment in ESG disclosure. With 2020 proving that organisations with strong sustainability credentials can significantly outperform conventional funds during shocks, the focus on legitimising green credentials can be seen as a vital push to protect revenues and asset values from future disruption. This also follows a broader cultural shift, with climate policy being a key point in the 2020 US election and ESG risks at the forefront of investors’ minds following the shocks felt from the COVID-19 pandemic.
The SFDR sit as a gateway to further ESG related legislative activity as part of the European Commission’s Sustainable Finance Action Plan. This includes complementing the EU Taxonomy Regulation, which looks to establish whether an economic activity is environmentally sustainable. When complying with obligations for financial products under the SFDR, this activates disclosure requirements from the taxonomy. Similarly, firms must follow the taxonomy regulation to comply with the SFDR. The SFDR also overlaps with the EU Regulatory Technical Standards (RTS), which supplement the SFDR, albeit these have currently been delayed and are now expected in 2022.
March 2021: What should firms do now?
While further industry guidance is expected, firms can take the following proactive steps now to ensure smooth implementation of the SFDR:
- Review your European footprint. Firms should clarify which of their EU investors and clients or their EU regulated activities and products will fall under the SFDR.
- Review potential Article 8 or Article 9 products. Prepare these products to be held against the higher disclosure standards by reviewing any marketing documents and assessing if any additional product disclosures need to be made.
- Undertake a gap analysis of the firms’ current disclosure. An understanding of the steps the firm is currently undertaking is essential to be able to project the scale of the task ahead. Firms need a clear understanding of how they currently disclose their sustainability risks to investors and clients and where the gaps lie for SFDR compliance.
How can Anthesis help?
Anthesis’ Strategy, Brand, and ESG team can help to align corporate sustainability and private equity strategy against the ever-changing landscape of standards and regulations. This can involve an assessment of materiality, benchmarking and peer reviews, as well as ESG metrics and KPI setting and annual report writing. We are also conducting climate risk assessments for corporates and private equity clients to help them align with the requirements of the Task Force on Climate Related Disclosures.