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 European Union (EU) has started to implement the Sustainable Finance Disclosure Regulation (SFDR), which sets out rules for classifying and reporting on sustainability and ESG factors in investments.
SFDR was developed to improve transparency, which of course helps to prevent greenwashing, as well as to direct capital towards more sustainable investments/ products and businesses.
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Who does SFDR apply to?
The regulation applies to all financial market participants (“FMPs”) and financial advisors (“FAs”) in the EU, FMPs with EU shareholders, and those marketing themselves in the EU, and sets out clear disclosure requirements.
- An insurance company that makes available an insurance-based investment product
- Investment firms that provide portfolio management
- An institution for occupational retirement provision
- A manufacturer of pension products
- An alternative investment fund manager
- A pan-European personal pension product provider
- manager of a qualifying venture capital fund
- A manager of a qualifying social entrepreneurship fund
- A management company for UCITS (Undertakings for the Collective Investments in Transferable Securities)
- A credit institution that provides portfolio management
The products that it encompasses include (not exhaustive): investment and mutual funds, UCITS, insurance-based investment products, private and occupational pensions and insurance and investment advice.
Has Brexit impacted SFDR?
The SFDR was not retained in UK law during the Brexit process. However, a UK-specific regulation is planned, which is expected to work similarly to the EU SFDR.
The SFDR has 2 levels of disclosure:
Entity Level: disclosure obligations for the entities themselves concerning their policies on decision-making on sustainability risks.
Product Level: reporting obligations concerning the financial products and their sustainability risks.
What must firms disclose?
The SFDR disclosure obligations are divided into three categories:
1. The 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 example of an environmental aspect that firms will need to disclose is biodiversity. Firms will need to demonstrate that the economic activity is not negatively affecting biodiversity-sensitive areas (through demonstrative evidence of ecological assessments, due diligence, and continual monitoring of any impacts – positive or negative).
2. Considering sustainability (ESG) risk in investment processes
Firms need to disclose where an ESG event could negatively impact material investment and align their remuneration policies with sustainability risk management.
3. Provision of sustainability information with respect to financial products
Where a product is categorised as an Article 8 or Article 9 product (see below), additional disclosures need to be made.
Classification of Products
SFDR distinguishes between three types of product classification:
|Article 6||Products that do not integrate ESG considerations into the investment decision-making process or explain where the integration is not relevant, where products do not meet the criteria of Article 8 or 9.|
|Article 8||Products that promote environmental and/or social characteristics amongst other characteristics and the companies in which the investments are made have good governance practices. This implies that ESG investing is not core to these products.|
|Article 9||Products that have sustainable investment as their core objective.|
Entity-Level Disclosure Requirements
The SFDR sets out requirements for FMPs and FAs to disclose sustainability information at the legal entity level. When FMPS and FAs disclose, they will be required to provide policies detailing how they will integrate sustainability risk into the investment decision-making process, information and considerations on adverse sustainability impacts, and consistency of remuneration policies with sustainability risks. A firm must publish a statement of intent on their website to demonstrate which Article they intend to align to.
SFDR sets out that FMPs shall publish and maintain their policies for due diligence over the adverse impacts of their investment decisions on sustainability factors on their websites.
There are also four narrative disclosures required at the entity level on the website:
- Information on policies to identify and prioritise Principal Adverse Impacts (“PAI”)
- A description of such impacts and any actions taken
- Summaries of engagement policies regarding the prevention and management of potential conflicts of interests
- Reference to responsible business conduct codes and standards for due diligence and reporting
Per the draft Level 2 RTS (Regulatory Technical Standards), this also includes disclosure against a possible 64 quantitative ESG metrics (14 mandatory), which is likely to be a significant amount of work for many FMPs.
With the breadth and depth of disclosure needed at the entity level and product level, it should be possible to understand which products are sustainable and which are not. However, supervisors have expressed concern that there is no licensing process to ensure that Article 9 investments are really Article 9 investments. So, it may come that investments will need to be reviewed and licensed at some point in time.
Product-level disclosures centre around the following areas for products covered by Articles 6, 8 and 9:
Pre-contractual disclosures cover similar areas to the entity-level disclosures around the integration of sustainability risks and principal adverse impacts, e.g. through contractual documentation, but include also additional disclosures for Article 8 and 9 products.
- For all products, there must be a disclosure of the principal adverse impacts on sustainability factors.
- Additionally, there are more sustainability disclosures for Article 8 and 9 products concerning the extent to which environmental and social characteristics are met and a comparison between the product impact and the impacts of a designated index.
- There are also requirements for green taxonomy-related disclosures for Article 8 and 9 products looking at the criterion do no significant harm (“DNSH”) and taxonomy objectives.
Website product disclosures – For each product under Articles 8 and 9, the entity must disclose its characteristics, how the characteristics are measured and monitored, due diligence on the underlying assets, data sources and any limitations met.
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”.
What is the impact of the regulation?
The regulation aims to reduce greenwashing and the overstating of green credentials. 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.
Implementation Considerations for FMPs and FAs
For FMPs and FAs that operate in the EU to be able to market investments as Article 8 or 9, they will need to review the whole lifecycle of their products, from initial product development, marketing, contracting, through to monitoring and reporting and update their policies and processes.
In short, we see the following areas that need to be addressed:
If you want to discuss any of the topics in this document with us, please reach out to the Anthesis Sustainable Finance team, using the contact form below.
How can Anthesis help?
Anthesis’ ESG and Sustainability Strategy 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.
Anthesis has experience in helping banking institutions and fund managers to implement SFDR and can support in incorporating the requirements of the SFDR into due diligence tools for private equity firms and develop SFDR screening frameworks for firms to assess and evidence the entity and product-level impact against PAIs.