SFDR: A Game-Changer for The Financial Industry

In 2015, the European Union (EU) adopted two ambitious targets in its super national policy framework: Net-Zero Greenhouse Gas emissions by 2050 and the United Nations Sustainable Development Goals (SDGs) by 2030. These targets set in motion a flurry of regulatory activity aimed at achieving these objectives. Significant funding was made available to develop regulations that address the financial services sector. This resulted in the creation of the Sustainable Finance Disclosure Regulation (SFDR) and, equivalently, the Corporate Sustainability Reporting Directive (CSRD), a regulatory framework for non-financial companies.

The SFDR is a regulation that mandates environmental, social, and governance (ESG) disclosure for asset managers and other financial market participants, with substantial elements of the legislation taking effect on March 10, 2021. 

This regulation is intended to help investors make informed investment decisions and promote capital flow to sustainable businesses.

The SFDR is the first regulation to introduce strict labeling for ESG-related products, which can help mitigate greenwashing and false claims. It applies to all financial advisers (FAs) and financial market participants (FMPs) based in the EU. FAs are entities that provide investment or insurance advice, while FMPs are entities that manufacture financial products, including portfolio management services.

FAs with at most three employees are not required to provide information under the SFDR. However, they must still consider sustainability risks in their advisory process. FMPs, on the other hand, must provide more extensive disclosures about their sustainable investment products, including information about their ESG objectives and how they are implemented.

The EU Taxonomy and the SFDR: A Guide to the Future of Sustainable Investing.

The EU Taxonomy falls between SFDR and CSRD. The EU Taxonomy is a list of economic activities that contributes to measuring sustainability through six environmental objectives:

1. Climate change mitigation
2. Climate change adaptation
3. Sustainable use and protection of water and marine resources
4. Transition to a circular economy
5. Pollution prevention and control
6. Protection and restoration of biodiversity and ecosystems

The EU Taxonomy is a framework for measuring sustainability, a central SFDR component. 

The aim of both the EU Taxonomy and the SFDR is to increase transparency regarding sustainability claims. Most organizations that fall within the framework of SFDR will be required to report in a manner aligned with the EU taxonomy.

Before reporting in alignment with EU Taxonomy, businesses should first understand SFDR product classifications to recognize product-level requirements.

 Below are the three main classifications:

• Article 6 refers to products that don’t integrate sustainability considerations into the investment process, including non-ESG funds. Asset managers must disclose how sustainability risks are integrated or explain why they aren’t.

• Article 8 (Known as green) refers to products with some investment strategy focused on environmental and social objectives, given that the investment companies have good governance practices but do not have sustainable investing as a core objective.

• Article 9 (Known as dark green) refers to products with a complete investment strategy toward an environmental or social objective.

Article 8 products have ESG objectives but do not meet the strict criteria for Article 9 products. For example, Article 8 products might invest in companies with good ESG ratings, but it might not invest in companies aligned with the EU Taxonomy.

The main difference between Article 8 and Article 9 is that in most cases, Article 9 products must align with the EU Taxonomy. This means that Article 9 products must invest in companies actively contributing to one or more of the six environmental objectives.

Therefore, Article 9 products are considered more sustainable than Article 8 products. This is because Article 9 products directly contribute to the fight against climate change and other environmental challenges.

The Limitations in SFDR Classifications and the EU Taxonomy.

The SFDR defines sustainable investment, but it does not require that all sustainable investments be aligned with the EU Taxonomy.  

This has created ambiguity, where FMPs argue that they are using SFDR definitions for sustainability, thus avoiding the more stringent disclosure requirements that apply to Article 9 funds.

The gap that exists between the SFDR and EU Taxonomy is likely to be addressed in the near future. The European Securities and Markets Authority has already recommended SFDR amendments to remedy this loophole. Furthermore, investors seeking sustainable investments are increasingly demanding that their investments adhere to the EU Taxonomy.

Therefore, it is shortsighted for FMPs to exploit the SFDR loophole to avoid taxonomy alignment. It is more likely to harm than help their firm long-term. 

Article 8 and Article 9 products promote ESG objectives; thus, they invest in companies working to improve their environmental impact, social responsibility, and corporate governance.

Both Articles must disclose information about their ESG objectives and policies. Moreover, both articles are subject to the European Securities and Markets Authority (ESMA) enforcement. This means ESMA, via national competent authorities, can act against financial institutions that fail to comply with the SFDR.

The differences between Article 8 and Article 9 funds are subtle. While Article 8 funds do not have a sustainable investment objective, they still must comply with specific sustainability disclosure requirements under the SFDR. Article 9 funds, on the other hand, ought to be aligned with EU taxonomy objectives and must also meet more stringent disclosure requirements because they are marketed as sustainable investments.

Given the similarities between the two articles, some institutions use Article 8 items to avoid going through Article 9. This is because Article 8 items have less stringent disclosure requirements, making it more straightforward for financial institutions to market their products as sustainable without having to satisfy all the SFDR’s standards. 

SFDR Disclosure Requirements.

Pre-contractual and Periodic disclosure are two types of disclosure requirements under the Sustainable Finance Disclosure Regulation (SFDR).

• Pre-contractual disclosure is made to investors before they invest in a fund. It includes information about the fund’s sustainability credentials and how it will comply with the SFDR.

• Periodic disclosure is information that FMPs must disclose to investors on an annual regular basis. This information must be more detailed than the pre-contractual disclosure. It must include information about the product’s performance against its investment objectives, the risks associated with the product, and how the FMPs manage these risks.

The pre-contractual and periodic disclosure requirements under the SFDR vary depending on the SFDR article classification of the product. For example, FMPs offering Article 9 products must provide more detailed disclosure than FMPs offering Article 8 products.

The SFDR’s pre-contractual and periodic disclosure requirements are designed to help investors make informed investment decisions. By providing investors with clear and concise information about sustainable investment products, the SFDR is helping to promote transparency and accountability in the financial market.

PAI Disclosures: A Step Towards a More Sustainable Financial System.

The key to adequate disclosure is Principal Adverse Impacts (PAI). PAIs measure the impact of investment decisions or advice that negatively affects sustainability factors, such as environmental, social and employee concerns, respect for human rights, anti-corruption and anti-bribery issues. For FMPs and FAs, providing the required PAI information is one of the most challenging obligations under SFDR.

Only recently, more information was available on the application of PAI obligations and the related disclosure requirements. However, the introduction of the SFDR Delegated Regulation, which entered into force on January 1, 2023, has provided much-needed clarity. 

PAIs are disclosed in the following independently applicable ways: 

• Disclosure on an entity level (Level 1) entered into force on March 10, 2021. Under Level 1, FMPs and FAs must report and publish annual PAI statements.

• Disclosure on a fund level (Level 2) should be reported by June 30, each year, from January 1 to December 31 the previous year. Under Level 2, PAI information is documented in pre-contractual financial product documentation, such as fund information memoranda or prospectuses.

 The main challenge with PAIs is that they require fund managers to gather data from each investor and report at the fund level, presenting it under one report. This can be a complex and time-consuming process, as it requires managers to track and analyze data on various ESG metrics, such as greenhouse gas emissions, water usage, and gender pay gap.

PAIs: A Boon or a Burden?

In addition to the challenges of PAIs, there are challenges in obtaining quality ESG data and limited resources in the field of sustainability.

• Quality Data: ESG data is often not easily accessible. Companies may not have a centralized system for collecting ESG data, and the available data may need to be standardized. This can make it difficult for investment managers to compare data across all portfolio companies.

Another challenge is that ESG data quality can vary. Some companies may need more resources to collect accurate ESG data, and others may need to be more transparent about their ESG performance. This can make it difficult for investment managers to trust the ESG data that they are provided with.

Data quality is defined by the ability to pass an audit. Consequently, the data must be accurate and verifiable. Currently, there is no requirement for audit in the SFDR, but it is a solid practice to follow, and it is likely to be required in the future. Moreover, regulators will start to crack down on data quality, and there will be no tolerance for poor data over time.

• Resource: There is also a shortage of skilled professionals in sustainability. This can make it difficult for investment managers to find qualified teams to collect and analyze ESG data, hence why 90% of the market relies on software for reporting. Though skilled personnel are still required to operate software.

SFDR: The Next Frontier in Sustainable Finance.

The SFDR is a groundbreaking piece of legislation that aims to increase transparency in the financial markets about sustainability risks and opportunities. The SFDR requires FMPs to disclose information about their sustainability-related activities and policies.

The SFDR is a positive development for investors, as it gives them more information about their investments’ sustainability risks and opportunities. Although the SFDR is still in its early phases of implementation, it has the potential to significantly contribute to the transition to a more sustainable economy. SFDR policies can redirect investment towards sustainable firms and projects by giving investors more significant information about organizations’ ESG performance. As a result, the transition to a low-carbon economy and achieving the SDGs by 2030 can be accelerated.

The SFDR is already being amended to reflect the evolving nature of sustainability risks and opportunities. It is likely that the SFDR will continue to be amended in the future as financial markets become more sustainable. Furthermore, in three to five years, the SFDR may see audit requirements like CSRD. This would mean that FMPs would be required to provide evidence to support their sustainability claims. This would ensure that investors can trust the information they are given.