The EU’s Sustainable Finance Disclosure Regulation (SFDR)

The EU’s Sustainable Finance Disclosure Regulation (SFDR)

As part of the European Union’s Action Plan on Financing Sustainable Growth, a new regulation on harmonising sustainability-related disclosures in the financial services sector has been developed to increase transparency in the disclosure of ‘sustainable’ investment products, thereby strengthening the protection to end users and cease ‘greenwashing’ whereby products are misleadingly labelled as sustainable, when they are not.

While the new regulation is not without its challenges, JANA sees the overall Action Plan as a step in the right direction in directing private capital to sustainable outcomes.  The regulation’s focus on enhancing transparency for the benefit of end investors is a positive in tackling greenwashing and creating a level playing field in an era where sustainability-related products are and will only further increase in both supply and demand.

What is Sustainable Finance?

In 1987, the United Nations (UN) defined sustainability as “meeting the needs of the present without compromising the ability of future generations to meet their own needs.”  Sustainable finance refers to the process of taking environmental, social and governance (ESG) considerations into account when making investment decisions in the financial sector.  The objective outcome is to increase long term investments in sustainable economic activities and projects.

In the European Union’s (EU) policy context, sustainable finance exists to support economic growth while reducing pressures on the environment and taking into account social and governance aspects.   It has a key role in delivering on the policy objectives under the European green deal as well as the EU’s international commitments on climate (Paris Agreement) and the UN 2030 Agenda (Sustainable Development Goals (SDGs)) – a commitment to eradicate poverty and achieve a sustainable world by 2030 and beyond, with human well-being and a healthy planet at its core.

The European Commission’s Action Plan on Financing Sustainable Growth

Sustainable development is a core principle and a priority objective for the EU’s internal and external policies.  As the world is increasingly faced with the challenges of climate change, biodiversity depletion and other sustainability-related issues, the EU has pressed for urgent action to mobilise capital not only through public policies, but also through the private sector.

The financial system can play a key role by re-orienting private capital to more sustainable investments and thereby creating a greener and more sustainable economy.  In recognition of this, the European Commission (hereafter ‘Commission’) in late 2016 appointed a High-Level Expert Group to develop a strategy on sustainable finance.  They saw the transition to a low-carbon, more sustainable, resource-efficient and circular economy to be in line with achieving the SDGs and supporting long-term competitiveness of the EU economy.

The review led to the development of the Commission’s Action Plan on Financing Sustainable Growth in 2018, and is part of their broader efforts to connect finance with the specific needs of the European and global economy for the benefit of the planet and society.  The key objectives and underlying actions are summarised in the graphic below.

On 6 July 2021, the Commission published its new sustainable finance strategy, which builds on the Action Plan while reflecting the changes in the global context since 2018 and an evolution of the Commission’s understanding of how to better meet its sustainability goals.  The new strategy is evident of the Commission’s determination to direct capital towards sustainable investments and their ambition to make the EU a global leader in setting standards for sustainable finance.

The Sustainable Finance Disclosure Regulation (SFDR)

While re-orienting private capital to sustainable finance and investments to achieve a sustainable economy is the ultimate objective, the EU realises this objective may lead to a proliferation of capital being directed to investments that are not genuinely sustainable – “greenwashing”.  As a result, the Sustainable Finance Disclosure Regulation (SFDR) has been developed for the “mainstreaming sustainability in risk management” and “fostering transparency and long-termism”, to address the twin objectives of increasing transparency of sustainability-related disclosures and to increase comparability of disclosures for the protection of end investors.

Under the SFDR, financial market participants¹ (FMPs) and financial advisers are required to report on how they account for sustainability risks at both the “entity level” and “product level” i.e. to disclose how and to what extent they include sustainability risks and performance indicators at the organisational level and in their investment decisions and products.

Entity Level Disclosures

As of 30 June 2021, FMPs with more than 500 employees, under Article 4 of the SFDR are required to publish and maintain on their websites, where they consider principal adverse impacts² of investment decisions on sustainability factors and a statement on the due diligence policies with respect to those impacts.  Where an FMP does not consider the adverse impacts of investment decisions on sustainability factors, they must publish and maintain on their website clear reasons for why they do not do so, including where relevant, information as to whether and when they intend to consider such adverse impacts.

Product Level Disclosures

Since 10 March 2021 European-based asset managers and those who market alternative investment funds in Europe are required to comply with a number of high-level principles-based disclosure requirements.  These include prospectus updates and website disclosures as well as the updating or preparation of a sustainability risk policy.  This is commonly referred to as “Level 1” of the SFDR.

The SFDR categorises financial products into three major groups:

• “Article 6” products, which do not have any particular ESG focus – the majority of products in the market;
• “Article 8” products, referred to as ‘light green’ products, which integrate ESG considerations, but are more focused on financial outcomes; and
• “Article 9” products, referred to as ‘dark green’ products, which effectively have sustainability as their objective such as reducing carbon emissions in line with the Paris Agreement, or building affordable social housing.

Naturally, additional disclosure requirements will apply to the “Article 8” and “Article 9” products funds to curb investment managers from greenwashing.

Next Steps and Challenges

The main provisions (Level 1) of the SFDR applied from 10 March 2021; however, the more detailed disclosure requirements relating to the technical details of the disclosures in periodic reports (Level 2) will apply from 1 July 2022 following the finalisation of the Regulatory Technical Standards (RTS).

The SFDR Level 2 requirements will introduce more detailed, and (for those products in scope) more onerous, sustainability-related disclosures at the firm and product level.  It will include disclosure templates that should be used to comply with the disclosure requirements in the SFDR.  The information disclosed must follow the prescribed content, methodology and presentation set out in the SFDR RTS.

Level 2 requirements were expected to apply from 1 January 2022 – a delay from 10 March 2021.  However, on 8 July the Commission announced a further delay to the application of the RTS due to a number of challenges such as its length and technical detail, and apparent concerns by some national regulators over potential shortcomings of the SFDR.

While the SFDR applies directly to managers who market funds into the EU, it also applies indirectly to managers providing portfolio management and/or investment advice services to EU firms that are subject to the rules.  However, this applicability and the actual geographic scope of the regulation also requires clarity.

Impacts on Investments

The successful implementation of the EU’s Action Plan will likely result in considerable amounts of private capital being directed at sustainable finance that should lead to long term benefits to the economy, the planet and society.   The SFDR has the merit of preventing greenwashing and creating a level playing field in an era where sustainability-related products are and will only further increase in both supply and demand.

However, any new regulation is not without its challenges and teething issues and this is evident by the further delay of the Level 2 requirements.  Some may argue that the regulations were rushed and have only caused confusion amongst those impacted.  The requirements under the SFDR RTS are detailed and will require asset managers to report on additional ESG datasets.  This data may not yet be readily availability for many managers and the diversity of the data and potential lack of comparability between different methodologies and standards may also pose additional challenges.

The postponement of the Level 2 measures will be welcome news for many of the impacted asset managers, as there remains uncertainty on some of the more complex RTS disclosure requirements.  The delay will provide managers with more time to carefully review the implications on their firm and investment products, so they are well-prepared to comply with the enhanced regulations, particularly given this will apply to all managers – not just those that offer sustainably-related strategies.  There will be some managers that underestimate the ESG impacts of their investment decisions, not fully comprehending the potential negative effects some of these decisions may have.

JANA continues to engage with our impacted managers to ensure they fully understand the implications of the SFDR and are well-informed and ready for when the Level 2 requirements are finalised.  Furthermore, we must ensure they do not lose sight of the bigger picture of generating investment returns for our clients.

¹ FMPs are defined as professional players in the financial market, like pension funds, asset managers (including alternative investment fund managers (AIFMs) and undertaking for collective investment in transferable securities (UCITS) management companies), insurance companies, banks, venture capital funds, credit institutions offering portfolio management or financial advisors.
² Principal adverse impacts are negative, material or likely to be material effects on sustainability factors that are caused, compounded by or directly linked to investment decisions and advice performed by the legal entity.  The EU has identified 64 adverse impact indicators that must be calculated, of which 18 will be mandatory to report, and 46 will be voluntary. They will focus on standard ESG factors, such as carbon emissions, fossil fuel exposure, waste levels, gender diversity, respect for human rights, anti-corruption and anti-bribery matters.

If you would like more information, please reach out to your JANA consultant.