The Sustainable Finance Disclosure Regulation (SFDR) is a European directive designed to enhance transparency in the financial sector regarding sustainable investment products. It serves the purpose of preventing greenwashing and increasing clarity on sustainability claims made by participants in the financial industry.
The SFDR is a key component of the EU Sustainable Finance Agenda and was introduced by the European Commission as part of its 2018 Sustainable Finance Action Plan, alongside the Taxonomy Regulation and the Low Carbon Benchmarks Regulation.
This regulation mandates sustainability disclosure requirements for EU-based financial actors, covering a wide range of environmental, social, and governance (ESG) metrics at both entity and product levels. The SFDR is integral to the broader European initiative for a sustainable economy outlined in the European Green Deal, aiming for a climate-neutral European economy by 2050, aligned with the Paris Agreement.
The SFDR was introduced in 2019 and came into effect in March 2021.
The main provisions (Level 1) of the Disclosure Regulation will apply from 10 March 2021.
The more detailed disclosure requirements relating to disclosures in the periodic reports of ESG-focused products are stated to apply from 1 January 2022 (Level 2).
The SFDR applies to EU-based financial market participants with over 500 employees. This includes banks, investment firms, asset managers, fund managers, pension funds, insurance companies, institutional investors, venture capital funds, alternative investment funds and credit institutions that offer portfolio management. Financial advisors providing investment advice or insurance advice regarding insurance-based investment products are also included. The SFDR is also applicable to investment managers and financial advisers based in the EU, even if they are based elsewhere.
If your company falls within the scope of SFDR as previously described, you will be obligated to fulfil specific disclosure obligations. These requirements encompass a wide array of environmental, social, and governance (ESG) metrics, both at the entity and product levels.
To adhere to SFDR, you will need to report sustainability-related information in a standardized manner, necessitating the collection of relevant data and information from your clients and portfolio companies.
The SFDR distinguishes between two levels of disclosures, as elaborated below:
Entity-level disclosures (Level 1):
As a financial market participant, the entity-level sustainability disclosures, also known as Level 1 disclosures, entail disclosing your sustainability policies at the entity level. These requirements have been in effect since March 10th, 2021. To comply, you must publish the following information on your website:
- Sustainability risk policy: Describe how sustainability risks are taken into account in your investment decisions.
- Principal adverse impact: Explain the impact of your investments on various sustainability factors, including social aspects and climate-related indicators. Compliance necessitates reporting on 14 distinct sustainability factors, with six specifically addressing greenhouse gas emissions.
- Sustainability risk remuneration policy: Detail if and how risks are considered in your company's remuneration policy.
If your investment decisions do not consider sustainability impact, you must explicitly state this on your website along with a clear rationale for your choice.
Under principal adverse impact, SFDR mandates financial actors to report on investee companies' volumes, encompassing Scope 1 and 2 emissions. Starting from January 1st, 2023, this reporting must also include Scope 3 emissions, which broadly cover a company's value chain. You must also disclose any actions taken to address these principal adverse impacts and provide a summary of your company's engagement policies.
For companies covered by SFDR, reporting on principal adverse impact became mandatory from January 1st, 2022.
Product-level disclosures (Level 2):
Reporting on product-level disclosures, or Level 2 disclosures, became obligatory as of January 1st, 2022.
This entails adopting additional disclosures for each financial product you create or promote, depending on the specific financial product category:
- Mainstream: For financial products that consider principal adverse impact, you should elucidate how your products account for these impacts. This applies to all your products, regardless of their intended alignment with sustainability goals.
- Promoting environmental or social characteristics: For products promoting environmental or social characteristics (referred to as Article 8 products), you should provide extra information on how these attributes are met, including the degree of alignment with EU Taxonomy for the underlying activities.
- Having sustainable investment objectives: For products with a sustainable investment objective (termed Article 9 products), you should clarify how the objective is achieved and offer additional disclosure on alignment with EU Taxonomy Regulation. Additionally, you should clearly specify which sustainability indicators are utilized for investment advice.
Starting from June 30th, 2023, companies will be required to disclose detailed indicators for principal adverse impacts for the period spanning from July 2022 to December 2022.
Product classification within the SFDR framework involves three distinct categories: Articles 6, 8, and 9.
Article 6:
These products typically do not consistently incorporate sustainability and ESG (Environmental, Social, and Governance) considerations into their investment decision-making process.
They are commonly referred to as 'mainstream' financial products.
Although they do not meet the criteria of Articles 8 or 9, they are still required to take sustainability risks into account.
Importantly, Article 6 mandates that all financial firms must disclose how sustainability risks are integrated into their investment decision-making process.
Article 8:
Financial products falling under Article 8 promote environmental and/or social characteristics, and the companies in which these investments are made are expected to demonstrate good governance practices.
However, it's important to note that ESG investing is not the central focus or core objective of these products. They may incorporate ESG factors to some extent but not to the same degree as Article 9 products.
Article 9:
Financial products categorized as Article 9 products have sustainable investment as their primary and core objective.
These products are designed with the explicit goal of aligning with sustainability principles and objectives.
Article 9 also plays a role in assessing whether a given financial product causes significant harm, providing a higher level of scrutiny and accountability for products with sustainability as their core objective.
In summary, the SFDR classifies financial products into Articles 6, 8, and 9, with each category reflecting different levels of commitment to sustainability and ESG principles. Disclosure and transparency requirements vary based on the classification, with Article 9 products subject to more stringent standards due to their core sustainability focus.
How can financial organizations prepare for the SFDR?
Financial organizations preparing for SFDR compliance should follow these steps to ensure effective adherence to the regulatory requirements:
Define ESG Data Requirements:
- Identify the specific ESG (Environmental, Social, and Governance) data needed from your investments and portfolios to meet SFDR compliance. This should encompass various aspects, including environmental data (e.g., carbon footprint, natural resources use), social data (e.g., labor issues, human rights), and governance data (e.g., corruption policies).
- Recognize that SFDR entails a total of 64 indicators related to principal adverse impacts (PAIs), so it's crucial to gather data relevant to these indicators.
Collect Relevant ESG Data:
- Gather the necessary ESG data required for SFDR compliance from your investments and portfolio holdings.
- Ensure that the data collected is reliable and unbiased. This may involve obtaining information directly from companies and cross-referencing it with impartial sources such as company reviews and financial news.
Portfolio Screening:
- Utilize the ESG database you've established to screen your current portfolio holdings for PAI indicators.
- Implement a system to screen potential future acquisitions and investments for sustainability characteristics.
- This screening process will help you identify areas within your portfolio that might raise concerns regarding sustainability practices and also highlight opportunities for positive sustainability impact.
Establish Reporting Processes:
- Once you have a robust screening process in place to detect SFDR risks and principal adverse sustainability impacts (PAIs) within your portfolio, establish a reporting mechanism.
- Comply with SFDR requirements by disclosing information about the current state of your investments on your organization's website.
- Be prepared to refine and enhance your reporting processes as SFDR evolves and reaches its full application.
Additionally, it's essential for financial organizations to stay updated on SFDR regulatory changes and guidance issued by relevant authorities. This proactive approach will help ensure ongoing compliance with SFDR and alignment with evolving sustainability disclosure standards.
What is the relationship between the SFDR and the EU Taxonomy?
The Corporate Sustainability Reporting Directive (CSRD) and the EU Taxonomy both play vital roles in advancing sustainable finance and endorsing sustainable growth and environmental goals in the EU. Enacted in 2020 as part of the EU Green Deal, the Taxonomy Regulation establishes a framework to define and disclose environmentally sustainable economic activities. It specifically targets six environmental objectives, including climate change mitigation, adaptation, sustainable use of water and marine resources, transitioning to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems. These objectives undergo further refinement through the development of regulatory technical standards and specific environmental criteria.
The CSRD's objective is to enhance corporate sustainability reporting by expanding reporting requirements for EU companies and promoting the integration of sustainability risks. It aims to align reporting with the sustainable objectives outlined in the EU Taxonomy, encompassing regulatory technical standards and specific environmental criteria. By integrating the Taxonomy's goals into the CSRD, the reporting framework will offer a more standardized and transparent approach to assess and disclose the environmental impact of companies. This alignment will simplify the identification of sustainable economic activities, empowering investors and stakeholders to make informed decisions and channel capital towards environmentally friendly investments. Ultimately, this contributes to fostering sustainable growth within the EU as part of the broader EU Green Deal agenda.
How is the SFDR different from the CSRD?
Different from the Corporate Sustainability Reporting Directive (CSRD), the SFDR focuses specifically on financial firms, emphasizing enhanced disclosure obligations on sustainability risks. The CSRD applies to a broader range of companies, requiring more comprehensive ESG information disclosure, with an emphasis on third-party verification and accountability for all companies. Both regulations aim to support informed decision-making by investors.
Principle Adverse Impacts (PAIs)
Principle Adverse Impacts signify significant negative effects that an organization's activities, products, or services may have on Environmental, Social, and Governance (ESG) factors. It is important to note that, according to the SFDR, financial actors are required to take into account PAIs in their investment or insurance advice.
Pre-contractual disclosures
Pre-contractual disclosures entail mandatory information that financial market participants must furnish to investors before entering into an investment contract. These disclosures aim to provide transparency regarding sustainability-related risks and impacts associated with the investment.
Carbon emissions
Carbon emissions denote the release of carbon dioxide (CO2) and other greenhouse gases into the atmosphere due to a company's operations. This includes activities like energy consumption, manufacturing processes, and supply chain activities.
Sustainability factors
Sustainability factors encompass a range of considerations falling under environmental, social, and governance (ESG) categories. These include respect for human rights, anti-corruption efforts, and other ethical practices relevant to influencing the financial performance and impact of investments or companies.
Sustainability risks
Sustainability risks pertain to potential adverse impacts on financial performance arising from ESG factors, such as climate change, resource scarcity, human rights violations, and other sustainability-related challenges. The SFDR mandates financial actors to integrate sustainability risks into their investment processes.
EU Sustainable Finance
EU Sustainable Finance refers to the framework and initiatives established by the European Parliament to integrate sustainability considerations into the financial system. The goal is to promote environmentally and socially responsible investments, thereby facilitating the transition to a sustainable economy.
Sustainable Investment
The SFDR defines a 'sustainable investment' as an investment in an economic activity that contributes to achieving the ESG objective.