Around the world, consumers and investors alike are powering a growing demand for transparency from the businesses they patronize and partner with. Simultaneously, governments and businesses seek methods to help individuals identify companies and any investment decisions that can help to propel forward a more sustainable economy.
In accordance with these efforts, recent regulations like the Sustainable Finance Disclosure Regulation (SFDR) have come forth to ensure that information is widely available.
The SFDR, which was introduced in 2019 and came into effect in March 2021, is part of a new wave of regulatory requirements set by the European Union (EU). Its stated purpose is to promote sustainable investment and increase transparency in the financial sector.
These new regulations were designed to standardize environmental, social, and governance (ESG) measurements, making it easier for both retail and institutional investors in the EU to understand, compare, and monitor investment funds through the lens of sustainability.
What are the SFDR reporting requirements?
With the SFDR now in effect, EU-based companies must quickly understand and align themselves with the stated rules for financial product reporting and ESG factors. So, what SFDR requirements must your company comply with?
According to the European Sustainable Investment Forum (Eurosif)—the leading European association for the promotion and advancement of sustainable and responsible investment—SFDR reporting regulations were introduced to “improve transparency in the market for sustainable investment products, to prevent greenwashing and to increase transparency around sustainability claims made by financial market participants.”
To that end, the SFDR compels market participants and financial advisers to disclose information about how sustainability risks and opportunities policies, as well as ESG factors, play into their investment strategies and decision-making. They’re expected to include this information on their:
- Website
- Periodic reports
- Contractual documents
- Prospectuses
- Ad Hoc marketing communications material
But what is considered a sustainability risk or opportunity?
This could include topics like human rights, labor practices, or climate change—basically, any issue that could significantly impact an investment’s long-term performance.
With the SFDR, a firm must report their methodology for assessing the impact of the investment, according to sustainability factors, noting any discovered adverse impacts. This encourages firms to be transparent about how they promote sustainability while also revealing the potential negative ramifications of any investment.
The goal of this regulation is to hold firms accountable for the global impact of their financial decisions.
Who does SFDR apply to?
Generally speaking, the SFDR applies to financial market participants (FMPs) and financial advisers operating within the EU’s parameters or offering financial services or products to EU investors.
This applies to a broad swath of financially-focused entities.
For example, both banks and asset managers must disclose relevant information on their tactics for identifying and assessing sustainability risks and opportunities, as well as any specific policies and procedures that have been implemented to manage these risks and opportunities. Insurance companies need to do the same regarding their underwriting and investment activities.
That said, SFDR doesn’t apply to all financial services and products—only those that fall within the scope of the EU's regulations on sustainability disclosures in the financial sector.
But what about American companies?
Although on the surface, it may only seem applicable to EU companies, if an American company operates or offers products or services within the EU, they, too, would be subject to the SFDR regulations.
But, even for those companies that don’t do business in Europe, the political and societal headwinds have already begun to turn in that direction—with many companies proactively adopting similar sustainable financial disclosure standards.
And in 2021, the SEC recently began requiring listed companies to disclose information on human capital resources on their Form 10-K. While it remains unclear what exactly this means for the broad swath of American companies, if recent history indicates, companies should get a head start on rolling out such initiatives sooner rather than later.
What must firms disclose?
SFDR mandates that firms disclose information on all policies, processes, and outcomes that relate to the integration of sustainability risks and opportunities within their investment decision-making processes. This is divided into three categories:
- Adverse impacts of investment decisions on sustainability factors
- Considering sustainability (ESG) risk in investment processes
- Provision of sustainability information with respect to financial products
The EU Commission believes that by providing end-investors with more information about the impact a certain investment has on society and the environment, investors will shift capital away from harmful activities and toward positive ones.
But even now, confusion remains about what exact disclosure requirements are mandated and what scope a product falls under. As Deloitte notes, the SFDR doesn’t prescribe how firms should determine which category their products belong in:
“Disclosure requirements apply under article 8 to products that also promote environmental or social characteristics, whereas disclosure requirements apply under article 9 to products that have sustainable investment as their objective. This forces asset managers to determine whether their products come under the scope of either article 8 or article 9 at a very early stage of their implementation project.”
Additionally, SFDR levels will also impact this determination.
What are the SFDR levels?
To add clarity to this regulatory environment, in April 2022, the EU Commission published its proposed regulatory technical standards (RTS), which would split SFDR guidance into two levels:
Level 1: Entity-level disclosure
The SFDR requires financial market participants and financial advisers to disclose information at the legal entity level on how they integrate sustainability risks into their investment decision-making process.
This is the basic level and typically requires subject companies to make principles-based disclosures on their ESG-focused activities. For instance, on its website, an entity-level company must publish and maintain:
- Information on policies to identify and prioritize Principle Adverse Impacts (PAI) and a statement on due diligence policies with respect to those impacts.
– In cases where PAI are not considered, they must provide clear reasons for why that is the case.
- Descriptions of impacts and actions taken to remedy them.
- Brief summaries of engagement policies about the prevention and management of possible conflicts of interest.
- Reference to adherence to applicable responsible business conduct codes and standards as they relate to due diligence and reporting.
Here, it’s essential to highlight that while Level 1 disclosure is the bare minimum requirement, applicable firms are encouraged to go above and beyond this disclosure to provide even greater transparency to current and would-be investors.
Level 2: Product-level disclosure
The next and more stringent level of disclosure is Level 2: product-level disclosures.
As a base requirement, entity-level disclosures remain largely applicable, particularly the principal adverse impacts on sustainability factors. This likely won’t change how products are managed, but it will necessitate enhanced disclosure beyond that which was required by Level 1.
That said, the nature and extent of disclosure requirements depend on whether the product is classified as an Article 8, Article 9, or Article 6 product. Those that fall under the auspices of Article 8 or 9 must provide even greater transparency by providing information about:
- The extent to which ESG characteristics are met
- How the product impact compares to the designated index
- Whether they satisfy Do No Significant Harm (DNSH) standards
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What are the SFDR classifications?
The classification for SFDR is a system that ranks product levels according to their sustainability and transparency. Broadly speaking, a fund will either be classified as:
- Article 6 – Funds that do not have a sustainability scope.
- Article 8 (light green) – Funds that promote environmental or social characteristics.
- Article 9 (dark green) – Funds that have sustainable investments as their objective.
Article 6
Article 6 covers the transparency of the integration of sustainability risks. It expects market participants to include the following disclosures in pre-contractual disclosures:
- How sustainability risks are integrated into their investment decisions
- The assessment results and likely impacts of sustainability risks on the returns of the available financial products
If an investment fund does have relevant sustainability risks, they are required to:
- State that they have integrated sustainability risks into their investment strategy
- Develop a process for assessing, identifying, and monitoring significant risks
- Provide a disclosure policy on risk mitigation that details how these ends will be achieved, tracked, and implemented
As mentioned previously, if funds determine a sustainability risk is irrelevant, they must clearly explain why.
Article 8
Article 8 covers the transparency of the promotion of environmental or social objectives in pre‐contractual disclosures.
Article 8 funds that follow good governance practices must provide information pursuant to article 6, in addition to more detail on how the environmental and social characteristics are met. The products must also benchmark themselves against other products that promote similar characteristics.
Article 9
Article 9 covers transparency of sustainable investments in pre‐contractual disclosures. For an investment fund to comply with article 9, sustainable investment must be its primary objective, with benchmarks used to measure contributions to stated ESG objectives. To that end, they must explain:
- How the index is aligned with that given objective
- Why and how the designated index that is aligned with the objective may differ from a broad market index
At its essence, an article 9 fund is focused on making a positive impact on society or the environment via sustainable investment, with a non-financial objective as the product’s core offering.
Prepare for SFDR regulations and requirements
The SFDR marks the first major regulatory financial initiative designed for sustainable investment. But it likely won’t be the last. And, chances are, such regulations will soon spread beyond the borders of the EU.
Modern investors want to understand the environmental and social risks and opportunities related to their business decisions. But with so much confusion over regulatory requirements and best practices, it’s little wonder why many companies struggle to determine the best course forward.
Sustain.Life’s sustainability management software, can help you embark on your path to greater transparency and shared progress for the planet. We provide the tools and expertise you need to measure your environmental data, build a carbon emissions-reducing action plan, and report your metrics and progress according to third-party standards.
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Sources
- Morgan Stanely. Sustainable Finance Disclosure Regulation. https://www.morganstanley.com/im/en-be/intermediary-investor/about-us/newsroom/press-release/sustainable-finance-disclosure-regulation.html Accessed February 13, 2023
- Eurosif. SFDR. https://www.eurosif.org/policies/sfdr Accessed February 13, 2023
- CPA Journal. First Look at the Human Capital Disclosures on Form 10-K. https://www.cpajournal.com/2021/10/27/first-look-at-the-human-capital-disclosures-on-form-10-k/ Accessed February 13, 2023
- Deloitte. Sustainable Finance Disclosure Regulation. https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/sustainable-dev/lu-sustainable-finance-disclosure-regulation.pdf Accessed February 13, 2023
- Official Journal of the European Union. REGULATION (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 27 November 2019 on sustainability‐related disclosures in the financial services sector. https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R2088&from=EN Accessed February 13, 2023
