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The first level of the Sustainable Finance Disclosure Regulation (SFDR) has been implemented in the EU since 10 March 2021. From 1 January 2023, the SFDR level 2 introduced additional technical standards.
This is a significant development for European financial markets with wide-reaching implications for investment strategies, capital flows, and reporting practices of financial market players.
Let’s take a look at the disclosure requirements and how to align with the regulation.
As momentum for ESG investing grows amidst a crackdown on firms found to be greenwashing their products/services, there is a real need for a common framework to disclose investing practices. While companies seek clarity on what qualifies as ‘sustainable’, clients question the legitimacy of products marketed or labelled as ‘ESG’.
In response to a broader regional push for EU sustainable finance, the European Commission issued the EU Action Plan on Sustainable Finance, under which the SFDR falls as a key mechanism to facilitate the framework.
The objectives of the SFDR are as follows:
Through these objectives, SFDR addresses some of the current challenges of ESG financing, namely the lack of a standardised approach to sustainable investing, resulting in a disparate financing landscape obscured by inconsistent disclosures across the board. Transparency and consistency are important as greenwashing ESG products is a growing regulatory concern.
The SFDR takes aim at company disclosures with the ultimate goal to promote sustainability-related considerations in investment decision-making. Disclosures are required from the business level i.e. the firm's investing practices, and the product level i.e. the sustainable nature of the product.
The general rule is to report on how ESG factors are integrated into a firm’s products/services. Firms are obliged to report on their management of two areas:
Asset managers are required to demonstrate a link between remuneration and ESG integration, while investors must disclose the degree of ESG consideration in their investment process and accordingly, the required disclosures. Specifically, a distinction is made between three categories of investments:
The SFDR outlines guidance for specific topics that are required for Articles 6, 8, and 9. Apart from Sustainability Risks and PAIs, topics such as governance practices and the ESG indicators used to assess sustainability are mandatory.
To prevent mislabelling where only a negligible proportion of funds is channelled to sustainable activities, firms are required to elaborate on their asset allocation strategy i.e. the minimum proportion of a fund that qualifies as sustainable under the defined guidelines.
The SFDR primarily affects so-called "financial market participants". These are, for example, insurance companies, investment firms, credit institutions and capital management companies.
Advisers outside of the EU with EU clients are also covered by the scope of the regulation, specifically, firms that fall under Article 42 of the EU Alternative Investment Fund Managers Directive (EU AIFMD).
If your firm falls within the scope of the SFDR, here are the recommended steps to align with SFDR compliance.
Like any reporting framework, the SFDR outlines particular topics for disclosure, depending on the firm type and activities as well as where they fall in the categorisation system. The first step is to familiarise yourself with the requirements relevant to your investment activity or type of product/service.
Look out for the Regulatory Technical Standards (RTS) with effect from 1 January 2023. If you are already aligned with the SFDR’s first set of requirements, there may still need to adjust to the RTS.
After understanding the requirements, assess if your current reporting processes are relevant. New or additional processes for data collection may need to be set up as a result of new disclosures.
In the process, you may need to engage with your stakeholders (e.g. data owners at investee companies) on capacity-building so that they fulfil their responsibilities for data collection. Expect lots of communication with investee companies as you collect data for assessing sustainability performance.
The point of the SFDR is to ensure financial market players are putting the money where their mouth is. The third and final step in achieving compliance is to vet investments based on where they fall in SFDR criteria. Substantiate any claims with the related data. For example, if a product claims to be an impact fund, it pays to know the exact definition of impact funds (vs. ESG funds), the fund’s objectives, and how the impact is measured and monitored over the fund’s time horizon. Accurate design and labelling of products are necessary here.
The biggest challenge for firms implementing the two levels of SFDR is the ESG assessment process. This puts demands on firms’ abilities to not only understand how to measure sustainability but also on collecting the information for measurement and reporting.
Furthermore, engaging with portfolio companies to obtain their metrics is an extensive process that takes up time and resources. In addition to the usual financial due diligence, the same level of due diligence is expected of sustainability-related matters.