Understanding the Sustainable Finance Disclosure Regulation (SFDR)

With the mainstreaming of ESG, as well as the increasing popularity of sustainable investing, there is mounting pressure for the international regulation of the financial sector concerning environmental, social and governance issues.

What is it?

The Sustainable Finance Disclosure Regulation (SFDR) is an EU initiative that requires financial market participants operating in the EU, to disclose the various sustainability risks associated with their investments and products, as well as to disclose their policies relating to these risks. The SFDR came into force on March 10, 2021 as part of the European Commission's (EC) Sustainable Finance Action Plan.

Background

The European Union’s High-Level Expert Group (HLEG) laid out a roadmap for the European Commission (EC) with 2 main goals to be achieved by the EU:

1. Integrate sustainability considerations into the financial system
2. Steer the flow of capital towards sustainable investments

The roadmap leads the EC to create the Sustainable Finance Action Plan with 3 key objectives:

1. To reorient capital flows towards sustainable investment and away from sectors contributing to global warming (i.e. fossil fuels)
2. To manage financial risks arising from climate change
3. To foster greater transparency and long-termism in financial and economic activity, to achieve sustainable and inclusive growth

The Sustainable Finance Action Plan has 10 key points, and the SFDR falls under point 7 - ESG in Investment Management.

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SFDR Broken Down

Requirements:

Obligates the sustainability disclosure of financial market participants. Requires the classification of all products based on ESG level. The SFDR has 2 levels:

• Entity Level: disclosure obligations for the entities themselves concerning their policies on decision-making on sustainability risks.
• Product Level: reporting obligations concerning the financial products and their sustainability risks for returns.

Goal:

Increase transparency on ESG information and therefore protect end-investors.

Scope:

‍Financial market participants and financial products.

Product Type:

• Dark Green (Article 9) products with a sustainable investment strategy.
• Light Green (Article 8) products promoting environmental or social characteristics, but not sustainability. Must indicate if they invest in a proportion of sustainable investments.
• Grey (Article 6) products that either consider ESG risks as part of the investment process, or are explicitly stated as non-sustainable.

→ The SFDR means that funds can no longer be simply described as ‘sustainable’. This now has to be proved and demonstrated. Financial products must fall under one out of the three product types.

Principal Adverse Impact Indicators (PAIs):

These are an important part of the SFDR. PAIs refer to the negative effects on environmental and social matters. Entities must disclose their negative impact on these issues. To measure this impact, 66 indicators have been identified. These indicators are split between mandatory and optional. Mandatory indicators include 9 environmental indicators and 5 corporate investment indicators.

Key Milestones:

March 10, 2021

Required that the company website must include information on:

• PAI Policy & Impact
• Policy on Sustainability Risk Policy
• Remuneration/policy - how the company will engage with investee companies
• Reference which international code standards they are signed to
• Light green fund, dark green fund (Article 8 & Article 9)

June 30, 2021 (For manufacturers of financial products)

• Larger firms (500+) must disclose how PAIs on sustainability factors are taken into account.

January 22, 2022 

For manufacturers of financial products

• Pre-contractual documentation from all 8 & 9 funds. Need to disclose how their ES objectives will be met and how they are achieving their ES goals.
• Next annual report must include a review of the ES achievements from the previous year.

For financial advisors

• State clearly IF and HOW the information provided by the manufacturers is taken into account.
• If and HOW PAI data is taken into account.

December 30, 2022

• Firms that consider PAIs must disclose how their products consider these impacts.
• Firms that do not consider PAIs must disclose why they do not.

The Significance of the SFDR

For the world, the SFDR signifies a shift towards a financial market that is concerned with its environmental and social impact, and its ethical operation. The new regulation also reflects the focus of governments on regulating their financial markets in line with ESG principles.

For investors, the SFDR signifies an opportunity to better understand the impact of their investments given the amount of information the regulation will produce for interpretation. The SFDR gives investors the chance to align their portfolio with their ESG preferences and hopefully we will see increased investor engagement and a greater sense of agency over their investments.

For manufacturers of financial products and financial advisors, the new regulation opens up an avenue for re-evaluating their products and risks. It tasks them with disclosing their policies and sustainability metrics for public scrutiny. The SFDR perhaps also opens up an avenue for competition amongst other providers and advisors now that they operate under a uniform framework.

Key Terms

End-Investor: The ultimate buyers of financial products.

Financial Market Participants (FMP): Those who actively work within the financial market, including manufacturers of financial products and financial advisors (i.e. fund managers, pension providers, insurance firms).

Financial Product: Investments and securities that are created to provide buyers with financial gain.