The EU Sustainable Finance Disclosure Regulation (SFDR) explained

Kees Kerstens

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9 minutes

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Knowledge

As of March 10, 2021, the Regulation on sustainability-related disclosure in the financial services sector has been applicable, better known as the Sustainable Finance Disclosure Regulation (SFDR). The SFDR is part of the European Commission's Action Plan for Financing Sustainable Growth. Virtually every financial market participant falls under the scope of the SFDR. The reporting requirements are substantial and have already broadly entered into force. Moreover, additional technical reporting standards will apply from January 01, 2023.

January 27, 2022
Image: 
Waldemar Brandt

Objective

The SFDR builds on the UN Sustainable Development Goals and the Paris Climate Agreement, which aim to significantly reduce the risks and impacts of climate change. The SFDR aims to improve the information provided to end investors about the effects on sustainability of investment policies and decisions by financial market participants (FMPs). The ultimate aim is to ensure that capital finds its way more easily towards sustainable financial products, diverting it from financial products with harmful social or environmental impacts.

Target group

In principle, the SFDR applies to all financial market participants and financial advisers, including banks, investment firms, pension funds, asset managers, insurance companies (cf. SFDR Articles 2.1 – 2.11). The disclosure requirements arising from the SFDR apply to all these FMPs, regardless of whether they offer sustainable financial products or not.

Obligations

Pursuant to its Article 1, the SFDR establishes “harmonised rules for financial market participants and financial advisers on transparency with regard to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products.”

 First,there are several general obligations at the entity level:

  • FMPs shall publish on their website information about their policies on the integration of sustainability risks in their decision-making process and advice (Article 3).
  • FMPs shall publish and maintain on their website a due diligence policy statement regarding the principal adverse impacts of investment decisions on sustainability aspects, or clear reasons for why they do not do so (Article 4).
  • FMPs shall include in their remuneration policies information on how those policies are consistent with the integration of sustainability risks and publish that information on their website (Article 5).
  • In the pre-contractual disclosures, FMPs shall include descriptions of the manner in which sustainability risks are integrated into their investment decisions and the results of assessments of the likely impacts of sustainability risks on the returns of their financial products (Article 6).

In addition, a number of obligations apply at the financial product level:

  • A sustainable investment means an investment in an economic activity that contributes to an environmental objective, such as scaling up renewable energy, using raw materials more efficiently or reducing greenhouse gas emissions, or an investment in an economic activity that contributes to a social objective. Provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices (Article 2.17).
  • By 30 December 2022, FMPs shall provide a clear and reasoned explanation for each financial product as to whether, and if so how, a financial product considers principal adverse impacts on sustainability factors (Article 7).
  • Where a financial product promotes ecological or social characteristics, FMPs shall provide information on how those characteristics are met and, if an index (e.g. an ESG Issuer Capped Index, greenhouse gas emissions, employee diversity rate, Gini index, etc.) has been designated as a reference benchmark, information on whether and how this index is consistent with those characteristics (Article 8). These products are also called 'light green' products.
  • Where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark, FMPs shall provide information about how the designated index is aligned with that objective, and how this differs from a broad market index. Where a financial product has a reduction of carbon emissions as its objective, the information to be disclosed shall also pertain to the goals of the Paris Climate Agreement (Article 9). These products are also known as 'dark green' products.
  • FMPs shall publish and maintain on their website for each financial product that promotes ecological or social characteristics (Article 8) or that has sustainable investment as its objective (Article 9) a description of the environmental or social characteristics or the sustainable investment objective, and information on the methodologies used to assess, measure and monitor the environmental or social characteristics or the impact of the sustainable investments selected for the financial product. This information shall be clear, succinct and understandable to investors. It shall be published in a way that is accurate, fair, clear, not misleading, simple and concise and in a prominent, easily accessible area on the website (Article 10).
  • FMPs are transparent about promoting ecological or social characteristics and sustainable investments in periodic reports, such as the annual report. For products from Article 8, FMPs shall inform about the extent to which the ecological or social characteristics are met and for financial products from Article 9, the overall sustainability-related impact of the financial product by means of relevant sustainability indicators (Article 11).

The Dutch Authority for the Financial Markets (AFM) has mapped out its expectations of Dutch FMPs here.

Sustainability risks and adverse impacts

It is clear from the above summary of the SFRD articles that principal adverse impacts play a central role in SFDR reporting. The European Supervisory Authorities have developed technical standards that prescribe how the reporting must take place to be in accordance with SFDR in the so-called Regulatory Technical Standards (RTS), containing a preliminary list of indicators of principal adverse impacts.

Environment:

  • mandatory: 9 indicators, including GHG emissions scope 1, 2 and from 2023 also scope 3, Carbon emissions scope 1, 2 and 3, water pollution, renewable energy use, impact on biodiversity, hazardous waste, etc.
  • optional: 16 indicators, including other emissions, investments in companies without carbon reduction strategies, water use, non-recyclable waste, etc.

Social:

  • mandatory: 5 indicators, including adherence to UN Global Compact principles, board diversity, etc.
  • optional: 17 indicators, including number of accidents, discrimination, CEO pay ratio, etc.

Connection to the EU Taxonomy

In addition to the SFDR, the EU is developing a taxonomy with criteria for determining whether an economic activity can be defined as environmentally sustainable and thus for determining the degree of ecological sustainability of an investment. From 1 January 2023 onward, reporting requirements concerning the EU Taxonomy are gradually phased in for FMPs with sustainable products.

Timeline

According to the AFM, Dutch FMPs have had to comply in broad terms with the requirements arising from the SFDR since March 10, 2021. The AFM also expects FMPs to start making the necessary preparations for compliance with the final RTS, which will take effect on January 1, 2023. The two sets of draft RTS, as published on February 04 and October 22, 2021, respectively, can be used as a basis for preparations in the run-up.

The Upshot

Complying with the SFDR is no small feat for FMPs. The old adage “good preparation is half the battle” also applies here. And the AFM explicitly expects this from Dutch FMPs. For many investors, however, the data for this reporting obligation must come from the companies in the investment portfolio. FMPs are therefore dependent on data from third parties.

Salacia Solutions is a Software-as-a-Service provider that simplifies environmental impact tracking and reporting for businesses and investors. We help you report in a transparent, traceable and consistent manner that is fully in line with legislation such as the SFDR, CSRD and the EU Taxonomy as well as underlying methodologies such as the GHG Protocol. Get in touch with us today to get a solution tailored to your needs.

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