Introduction
Sustainable Finance Disclosure Regulation (SFDR) is a European Union regulation mandating ESG disclosure obligations for asset managers and other financial market participants with substantive provisions of the regulation effective from March 2021. Sustainable finance has become increasingly trendy among investors. Asset managers are responding to this by coming up with more and more funds and sustainable investment products that are classified as ‘ESG’ or ‘sustainable.’ Nowadays, most financial institutions, investors, and asset managers extensively display and communicate their pursuit of climate goals and sustainable investments. The Regulation aims at increasing transparency and boosting environmental and social responsibility in the finance industry.
Non-compliance with SFDR can have adverse consequences, including a negative impact on the reputation of the company or firm, disciplinary action from local financial authorities, and negative signaling to current and prospective clients and investors.
This article will walk you through the SFDR’s latest requirements and how to meet them for optimal compliance.
Definition and Purpose of Sustainable Finance Disclosure Regulation (SFDR)
The SFDR strives to create a level playing field for financial market participants (“FMPs”) and financial advisers in terms of transparency regarding sustainability risks, consideration of adverse sustainability impacts in investment decisions, and the provision of sustainability-related information about financial products.
The SFDR urges financial market participants and financial advisers, such as AIFMs and UCITS managers, to provide mandatory and standardized disclosures on how ESG elements are incorporated at both the entity and product levels.
Disclosures indicated in the SFDR can be shared with financial market participants in the form of a website, prospectus, or quarterly report.
What are SFDR objectives?
Envisioning the removal of barriers that inhibit access to requisite sustainability data for informed investment decisions by asset managers and investors, the SFDR seeks to achieve three key objectives:
- To enhance disclosures so that institutional investors and retail customers can comprehend, compare, and monitor the sustainability features of financial products and organizations.
- To maintain a level playing field inside the EU, ensuring that European enterprises are not subjected to unfair competition from firms located outside the EU.
- To counteract the practice of greenwashing.
As discussed, beforehand, the fundamental objectives of the EU SFDR are to increase openness about environmental and social aspects, as well as sustainability, in financial markets, and to establish consistent criteria for reporting and disclosing information pertaining to these issues.
Increasing openness and establishing standards contribute to two other critical factors.
One, it will make “greenwashing” tougher for firms and asset managers. In other words, It will make it tougher for companies to brand a product with an ESG or sustainable label without disclosing how this was accomplished.
Second, it considerably improves investors’ capacity to evaluate investment choices in terms of the ESG aspects considered throughout the investment decision-making process, enabling them to make educated investment selections that match their investment objectives.
Who Does SFDR Apply To
Overall, the SFDR applies to two types of financial institutions:
- Financial advisers that provide investment or insurance advice concerning insurance-based investment products (IBIPs).
- Participants in the financial markets who produce and sell financial goods as well as provide portfolio management services.
Among the companies that fit within these two groups are the following:
- Investments Fund Managers
- Banks
- Financial consultancy firms
- Administrators of pension funds
- Insurers
The SFDR primarily applies to financial institutions operating in the EU (banks, insurers, asset managers, and investment businesses). Non-EU firms will be impacted indirectly due to EU subsidiaries, services offered in the EU, and market pressure.
Investment managers or advisors operating outside the EU who advertise (or seek to market) their products to EU customers will also be required to comply with the SFDR disclosures.
Larger organizations (defined as those with an average of 500 workers or those that are parent companies of a large group with an average of 500 employees) are subject to all SFDR’s disclosure requirements.
Regarding the SFDR’s specific requirements on the consideration of principal adverse impacts (PAIs), organizations with fewer than 500 workers can comply with this entity-level disclosure requirement or explain why they do not examine the unfavorable effects of investment choices on sustainability criteria.
Importance of transparency and accountability in sustainable finance
While reporting on sustainable investments has been niche for a long time, it is now becoming mainstream to communicate about the impact of long-term investments and social importance. It is worth noting that sustainable financing involves various groups and stakeholders including investors, financial institutions, public and private issuing companies, regulators, supervising authorities, and other market players.
These different groups are all subject to different social responsibilities and accountability regarding the impact of these sustainable investments.
Governments
Government bodies worldwide are increasingly recognizing the urgency to address the issue of greenwashing, but current policies and sanctions mainly focus on consumer markets. For instance, the UK government is developing “The Call for Evidence” framework to encourage energy product providers to be more transparent about their green energy claims. Similarly, the French government has taken the lead by introducing legal sanctions that can result in fines of up to 80% of the false promotional campaign costs for greenwashing companies. However, doubts remain about the effectiveness of these measures in completely eradicating greenwashing practices, as they may only lead to slightly higher risks or costs without making it significantly more difficult to engage in greenwashing.
In contrast, the European Union (EU) has emerged as a global frontrunner in addressing greenwashing through comprehensive frameworks such as the EU Taxonomy Regulation and the EU Green Bond Standard. These guidelines cover a wide range of activities and provide sustainability criteria aligned with the International Capital Markets Association’s (ICMA) Green Bond Principles. Despite their voluntary nature, a more effective approach to combatting greenwashing could be to mandate issuing companies to provide full disclosure of their carbon emissions and sustainability commitments. This would eliminate the possibility of selectively omitting environmentally unfriendly practices while seeking positive ESG labels. Such a mandatory disclosure requirement would enhance transparency, allowing investors to make more informed decisions based on reliable and standardized sustainability information.
Issuing companies
Issuers of green financial products are subject to the same voluntary principle of providing data and transparency. Labeling an investment fund or corporate bond as ‘green’ is possible without full disclosure. When these issuing companies would be held more accountable for the sustainability claims they make with their green-labeled investment products, and especially for the use of the proceeds, this would lead to an increase in transparency and accessibility in their reporting. However, many public companies are critical of the workload and the required resources due to the large number of different standards on sustainability reporting. A key challenge here lies in the harmonization of this standard so that public and private companies can incorporate the required sustainability disclosures more easily.
Investors and Asset Managers
From an investor perspective, the most important tool for managing the risk of potential greenwashing and making sure that issuing companies are held accountable for their sustainability commitments is full, transparent, and correct information. This implies that investors must also be able to understand and scrutinize the sustainability metrics and understand the factors that are most material to them from a sustainability perspective. In recent years, an increasing number of investors and asset managers are gearing up their investment criteria and improving their investment processes to prevent investments that are subject to greenwashing.
Understanding Sustainable Finance Disclosure Regulation (SFDR)
The SFDR aims to change the financial sector’s behavior when making ESG-related claims, promote sustainable and responsible investments, and discourage greenwashing.
Mandated transparency surrounding ESG-related claims can combat ambiguity and hold firms accountable for those claims. The SFDR achieves this transparency through comprehensive technical reporting and disclosure standards through the Regulatory Technical Standards (RTS).
This provides both FAs and FMP guidelines to evaluate and label products accurately. Mandated compliance provides an additional layer of accountability that does not present before the SFDR.
Standardized requirements and thorough reports can also provide users with better information to understand and compare the sustainability characteristics of financial products and firms. As a result, investors and other stakeholders will be provided with more transparency over the ESG performance of the financial product and or advice.
These advancements can also help combat greenwashing related to financial products, as FAs and FMPs must now comply with the SFDR before making claims or applying labels.
Key components of SFDR, including ESG disclosure obligations
The SFDR includes both core content categories as well as disclosure levels. The core content includes the following elements:
Principal adverse impacts
This disclosure element requires that management speaks to the negative impact investment decisions have on the environment and society. It specifically requires participants to disclose how their investment activities influence a broad set of environmental and social issues. For example, participants will need to disclose how their investment decisions impact water supply and quality.
Integration of sustainability/ESG risks
This disclosure element requires detailed information about ESG policies and risk management processes. For example, participants will need to disclose if/how they integrate ESG issues into each stage of the investment process.
Sustainability/ESG information around financial products
This disclosure element requires vendors of sustainable finance products to detail how environmental, social, and governance issues impact decision-making and core activities within the firm, as well as how the product impacts broader sustainable development objectives.
Applicability and timelines for compliance with SFDR
The SFDR came into effect in March 2021. Since then, financial market participants and financial advisors have been expected to disclose the following:
- Sustainability risks policy and integration of sustainability risks into investment decisions and investment advice
- Principal adverse impacts (PAI) of investment decisions on sustainability factors at the entity level (or explanation of no consideration of PAI at the entity level)
- Consistency of remuneration policies with the integration of sustainability risk
Financial market participants and financial advisors have until the end of June 2023 to disclose mandatory and additional PAI indicators in their PAI statements (covering the calendar year 2022).
The following disclosure is required at the financial product level:
- Integration of sustainability risks into investment decisions and investment advice
- Consideration of PAI (or no consideration)
- Pre-contractual disclosures for products promoting environmental or social characteristics and for products with a sustainable investment objective
- Since January 1st, 2022, it includes taxonomy-related disclosures for climate change objectives
- From January 1st, 2023, it includes taxonomy-related disclosures for all environmental objectives
- Website disclosures for Article 8 and 9 SFDR products
- Periodic disclosures
- Marketing communications not contradicting disclosures in SFDR
The Sustainable Finance Disclosure Regulation deadline is approaching, and it is important to meet its requirements to not risk any non-compliance penalties.
At IRIS Carbon®, our tool is designed to simplify your compliance with the Sustainable Finance Disclosure Regulation (SFDR) by generating all the required disclosures.
Enhancing Transparency through SFDR
SFDR has become a game-changer in terms of ESG disclosure and transparency. It mandates enhanced disclosure practices, thereby promoting accountability, trust, and comparability in the financial sector. SFDR concentrates on three critical areas: enhancing the disclosure of ESG information, enhancing the comparability of data and metrics, and increasing the transparency of sustainability risks and impacts. As SFDR continues to shape the industry, it has the potential to accelerate the transition to a more sustainable and transparent financial ecosystem and drive notable change.
Improved disclosure of ESG information by financial market participants
The SFDR mandates financial market participants, such as asset managers, investment advisors, and pension funds, to disclose relevant ESG information to investors. This includes information about their ESG policies, the integration of sustainability risks into investment decisions, and the potential impacts of these risks on investment performance. By requiring this disclosure, SFDR ensures that investors have access to reliable and comprehensive information to make informed decisions aligned with their sustainability preferences. Improved ESG disclosure enables investors to assess the sustainability practices of financial market participants, thus fostering greater accountability and trust in the industry.
Enhanced comparability of ESG data and performance metrics
One of the challenges in sustainable investing has been the lack of standardization and comparability of ESG data and performance metrics. SFDR addresses this issue by establishing a common framework for reporting and categorizing ESG-related information. The regulation introduces specific disclosure requirements, such as the publication of ESG indicators, principal adverse sustainability impacts, and the integration of sustainability risks into investment processes. By setting these standardized requirements, SFDR enables investors to compare and evaluate the ESG performance of different financial market participants, facilitating better decision-making and benchmarking.
Increased transparency of sustainability risks and impacts
SFDR places a strong emphasis on transparency by requiring financial market participants to disclose information about sustainability risks and the potential impacts of these risks on investments. This includes risks related to climate change, resource depletion, social factors, and corporate governance. By disclosing these risks, financial market participants provide investors with insights into their exposure to sustainability challenges and how these challenges could affect the value and performance of their investments. This enhanced transparency empowers investors to assess the long-term sustainability resilience of their portfolios and make more informed investment choices.
Driving Accountability with SFDR
SFDR enhances transparency in sustainable investing through strengthened accountability, improved communication of ESG-related risks and opportunities, and enhanced reporting and monitoring of sustainability objectives and outcomes. It provides investors with the necessary tools to make informed and responsible investment decisions. While challenges exist in its implementation, the benefits of SFDR to investors, asset managers, and society at large make it a crucial regulation driving the transition toward a more sustainable financial system.
Strengthened accountability for sustainable investment products
SFDR introduces a framework that strengthens accountability for sustainable investment products by imposing obligations on financial market participants, including asset managers, fund advisors, and financial advisors. These obligations require them to integrate sustainability risks into their investment decision-making processes and disclose how they consider adverse sustainability impacts in their investments.
Under SFDR, asset managers are required to classify their investment products as either promoting environmental or social characteristics (Article 8 products) or having a sustainable investment objective (Article 9 products). This classification provides investors with clear information on the sustainability characteristics of the products and helps them make informed investment decisions.
One of the primary objectives of SFDR is to enhance communication of ESG-related risks and opportunities to investors. It mandates financial market participants to provide pre-contractual and periodic disclosures that clearly explain the approach they take to integrate sustainability risks into their investment decisions. This includes information on how they consider the adverse impacts of investment decisions on sustainability factors such as climate change, biodiversity, and human rights.
To facilitate comparability and standardization of ESG disclosures, SFDR introduces mandatory ESG indicators, such as greenhouse gas emissions, in the annual reports of financial market participants. These indicators help investors assess the environmental impact of their investments and make more informed choices aligned with their sustainability goals.
Enhanced reporting and monitoring of sustainability objectives and outcomes
SFDR introduces reporting obligations to ensure financial market participants effectively monitor and report on the sustainability objectives and outcomes of their investment products. This includes disclosing the methodologies used to assess and measure the sustainability impact of investments and providing information on the extent to which the stated objectives have been achieved.
Additionally, SFDR requires asset managers to publish website disclosures that provide detailed information on the integration of sustainability risks into their investment decision-making processes. This transparency promotes accountability and allows investors to evaluate the sustainability practices of financial market participants.
Benefits and Challenges
Enhancing transparency through SFDR offers several benefits to investors, asset managers, and society as a whole. Firstly, it enables investors to make more informed decisions aligned with their sustainability preferences and values. By providing clearer information on sustainability characteristics and risks, SFDR empowers investors to support companies that prioritize environmental and social factors.
Moreover, SFDR promotes market integrity by preventing greenwashing, where companies falsely claim to be sustainable without substantiating their claims. By imposing reporting obligations and mandatory disclosures, SFDR ensures that financial market participants accurately communicate the ESG-related risks and opportunities associated with their investment products.
However, implementing SFDR also presents certain challenges. Compliance with the regulation requires significant efforts from financial market participants, including collecting and reporting comprehensive ESG data, integrating sustainability risks into investment processes, and educating staff on the new requirements. Standardization and harmonization of ESG metrics and methodologies across industries and jurisdictions are also essential for effective implementation.
The Role of Stakeholders in SFDR Implementation
The successful implementation of SFDR relies on the active participation and collaboration of various stakeholders. Financial market participants, regulatory bodies, investors, sustainability experts, and industry associations all have important roles to play in ensuring transparency, accountability, and the advancement of sustainable finance practices. By working together, these stakeholders can contribute to the achievement of SFDR’s objectives and drive positive change in the financial industry toward a more sustainable future.
The role of stakeholders in SFDR implementation can be summarized as follows:
Financial Market Participants: Asset managers, fund advisors, and financial advisors play a pivotal role in integrating sustainability risks into their investment decision-making processes.
They are responsible for classifying investment products according to SFDR criteria, clearly communicating sustainability characteristics to investors, and disclosing adverse sustainability impacts.
Regulatory Bodies: Regulatory bodies, such as the European Securities and Markets Authority (ESMA), are responsible for enforcing SFDR requirements and ensuring compliance.
They provide guidance and interpretative clarifications to financial market participants, ensuring consistent implementation across the industry.
Investors: Investors have a crucial role in driving the demand for transparency and sustainable investment practices. They can actively engage with financial market participants by seeking information on ESG integration, challenging greenwashing practices, and making informed investment decisions aligned with their sustainability goals.
Sustainability Experts and Rating Agencies: Sustainability experts and rating agencies contribute by providing expertise in ESG analysis and evaluating the sustainability performance of financial market participants.
They develop standardized metrics and frameworks for measuring and comparing sustainability practices, enabling investors to make more informed choices.
Industry Associations and Non-Governmental Organizations (NGOs):
Industry associations and NGOs play a supportive role by advocating for best practices, sharing knowledge, and promoting collaboration among stakeholders.
They contribute to the development of industry standards and guidelines, fostering transparency and accountability.
Conclusion
The Sustainable Finance Disclosure Regulation is an important step toward promoting sustainable finance and increasing transparency in the financial sector. By requiring financial market participants and financial advisors to disclose information on the sustainability risks and characteristics of their investment products, the SFDR helps investors make informed decisions and promote the transition to a more sustainable economy. The Sustainable Finance Disclosure Regulation deadline is approaching, and it is important to meet its requirements to not risk any non-compliance penalties. At IRIS Carbon®, our tool is designed to simplify your compliance with the Sustainable Finance Disclosure Regulation (SFDR) by generating all the required disclosures.
