What is the Sustainable Finance Disclosure Regulation (SFDR)?

The Sustainable Finance Disclosure Regulation (SFDR) is European Union regulation mandating ESG disclosure obligations for asset managers and other financial markets participants with substantive provisions of the regulation effective from 10 March 2021. The Regulation aims at increasing transparency and boosting environmental and social responsibility in the finance industry. 

The SFDR requires banks, insurers, investment firms, and other financial institutions to report their sustainable investment practices to investors in a standardised format so that they can make informed decisions about their investments.

Non-compliance with SFDR can have adverse consequences, including negative impact on the reputation of company or firm, disciplinary action from local financial authorities, 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.

What is 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 standardised disclosures on how ESG elements are incorporated at both the entity and product level.

Disclosures indicated in the SFDR can be shared with financial market participants in the form of a website, prospectus, or quarterly report.

Learn more about it here.

What are SFDR objectives?

Envisioning 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 organisations. 
• 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 is applicable 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.

Regarding the SFDR’s specific requirements on the consideration of principal adverse impacts (PAIs), organisations with fewer than 500 workers can comply with this entity-level disclosure requirement or explain why they do not examine the unfavourable effects of investment choices on sustainability criteria. 

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SFDR classification: Articles 6, 8 and 9

The EU SFDR defines three separate kinds of investment products in terms of sustainable investing and environmental, social, and governance (ESG) considerations: 

Article 6

Article 6 applies to funds that do not incorporate sustainability into their investing strategy and may contain stocks that are presently excluded from ESG funds, such as tobacco businesses or thermal coal producers.

While they will be permitted to be offered in the EU as long as they are explicitly labeled as non-sustainable, they may have significant marketing difficulties when compared to more sustainable funds. 

Article 6 items either include ESG factors into the investing process or explain why sustainability risk is irrelevant, but do not fulfill the extra standards of Article 8 or Article 9 strategies.

Article 8

Also referred to as  'environmental and socially promoting", Article 8 applies where a financial product promotes, among other features, environmental or social attributes, or a mixture of those attributes, given that the enterprises in which the investments are made adhere to sound governance practices (light green). 

While Article 8 financial products promote environmental and/or social qualities and may invest in sustainable initiatives, it's not as a primary purpose. Firms must examine if a fund supports "environmental or social qualities, or a combination of such characteristics, and, if so, whether the fund's investee firms adhere to good governance procedures".

Article 9

Also dubbed 'products targeting sustainable investments', Article 9 refers to financial products that aim tailored sustainable investments and is applicable "... where a financial product has sustainable investment goals and an index has been established as a reference benchmark” (dark green).

The basic objective of Article 9 financial products is to encourage sustainable investment.

The SFDR defines sustainable investment as an investment in an economic activity that supports an environmental or social goal, given that the investment does not significantly undermine any environmental or social goal and that investee firms adhere to solid corporate governance norms.

Link between SFDR and CSRD: explained‍

The SFDR and the CSRD are closely linked in the European Union's framework for sustainable finance and corporate transparency. The CSRD mandates a broader range of companies to disclose detailed sustainability information, which directly supports the data needs of SFDR. By ensuring companies provide standardised, comparable, and reliable sustainability information, the CSRD effectively feeds into the SFDR's objectives, enabling investors and stakeholders to make more informed decisions. This synergy enhances overall transparency and drives the EU's agenda for a sustainable economy.

What are SFDR requirements?

The following information has been simplified for the purpose of this article. To know precisely what your company needs to do to comply with SFDR, reach out to our experts and test our SFDR feature.

Under the SFDR, financial entities have to disclose how they integrate sustainability factors into their decision-making process and what adverse impacts their financial products have on society and the environment. 

Disclosure requirements cover 3 different scopes:

• Entity-level requirements
• Fund-level requirements
• Information to ask from portfolio companies 

In addition to these levels of disclosure, a few concepts need to be understood:

• Articles 6, 8 and 9
• Sustainability risks
• Principal adverse impact (PAI)
• Do No Significant Harm (DNSH)
• Minimum safeguards and good governance practices

Learn more about it here.

SFDR disclosure at the entity and product level

At entity-level, companies need to explain and disclose the following:

• Risk management for sustainability (integration of sustainability risks into the investment decision-making process) 
• Alignment of compensation plans with sustainability risks
• Principal Adverse Impacts (consideration of principal adverse impacts of the investment decisions and/or investment advice on sustainability factors)

This information is mainly to be disclosed on the website of the financial market participant or financial adviser.

At financial product level, the following items need to be explained and disclosed:

• The article the fund classifies for (art 6, 8 or 9)

For article 8 and 9 funds:

• Risk management for sustainability (integration of sustainability risks into the investment decision-making process) 
• Principal Adverse Impacts (consideration of principal adverse impacts of the investment decisions and/or investment advice on sustainability factors)
• Do No Significant Harm (ensuring portfolio companies’ activities are not negatively affecting any sustainability factor)
• Minimum safeguards and good governance practices required from all portfolio companies

Fund-level requirements are to be disclosed in pre-contractual disclosures and updated on the website and in the fund’s periodic reports.

How to implement SFDR?

To comply with the SFDR requirement, businesses must declare their PAI, which includes greenhouse gas emissions, waste management, biodiversity, and human rights. Disclosures on PAIs is increasingly becoming important; businesses that fail to report and meet the basic requirements are facing multidimensional consequences in the short and long term.

The higher the quality of information available to fund managers, the more confidently they may include firms in their Article 8 or 9 funds. 

According to the most recent data from Morningstar for Q3 2022, the market share of Article 8 and Article 9 fund assets continued to increase and reached 53.5% at the end of September 2022.

Nevertheless, a trend can be observed in recent weeks (after clarifications given by the regulator this summer): a growing number of Article 9 funds are being downgraded to Article 8.

In light of all these recent developments and in expectation of further downgrades, it can be expected that the number of Article 9 products will decline in the next six months from its current level of 1,080 funds (representing 4.3% of funds distributed in the EU).

What can businesses do?

Financial market participants may explore the following first efforts to comply with the SFDR and anticipate their capital providers' sustainability disclosure requirements: 

• ‍Leveraging quantitative and qualitative data to evaluate the sustainability risks that may affect their own business, and providing internal reports; 

• ‍Preparing to require portfolio companies to report on the mandatory PAI indicators and disclose the aggregated data by June 2023;

• ‍Evaluating the PAIs of their own activities in light of sustainability considerations, including the actions taken or planned to mitigate these impacts, through the application of, for example, the OECD due diligence guidance for responsible business conduct and the production of internal reports; and 

• ‍Defining the strategic sustainability objectives for their own economic operations (as underlying assets for financial products), i.e., encouraging environmental and/or social qualities or contributing to an environmental or social aim based on quantitative and qualitative data. 

• ‍Examine possible Article 8 or 9 funds. Prepare these items to meet the new disclosure criteria by analysing all marketing materials and determining if any further product disclosures are necessary. 

• ‍Conduct a gap analysis of businesses' current disclosure practices. Understanding the actions the business is now doing is critical for projecting the scope of the work ahead. Firms must have a thorough knowledge of how they presently communicate sustainability risks to investors and customers and where compliance gaps exist with the SFDR.

Timeline

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 entity level (or explanation of no consideration of PAI at entity level)
• Consistency of remuneration policies with the integration of sustainability risk

Financial market participants and financial advisors had until the end of June 2023 to disclose mandatory and additional PAI indicators in their PAI Statement (covering the calendar year 2022).

The following disclosure are required at 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 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

June 30, 2024 is the final deadline for financial market participants to submit the second report. Starting from this point, they are also required to compare data from the first and second reference periods.

The Sustainable Finance Disclosure Regulation deadline is approaching and it's important to meet its requirements to not risk any non-compliance penalties.

At Apiday, our tool is designed to simplify your compliance with the Sustainable Finance Disclosure Regulation (SFDR) by generating all the required disclosures.

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