A few years after the 2015 Paris Agreement, which saw 196 Parties agree to limit global temperature rises by 2° (ideally 1.5°) by 2050, the European Commission released an Action Plan for Financing Sustainable Growth.
In line with the UN’s Agenda for Sustainable Development, the action plan comprises a number of complementary regulations designed to promote sustainable investments and direct more capital towards a sustainable economy.
Some of the regulatory mechanisms in the action plan include the Taxonomy Regulation and the Low Carbon Benchmarks Regulation, but one key piece of legislation is the Sustainable Finance Disclosure Regulation — the SFDR. In this article, we’ll explain what the SFDR is, how it works, and how it came about.
What is the SFDR and what are its objectives?
The SFDR is a set of ESG disclosure obligations for Financial Advisors (FAs) and Financial Market Participants (FMPs) based in or trading in the EU. The ultimate aim of the SFDR is to direct more capital towards sustainable growth by improving the transparency of financial products and entities and preventing greenwashing.
Complying with the SFDR will improve transparency around adverse sustainability impacts in financial markets, making it easier for investors to understand, compare, and monitor the sustainability characteristics of investment funds available.
First proposed in 2018, the SFDR came into effect on March 10, 2021.
Why is the SFDR important?
By improving transparency across environmental and social metrics, the SFDR helps to re-orient capital towards sustainable growth.
The new regulations would mean investors would have access to much more reliable data, enabling ESG-driven analysis to derive valuable insights about factors that can have a significant impact on the financial metrics of a company and therefore better inform their investment decisions.
With the SFDR, investors will benefit from:
- Improved ESG investment options and analysis: With new regulations setting the standard for disclosure, investors should have a much easier time comparing and contrasting sustainable investment products and features.
- Increased transparency: With the SFDR, investors would be better able to assess which funds and companies are supporting the ESG objectives that they claim to support. Even for funds outside of the EU, the SFDR raises the bar for everyone. A firm’s lack of transparency could become a competitive disadvantage when raising or attracting capital.
- Quality data and information: Quality information can lead to improved financial performance and a better understanding of the impact of one’s investments. The SFDR will provide investors with more awareness of the sustainability measures of their portfolio, analysis of risk, and achievement of sustainable objectives over time.
- Improved risk management: The availability of quality data and information will allow investors to better identify potential sustainability risks that could pose a threat to their investments.
- More autonomy: As SFDR marks the standard of disclosure in the industry, investors will actively pick and choose the advisors, managers, and funds that are meeting the new standards, driving adoption throughout the global financial industry.
What makes the SFDR notable?
The SFDR is built on two concepts that differentiate it from other sustainable finance policies. These are:
- Sustainability Risks: These refer to environmental, social or governance events or conditions that could cause a material negative impact on the value of an investment.
- Principal Adverse Impacts (PAIs): PAIs are the negative consequences an investment decision or advice might have on sustainability factors, including on environmental, social, human rights, anti-corruption, and anti-bribery matters.
Who does the SFDR Apply To?
The SFDR regulation applies to EU-based FMPs with 500+ employees, such as investment firms, pension funds, asset managers, insurance companies, banks, venture capital funds, and credit institutions offering portfolio management. The list also includes financial advisors that provide investment advice or insurance advice regarding insurance-based investment products (IBIPs). The SFDR also applies to investment managers and advisers who market products within the EU, even if they are not based in the EU.
What are the main requirements under the SFDR?
With the SFDR, FMPs are required to disclose information on two levels.
Level 1
At Level 1 (firm level or entity level), the SFDR requires FMPs to undertake a series of disclosures on their sustainability practices:
- Sustainability risk policy: How an entity integrates sustainability risks in its financial advice or investment decision‐making process
- Principal adverse impact (PAI): How their investments impact sustainability considerations
- Sustainability risk remuneration policy: How remuneration policies take sustainability risks into account
There are 14 different entity-level sustainability factors FMPs must disclose, ranging from greenhouse gas emissions to social impact. FMPs that don’t consider sustainability in their investment decisions must clearly state this on their website, along with an explanation for why.
Level 2
At Level 2 (product level), the SFDR requires FMPs to adopt a further series of disclosures for each of the financial products they make or market. There are different categories for financial products:
- Mainstream: For FMPs that do consider PAIs, an explanation of how financial products account for these impacts should be provided. This applies to all the FMP’s products, whether they are intended to meet sustainability goals or not
- Promoting environmental or social characteristics: For ‘Article 8’ products that promote ‘environmental’ or ‘social’ characteristics, there must be additional information on how these are met, including disclosure on the degree of EU Taxonomy alignment of underlying economic activities
- Having sustainable investment objectives: For ‘Article 9’ products that have a sustainable investment objective, firms must provide an explanation on how the objective is achieved, as well as additional disclosure on alignment with the EU Taxonomy Regulation
How can FMPs prepare for the SFDR?
Preparing to meet the SFDR requirements can feel daunting, but FMPs can simplify the process by beginning by reporting internally on the sustainability risks they face, evaluating the adverse impact of their operations and products, and setting sustainability goals.
Will your company be affected?
While only FMPs will be required to disclose with the SFDR, FMPs will need to source this information from their portfolio companies. As the SFDR comes into play, companies that rely on external investments will need to have the right data available, and be able to easily share this data with their investors. The best way to ensure you are fully prepared for ESG data demands is to implement a sophisticated ESG data management platform.
Whether you’re just getting started on your ESG journey, or you’re working from spreadsheets and legacy tools and looking for more sophisticated ESG management, Novisto can help you conquer your ESG data challenges.
To learn more about what our ESG reporting software can do for your organization, request a demo today.
