Implementing SFDR: Strategies, Requirements, and Recommendations

The European Union’s Sustainable Finance Disclosure Regulation (SFDR) is one of the regulatory measures introduced by the European Union introduced to help financial services industry create a harmonized Environmental, Social, and Governance (ESG) framework.

The SFDR resulted from work done by High-Level Expert Groups (HLEG) of the EU on sustainable finance between 2016 and 2018. The HLEG formulated a path for the EU to integrate sustainability considerations into the financial system and direct the flow of capital to sustainable investments.

It aims to channel about €1 trillion over the next decade into green investments, give firms that already offer genuinely sustainable products a competitive edge, and address the inconsistency in the climate-related information that the financial market participants currently provide.

“To be clear, this is not just about climate change but is focused on a much broader topic of sustainability,” Ogier law firm’s head of ESG, Kate Hodson, said. “In short, we are talking about an environmental, social or governance event or condition that, if it occurs, could cause a negative material impact on the value of the investment.”

SFDR Sustainability Risks and Principal Adverse Impacts:

• Sustainability Risks: These are Environmental, Social, and Governance (ESG) events or conditions like climate change that can cause a material negative impact on an investment’s value.
• Principal Adverse Impacts: These are negative effects on sustainability factors resulting from investment decisions or advice.

What is SFDR?

In summary, the SFDR is a regulation that contributes to the EU in transforming itself into a more sustainable low-carbon economy according to the sustainable development goals. The SFDR design aims to increase transparency on how sustainability risks and opportunities are factored into financial market players’ investment decisions and recommendations and give considerations to the possible adverse sustainability impacts.

The Principal Adverse Impacts (PAIs) concept was introduced for the SFDR to achieve its aims and objectives. APIs are the adverse effects on the factors of sustainability that investment advice or decision might have.

These sustainability factors include environmental, employee matters, social, human rights matters, anti-bribery, anti-corruption. The PAIs represent a basic SFDR unit. Thus, they are essential in understanding the regulation.

A key part of its directives is focused on preventing the practice of greenwashing, whereby financial firms exaggerate their environmental commitments on paper. Still, they do not necessarily practice those commitments. 

Who are SFDR FMPs?

The SFDR applies directly to financial market participants (FMPs). These FMPs are professional entities like asset managers (including AIFMs and UCITS management companies), pension funds, banks, insurance companies, venture capital funds, credit institutions that offer financial advice or portfolio management.

It also applies to financial advisors and directly to managers who market funds into the EU under the national private placement rules. The SFDR also applies indirectly to managers that provide portfolio management services and/or investment advisory services to EU firms subject to the rules.

The Main Requirements of the SFDR

Entities under the SFDR scope must identify and disclose sustainability impacts at both the entity and product level. Disclosures required by firms to undertake at the entity level include:

• Information on how the entity incorporates sustainability risks into their financial advice or investment decision-making process
• A statement on policies about how PAIs are considered on sustainability factors by the entity. 
• Information on the consistency of remuneration policies with the incorporation of sustainability risks
• Pre-contractual disclosures on the integration of sustainability risk and assessments of how those risks may affect the performance of the product.
• Further series of disclosures are required for firms to take by the SFDR at the product level, but these disclosures depend on a given product’s objective. These disclosures include provisions explaining how these impacts are accounted for by financial products from firms that consider PAIs. Whether the firm’s products are intended to meet sustainability goals or not, this rule applies to all of the firm’s products. 
• There must be added information on how these impacts are met for ‘Article 8’ products that promote “Environmental” or “Social” characteristics, as well as disclosure to the extent the underlying economic activities align to the EU Taxonomy.
• There must be an explanation provided on how the objective is achieved for ‘Article 9’ products having sustainability investment as one of its objectives, including an added disclosure on their alignment with the EU Taxonomy Regulation. 

As of March 10, 2021, the SFDR high-level and principle-based requirements became active, and the European Commission made it clear that firms must adhere to those requirements. They also clarified that the Level 2 measures, also known as Regulatory Technical Standards, will become applicable possibly by January 1, 2022.

What is SFDR Level 2?

The Level 2 measures will provide important details on the presentation and content of disclosures, including the indicators for PAIs. By June 30, 2021, large firms with more than 500 employees must disclose their PAIs’ due diligence policies on sustainability factors. Beginning from January 2022, periodic reporting on “Environmental” and “Social” characteristics and sustainable investment, including relevant alignment to the two climate change mitigation and adaption objectives of the EU Taxonomy.

Firms that consider PAIs must disclose how their products consider these impacts by December 30, 2022, while the others will have to explain why they do not. Products that have sustainable investment as their objective and products that promote “Environmental” or “Social” characteristics, by January 2023, must have periodic pre-contractual reports on alignment with the EU Taxonomy’s remaining four objectives in place. Firms must disclose the PAIs’ detailed indicators for January 2022 to December 2022 by June 30, 2023.

Recommendation 

The recommendations of the SDFR are for entities to 

• Review their marketing materials, pre-contractual, and website disclosures in alignment with the EU’s SFDR requirements 
• Integrate into all their investment and research processes, sustainability risk
• Prepare their position on principal adverse impacts, considering the size of their organization, long-term strategy, and stakeholder expectations. 

Financial products without the claim of achieving any degree of sustainability may face difficulties with distribution because they would have to disclose clearly that they do not consider sustainability risks, PAI on sustainability factors, nor EU Taxonomy criteria that define the environmentally sustainable activities.

According to the MiFID II amendment adopted in the first quarter of 2021, those products will no longer be eligible to be advised to clients who have expressed preferences for ESG.

Conclusion

It is expected that the SFDR will shift the interest of the market to companies that are sustainability-minded in their capacities as issuers, borrowers, and investees. Its application will influence the businesses’ activities of raising capital. It will also give a competitive advantage to companies prepared and aligned to the SFDR’s requirements in the financial market. Companies can align themselves to the SFDR’s requirements if they prepare sustainability-related information of high quality and integrate sustainability factors into the financing instruments, both existing and planned.