In 2019, the European Union implemented the Sustainable Finance Disclosure Regulation (SFDR), a new set of Environmental, Social, and Governance (ESG) transparency requirements for financial participants.
This initiative aimed to improve market transparency for sustainable investment products, prevent greenwashing, and increase transparency surrounding sustainability claims made by market participants.
To that end, applicable entities operating or selling financial products within the EU are legally obligated to satisfy SFDR reporting requirements.
But what does that entail? And to whom do these regulations apply?
Here’s what you need to know about SFDR reporting and compliance.
What does an SFDR report disclose?
So, what is SFDR? SFDR is a disclosure-based reporting system designed to increase transparency on sustainability between financial institutions, investors, and other relevant market participants. These regulations cover the publication of information from the parties mentioned above on the sustainability of their investment decisions and strategies, even if the fund is not expressly focused on ESG or sustainability.
The EU hopes to achieve the SFDR’s stated goals by setting universal standards for:
- Financial market participants regarding the implementation and integration of sustainability risks.
- The measuring and monitoring of negative sustainability impacts on these processes.
- The provision of sustainability-related information about financial products.
Under the SFDR, applicable market participants within the EU are compelled to divulge information regarding:
- Their sustainability practices (firm-level)
- Their financial products (product-level)
- A Principle Adverse Impacts (PAI) statement covering both the firm and product levels
In doing so, the policy creators seek to provide end investors with more accurate and relevant information regarding the societal and environmental impacts of certain investments. Regulators assumed that if investors had this information, they would make better investment decisions—transferring their capital from negative-impact funds to positive-impact funds.
And, although we’re only in the early stages, it appears as though their policy aims have thus far been largely successful. According to a recent Goldman Sachs report:
“One year on from the launch of the first stage of the European Sustainable Finance Disclosure Regulation (SFDR), SFDR funds are growing significantly compared to non-ESG counterparts. Flows into Article 8 & 9 funds have significantly outpaced non-ESG, despite the latter representing nearly 2x the number of funds.”
The report continues by saying that, based on these findings, it’s highly likely that there will be a significant impact on capital flows, with investors shying away from non-ESG-friendly sectors towards more positive sectors, such as utilities, renewables, and industrials.
Who has to comply with SFDR reporting?
The SFDR applies to financial advisers and market participants with more than 500 employees within the EU. This regulation applies to all asset classes, including within the private equity space, and covers:
- Asset managers
- Insurance companies
- Pension funds
- Institutional investors
Although there aren’t currently regulations for American companies, those that sell to EU-based clients or are domiciled in the EU must also adhere to SFDR regulations and requirements for each fund or product they market to EU citizens.
That said, American businesses should begin preparing for similar initiatives, seeing as the U.S. Securities and Exchange Commission (SEC) has already begun asking companies to provide human capital resources disclosures on Form 10-Ks.
The SFDR framework, explained
The disclosure requirements for SFDR reporting break down into two levels:
- Organizational-level reporting – Disclosures on the holistic level, covering a firm’s entire portfolio.
- Fund/product-level reporting – Disclosures on each product or fund within a portfolio.
Level 1: Organizational-level disclosure
As noted, the reporting disclosures at Level 1 cover all of the investments of a firm. As a result, there’s no delineation between different funds or products.
This is the basic reporting level. As such, it requires that impacted companies make principles-based disclosures of their ESG activities. To comply, an applicable entity must:
Publish and maintain website disclosures
A website is a company’s virtual calling card—the first place an individual will go to learn more about the business. As such, the EU requires applicable companies to provide entity-level disclosures to their website, which include:
- Details on policies that will identify and prioritize Principal Adverse Impacts (“PAI”).
- A description of such PAI and any remediating actions implemented.
- Summaries of engagement policies that cover the prevention and management of potential conflicts of interest.
- A listing of relevant business conduct codes and standards for due diligence and reporting.
A PAI report is a quantitative analysis of how a firm’s investment activities affect ESG factors. This report covers a list of sustainability factors that a firm must account for in its investment policies, strategies, and decisions. For businesses, a PAI report acts as a historical comparison of previous performance that should theoretically incentivize companies to improve and reduce the negative impact on ESG over time.
Under SFDR, there are 64 different PAI indicators, all of which can help market participants understand how certain investments pose sustainability risks. Some category examples include sustainability, climate change, fossil fuels, nuclear energy, deforestation, human dignity, human rights, labor rights, gambling, tobacco, controversial weapons, and more.
These indicators are typically divided into the following buckets:
- 14 mandatory corporate indicators
- 33 optional corporate indicators
- 2 mandatory sovereign indicators
- 8 optional sovereign indicators
Companies must provide an annual report that covers at least 16 of these PAI—though it’s advisable to cover several optional indicators as well.
Many consider this to be the most difficult aspect of Level-1 reporting since it involves collecting and compiling relevant data. That data is rarely readily available, nor is it easy to collect. Data collection must be conducted quarterly for the relevant indicators across all investments, and it may require several data points for just a single indicator.
Smaller firms with less than 500 employees may be able to opt out of this reporting. However, if a firm does not consider PAIs in their investment decisions, they must specify clear reasons why and then answer whether they will consider them in future decisions.
Sustainability risk report
The sustainability risk report is another annual report that discusses how ESG factors impact investor behavior. This report must detail how the risks are integrated into decision-making and strategy-setting for both current and future investments.
After the sustainability risk report concludes, the applicable entity must disclose its remuneration policy on its website. This report will also explain how the policy is consistent or inconsistent with the company’s sustainability risk report.
Level 2: Product-level disclosures
Level 2 product-level disclosures can be more burdensome since they’re specific to each and every fund or product an entity markets to investors. As a result, there are different disclosures required for different funds, depending on their product classification.
According to the SFDR, each fund will fall into one of three article categories:
- Article 6 products – Funds that have neither sustainable investment objectives nor investment assets that offer environmental or social benefits. Article 6 funds are required to disclose a sustainability report as well as a remuneration policy that is consistent with the SR report.
- Article 8 products (light green) – Funds that promote environmental or social characteristics. In addition to Level 1 SFDR disclosures, Article 8 products need to benchmark themselves against competing products that promote similar characteristics.
- Article 9 products (dark green) – Funds that have sustainable investments as their core objective. In addition to Level 1 disclosures and Article 8 benchmarks, Article 9 products are expected to use benchmarks to measure their actual contributions against their stated ESG objectives.
What must you do to comply with SFDR?
Since its introduction, SFDR has been rolled out slowly. To comply, applicable parties must be ready to fulfill the SFDR requirements discussed above ahead of deadlines.
So, what are the compliance dates your business must follow?
- March 10, 2021 – By this date, businesses must have included disclosures on their website to reflect:
– How sustainability risks are considered in due diligence reporting and investment decision-making.
– How any adverse sustainability impacts of an investment are considered in the decision-making process.
– What their stated ESG aims are.
– The methodologies used to assess the impacts of the investment of an ESG fund.
– An explanation of how the remuneration policy aligns with the sustainability risk prospectus.
– How a fund considers sustainability risk in its decision-making.
– What projected potential impacts of the decision will have on the investment returns.
- January 1, 2022 – ESG fund managers are required to provide annual progress reports concerning ESG objectives.
- December 30, 2022 – Fund managers are required to disclose how they consider adverse sustainability impacts of investment decisions in prospectuses, PPMs, and pre-contractual investments.
- January 1, 2023 – The SFDR regulatory technical standard came into effect.
Currently, there are no direct penalties nor explicit sanction regimes for SFDR non-compliance. However, there will likely be penalties and enforcement measures that eventually roll out to pressure companies into compliance.
Tracking your sustainability impact
Although the SFDR hasn’t yet reached U.S. shores, the tides appear to be shifting that way. American businesses would be wise to start getting their house in order now, rather than scrambling after the fact to catch up with burdensome regulations.
How, then, can you prepare for corporate sustainability reporting and regulations such as these?
Sustain.Life, offers comprehensive sustainability management software for every business. Sustain.Life provides ESG data-driven tools and regulatory expertise you need to capture your environmental data, create an emissions reduction plan, and report your progress according to third-party standards.
To start making business decisions with the environment in mind, schedule a demo today.
- Official Journal of the European Union. REGULATION (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 27 November 2019 on sustainability‐related disclosures in the financial services sector. https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R2088&from=EN Accessed February 13, 2023
- Goldman Sachs. SFDR, one year on: The Trends and Anatomy of Article 8 & 9 funds. https://www.goldmansachs.com/insights/pages/gs-research/gs-sustain-sfdr-one-year-on/report.pdf Accessed February 13, 2023
- JD Supra. SFDR and Taxonomy Regulation deadlines – A compliance checklist for private banks, wealth managers and advisers. https://www.jdsupra.com/legalnews/sfdr-and-taxonomy-regulation-deadlines-8612204/ Accessed February 13, 2023
- The CPA Journal. First Look at the Human Capital Disclosures on Form 10-K. https://www.cpajournal.com/2021/10/27/first-look-at-the-human-capital-disclosures-on-form-10-k/ Accessed February 13, 2023