In March 2021, the European Union’s Sustainable Finance Disclosure Regulation (SFDR for short) became a mandatory disclosure obligation for EU-based financial market participants (FMPs) and financial advisors. The SFDR standardizes environmental, social, and governance-oriented (ESG) disclosures in the financial realm. SFDR aims to promote transparency and human rights and ensure investments do no significant harm to the EU’s environmental objectives in the fight against climate change. It is widely considered a powerful tool against greenwashing because it standardizes the definition of sustainable activities and initiatives and establishes acceptable evidence to demonstrate such claims.
What is SFDR?
The Sustainable Finance Disclosure Regulation (SFDR) came about after a two-year review from 2016–2018 by the EU’s High-Level Expert Group (HLEG) on sustainable finance. HLEG sketched out two core aims for the EU: first, integrate sustainability into financial systems; second, help funnel capital into sustainable investments. The SFDR helps achieve both goals by elevating considerations around sustainability impacts in investments and investment processes and sustainability-oriented information around financial products. It requires asset managers, fund managers, investment managers, etc., to show whether or not investments have a sustainability or ESG focus, regardless of if they identify themselves as an “ESG-focused” financial firm.
Before the SFDR, financial firms in the EU could create their own criteria or provide blanket statements on their ESG status. They could promote investments and activities as ESG-centric without any standardized reporting criteria for accountability on whether or not those statements were factual—a behavior often characterized as greenwashing. For example, a firm could say they are ESG-centric in its approach outwardly while simultaneously financing a major oil field in an ecologically high-risk area. The SFDR put a stop to that lack of transparency within the EU and gives clarity on the labeling of ESG financial products.
Under the SFDR, ESG disclosure obligations are mandatory for asset managers and FMPs operating within the EU. The European Commission introduced the SFDR in tandem with the EU Taxonomy Regulation—EU Taxonomy for short. While the EU Taxonomy provides regulatory technical standards around uniform standards, policies like the SFDR give EU-based financial institutions an understanding of how, what, and why to report. The SFDR’s core goal is to avoid greenwashing in financial products in the EU by requiring more sustainability-related information. With the SFDR, European investors have the transparency they need to make investments that correspond to their own sustainability goals.
Who is impacted by the SFDR?
The SFDR forces firms to consider their strategic decisions and general approach toward sustainability and how they communicate those considerations outwardly. The SFDR primarily applies to EU-based financial institutions with over 500 employees and all FMPs, including banks, insurance companies, investment firms, and asset managers. In addition to financial advisers based in the EU, the regulation also impacts those based outside the EU who market their products to EU-based clients. The SFDR touches virtually anyone and everyone operating in the EU financial market.
The scope of global and European money impacted by the SFDR is colossal. In 2021, the total worth of EU-based financial corporations was valued at €81.6 trillion. And because the SFDR affects non-EU-based financial firms via their EU subsidiaries, its reach extends further. An analysis of globally based companies with at least one subsidiary in the EU financial market showed that 62 global parent companies together represent a collective $3.2 trillion (USD) annual market cap. U.S.-based parent companies alone represented a $2.5 trillion (USD) annual market cap and accounted for 22 companies.
Core disclosure requirements
Under the SFDR, sustainability impacts must be disclosed and identified at the product and entity levels. Think of entity-level disclosures as the ESG statement a financial firm puts on its website. Entity-level disclosures require financial firms to share information on their corporate websites about how their advisors, financial services, pension products, and alternative investment funds consider sustainability.
Think of product-level disclosures as a way for financial firms to classify how green an investment or activity is. Product-level disclosures under SFDR require advisers and financial market participants to disclose product information on sustainability for ESG-oriented products and non-ESG products. The SFDR requires firms to classify products and investment advice offered across three categories: mainstream products (Article 6), products that promote environmental or social criteria (Article 8), or products with sustainable investment objectives (Article 9). Product labeling aims to inform investors about whether and to what extent sustainability, environment, and human rights considerations are considered in investment activities.
Sustainability indicators and impacts
The SFDR introduced a new concept around Principle Adverse Impacts (PAIs), representing the negative impacts financial advice or investment could have on sustainability factors. Those sustainability factors include anti-bribery, anti-corruption, human rights, environmental, social, and employment issues, and, more broadly, ESG. The SFDR aligns with the UN Guiding Principles on Business and Human Rights, the UN Global Compact (UNGC), and the goals illustrated in the EU’s Green Deal, namely, to make Europe climate neutral by 2050 and to disconnect finance from extractive resource use.
When FMPs and financial advisors disclose their sustainability information on an entity and product level, environmental and social indicators are a core focal point for consideration. When it comes to activities that are PAIs, an understanding of mandatory adverse sustainability impacts is required to ensure a comprehensive assessment of negative sustainability impacts across ESG indicators, particularly for investments. These categorize into nine environmental and five social indicators for financial advisors and FMPs to incorporate into their PAI mandatory assessments under the SFDR.
How does the SFDR relate to the EU Taxonomy and other EU policies?
Through a series of regulatory measures, the EU continues to push the envelope on sustainability reporting across financial and non-financial sustainability disclosures. The SFDR and EU Taxonomy are interrelated but not synonymous. The EU Taxonomy is the primary tool for the EU to set criteria to determine if an activity is sustainable while providing a uniform reporting standard for various sectors.
The SFDR requires product-level disclosures to align with the EU Taxonomy. Entity-level disclosures aim to promote increased transparency by forcing entities to directly list related sustainability risks and disclosures on their website. From 2023, products that promote ESG must align with the EU Taxonomy’s objectives, like circular economy, pollution control and prevention, protection of biodiversity and ecosystems, and protection and sustainable use of water and marine resources.
Like other EU sustainability disclosure policies, the SFDR is built around transparency and accountability and encourages a transition from extractive resources. Non-financial sustainability reporting requirements, like the EU’s Corporate Sustainability Reporting Directive (CSRD), further encourage companies across various sectors to address sustainability challenges better.
Benefits and shortfalls of the SFDR
Reporting on the SFDR will continue to generate a well of sustainable finance data for investors to consider that could transform markets in the EU and globally. Sustainability disclosure policies like SFDR could pave the way for a future green economy. Ultimately, if investments continue to fuel extractive and high climate-related impact industries, we will struggle to keep the Paris Agreement goal of keeping warming below 1.5°C.
While the SFDR puts investment decision-making and investments themselves under the sustainability microscope, it does not regulate or restrict the import of goods into Europe that rely on climate-, biodiversity-, or human rights-impacted industries. In 2022, the EU implemented a novel carbon border tariff for imports like steel and cement from hard-to-abate industries. However, this policy leaves out leather produced from deforestation and other examples of environmental and social harm. A large area of supply chain financial flows is missing by focusing exclusively on European markets and actors. Other recent EU policies, like the CSRD, cover value and supply chains. Still, limited restrictions on high climate impact and human rights-impacted products are finding their way into the EU. The SFDR is yet another EU sustainability policy action in the tapestry of EU policies linked to the EU Green Deal. In time, we should expect additional policy instruments to come online.
Importance of SFDR
Financial market actors should be increasingly aware of how their investments contribute toward scope 1, 2, and 3 emissions and environmental and social harm. The SFDR will transform the way investments happen, both in and outside Europe. Firms will have to account for how they integrate ESG into their investments. Financial firms and advisors will no longer be able to create their own blanket ESG statements while simultaneously investing in areas that cause irreparable environmental and social harm. Greenwashing in the EU financial market is effectively over. These disclosures will empower both large institutional and everyday investors to choose green investment products and open funds and accelerate the path toward net-zero.