This piece is produced by S&P Global Sustainable1, S&P Global's single source of essential sustainability intelligence to navigate the transition to a low carbon, sustainable and equitable future.

SFDR, CSRD, green taxonomy — there's a veritable alphabet soup of regulation coming out of the EU this year, with the potential to dramatically change the landscape of sustainable investing in Europe.

The EU's sustainable finance action plan in 2018 put the bloc at the forefront of creating global sustainability policies. A cornerstone of that strategy was to make environmental, social and governance investing more transparent and improve disclosure. That led to the Sustainable Finance Disclosure Regulation, or SFDR.

Learn more about SFDR in this episode of ESG Insider, a podcast hosted by S&P Global Sustainable1.

The SFDR will create a structural change in financial markets by making sustainability reporting mandatory and will push investment firms marketing ESG funds to change the way they produce, sell and market products. It will force portfolio managers to assess sustainability-related risks in their investments.

Under SFDR, asset managers, pension funds and insurers must disclose how they consider ESG risks in their investment decisions. The new regulations are designed to provide a common set of rules on sustainability risks and to prevent greenwashing, a practice of making an investment sound more sustainable than it is actually is.

Asset managers and owners will have to include information on their websites as well as in their fund documentation and tell investors, for the first time, where the ESG risks lie in their fund portfolios. And if they don’t take sustainability risks into consideration, they will have to explain why.

The change marks one of the first major regulatory steps in the EU's efforts to drive capital toward sustainability, as the bloc seeks to achieve net zero emissions by 2050. Through its Green Deal, announced in 2019, the EU aims to mobilize at least €1 trillion of sustainable investment over the next 10 years.

SFDR + CSRD + green taxonomy = new sustainability landscape

The SFDR is part of a broader package of EU sustainability rules that are significantly changing the sustainability landscape. 

Some parts of the SFDR regulation came into force on March 10, but that is just a first step, and the regulation will evolve over the next two years. As of July 1, 2022, disclosure requirements will become more onerous. Further tweaks will continue till mid-2023. Importantly, those rules will not only apply to European companies. A recent analysis by S&P Global found that companies outside the EU with more than $3 trillion in market capitalization could be subject to SFDR.

The disclosure rules work in tandem with the EU's green taxonomy. Simply put, the taxonomy is a classification system defining environmentally friendly investments. It's also designed to set voluntary performance thresholds for companies and industries that seek to reduce greenhouse gas emissions or adapt to a changing climate.

Under SFDR, investors managing ESG-related funds will have to explain how they use the green taxonomy to determine the sustainability of their investments. They will also have to disclose what percentage of their investments are in line with the taxonomy. Investors will have to rely heavily on the taxonomy to meet SFDR disclosure requirements as it will help them define what is "green." ESG funds will have to comply with the taxonomy’s climate objectives from 2022. In 2023, they will have to answer to more taxonomy disclosure requirements, some of which are still to be finalized.

Under SFDR, investment portfolios will have to consider everything from a firm's carbon footprint to its board diversity to water management and controversial weapon exposure of the companies in which they invest.

For example, under SFDR, fund managers must assess the average ratio of female to male board members at a company. Based on an S&P Global analysis of 11,647 companies, women make up only 11.59% of board members.

Asset managers and owners subject to SFDR will also look at fossil fuel exposure as a potential risk. Under SFDR, companies with fossil fuel exposure are those that make money from oil and gas exploration, coal mining, and the distribution or refining of coal, oil and gas. An S&P Global analysis of 19,606 companies found that only 4.18% reported revenue from fossil fuel activities. However, fossil fuels account for 8.07% of their actual revenues. For those companies reporting fossil fuel revenue, on average 42.76% of that revenue is from activities aligned with SFDR’s definition of companies active in the fossil fuel sector.

The SFDR regulation dovetails with the EU’s proposed Corporate Sustainability Reporting Directive, or CSRD, which will replace yet another acronym, the Non-Financial Reporting Directive (NFRD). NFRD currently requires large businesses to report how they take sustainability into account annually, and the CSRD proposal aims to broaden its reach. Importantly, it will ensure companies report the information that fund managers need to comply with SFDR.

The combination of legislation will be particularly important for informing the market on the flood of net zero emissions goals coming from countries and corporations around the world.

"The SFDR, the taxonomy and the NFRD all contribute from their perspective to inform how close we are to reaching those goals, which sectors are lagging, what sectors are leading, how are investors doing, so beneficiaries can know how their pensions are aligned or not with the Paris agreement," said Margarita Pirovska, director of policy at the U.N.-backed investor group Principles for Responsible Investment. "It is not about pointing fingers. It’s about understanding the situation, assessing where we are at and taking the appropriate measures to ensure a just sustainable and orderly transition."

Challenges ahead

The time lag in the rollout of the SFDR does, however, create hurdles for market participants. Investment managers will need to adjust their strategies and documentation for the additional SFDR rules, expected in 2022 and 2023, adding to the complexity of what already is a huge challenge for investors.

Potential risks in investment portfolios will become more apparent as disclosure requirements increase. For example, funds will need to measure firms' Scope 3 emissions — emissions that come from companies’ supply chains — as of Jan. 1, 2023, a year later than the reporting requirements for Scope 1 and 2 emissions, which account for firms' own business operations. 

S&P Global data shows that Scope 3 downstream emissions, which represent goods and services once they leave a company’s control, on average account for around 49% of emissions for most sectors.

Companies won't have to report under the new CSRD rules until 2023, which means investment firms will have to wait to obtain key sustainability data about the firms in which they invest.

And that could delay key data points that investors desperately need to make their investments. One of the main issues for ESG investors over the last few years has been a lack of forward-looking information about climate risks. Social factors are difficult to quantify, as are governance risks.

SFDR aims to change investor behavior and shine a light on which companies and funds are ESG-focused. That increased transparency could result in a growth of sustainable investing. 

Olivier Carré, Financial Services Leader of PwC Luxembourg, predicts by 2025 half of Europe’s mutual funds will adhere to SFDR's Article 8 — known as "light green" funds that promote both environmental and social investing — and Article 9 — considered as "dark green" funds that put sustainability at the heart of their investments.

The fact that fund managers must acknowledge ESG risks in their investments means investors are more likely to pay a premium for ESG products, while those funds not taking sustainability into account face trading at a discount, he said.

For some market participants, SFDR and regulation in general is the only way to ensure asset managers are integrating ESG into their portfolios.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.