What is the Impact of the EU Sustainable Finance Disclosure Regulation (SFDR)?

This is the first in a three-part series on new ESG regulations in Europe. We begin with the SFDR.

How do my investment choices impact the planet? This is the simple question at the heart of the complex Sustainable Finance Disclosure Regulation (SFDR). There is no escaping the truth: the SFDR is complicated. It is multifaceted. It is – at times – slightly enigmatic. The goal of this article is to untangle the intricate SFDR provisions to reveal its true impact.

The SFDR Basics

Let’s tackle the basics. The SFDR became applicable on 10 March 2021. Its scope captures financial market participants and financial advisers operating in the EU. It sets specific rules for how and what sustainability-related information they need to disclose.

But why does it exist? The origins of SFDR lie in work undertaken by EU’s High-Level Expert Group (HLEG) on sustainable finance from 2016 to 2018. HLEG produced a roadmap for the EU to pursue two goals: (1) Integrate sustainability considerations into the financial system, and (2) Steer the flow of capital towards sustainable investments.

To implement the HLEG roadmap, the European Commission launched its flagship Sustainable Finance Action Plan with the SFDR as one if its core pillars.

The Objectives Behind SFDR

Despite its complexity, the SFDR has a simple objective: avoid the ‘greenwashing’ of financial products and financial advice in the EU by providing more sustainability related information. SFDR aims to ensure that EU investors have the disclosures they need to make investment choices in line with their sustainability goals.

To achieve its objectives the SFDR introduces the concept of Principal Adverse Impacts (PAIs). PAIs are essential to understanding the regulation as they represent a basic SFDR unit. PAIs are the negative effects on sustainability factors that an investment decision or advice might have. Sustainability factors are listed as environmental, social, and employee matters, as well as matters relating to human rights, anti‐corruption, and anti‐bribery.

The Impact of SFDR

At first glance, the SFDR creates significant additional administrative burden to fulfil the disclosure requirements. However, it has a deeper more far reaching normative impact for providers of financial products and financial advice.

Through the disclosure requirements SFDR essentially requires firms to make strategic decisions about their approach to sustainability. For example, to communicate how a product impacts sustainability, providers will need to decide whether to measure that impact. Does the provider have a system in place to measure such impacts? If it does, how does it work? If not, should it develop a system? Which products are intended to minimize PAIs and which are not? Where PAIs are not considered, the SFDR requires a clear explanation for why this is the case.

Moreover, the SFDR can present the illusion of choice. For example, at first glance scoped entities appear to be able to state that they simply do not take account of PAIs. However, this option is removed for entities over 500 employees after 30 June 2021.

Main SFDR Requirements

But what does the SFDR actually require? For scoped entities, sustainability impacts must be identified and disclosed at both the entity and product level.

At the entity level, the SFDR requires firms to undertake a series of disclosures:

• Information on how an entity integrates sustainability risks in its investment decision‐making process or financial advice;
• A statement on policies about how an entity considers PAIs on sustainability factors.
• Information on how remuneration policies are consistent with the integration of sustainability risks;
• Pre-contractual disclosures on sustainability risk integration, including assessments of how the performance of financial products may be affected by those risks.

At the product level, the SFDR requires firms to undertake a further series of disclosures, depending on the objective of a given product:

• For firms that do consider PAIs, an explanation of how financial products account for these impacts should be provided. This applies to all the firm’s products, whether they are intended to meet sustainability goals or not;
• 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 Taxonomy alignment of underlying economic activities
• For ‘Article 9’ products that have sustainable investment as an objective, there must be an explanation on how the objective is achieved as well as additional disclosure on alignment with the EU Taxonomy Regulation.

SFDR Implementation Milestones

So far so simple. Let’s end by demystifying the SFDR’s timetable. The SFDR takes a phased approach to implementation with different provisions applying over an extended timeframe. In addition, Level 2 measures — known as Regulatory Technical Standards — will provide important details on the content and presentation of disclosures, as well as the indicators for PAIs. Critically, these Level 2 measures have not been finalised, creating added uncertainty.

The European Commission has clarified that the Level 2 will become applicable at a later stage, possibly on January 1, 2022. However, the Commission made clear that firms must comply with the SFDR’s high-level and principle-based requirements from March 10, 2021.

Key milestones on the SFDR path forward include:

• June 30, 2021: Large firms with over 500 employees must disclose their due diligence policies for PAIs on sustainability factors.
• January 2022: Periodic reporting on “Environmental” and “Social” characteristics and sustainable investment objectives will begin, as well as relevant alignment with the EU Taxonomy on its two climate change mitigation and adaption objectives.
• By December 30, 2022: Firms that consider PAIs must disclose how their products consider these impacts, while others have to explain why they do not
• January 2023: Products that promote “Environmental” or “Social” characteristics and products with sustainable investment as their objective must have periodic and precontractual reporting in place on alignment with the EU Taxonomy’s remaining four objectives:
  
  • The sustainable use and protection of water and marine resources;
  • The transition to a circular economy;
  • Pollution prevention and control; and
  • The protection and restoration of biodiversity and ecosystems.
• June 30, 2023: Firms must disclose the detailed indicators for PAIs for the period from January 2022 to December 2022.

In summary, the impact of the SFDR will be significant in terms of additional disclosure. This may include developing and communicating new processes and procedures for entities affected by its requirements. It will also likely catalyze strategic choices on how to approach sustainability as a firm. Finally, SFDR will unleash a flood of new sustainability information for investors to interpret. An often-expressed concern is the availability of relevant corporate data that feeds into these disclosures by financial market participants. In many ways, the impact of the SFDR revolution is just beginning.

Listen to our webinar replay for more information on SFDR and how S&P Global can help with implementation.