The Sustainable Finance Disclosure Regulation (SFDR) imposes obligatory ESG reporting requirements on asset managers and other financial market players, with the regulation's core components effective since 10 March 2021.
The European Commission established the SFDR along with the Taxonomy Regulation and the Low Carbon Benchmarks Regulation as part of a package of legislative initiatives resulting from the Commission's Action Plan on Sustainable Finance.
After acknowledging the importance of sustainable finance regulation in attaining the EU's long-term development goals in 2017, the EU has been working to tighten its sustainable finance regulations since then.
The purpose of these legislative measures is to urge the financial sector to promote sustainable businesses while diverting resources away from damaging ones.
To accomplish this, the SFDR places a premium on disclosures. There is a widespread view that increasing openness about the effect of end-investors' investments on society and the environment would motivate them to direct resources toward less damaging and maybe even beneficial activities.
Overall, the SFDR is a component of the EU's broader Sustainable Finance Framework, supported by a slew of new and strengthened legislation that will apply throughout the bloc's member countries.
The SFDR complements the EU's Sustainable Finance Action Plan, which seeks to stimulate sustainable investment throughout the EU. The European Commission announced an action plan on sustainable finance in March 2018 as part of a strategy to include environmental, social, and governance concerns into its financial policy framework and to mobilise financing for sustainable development.
In May 2018, the Commission unveiled the action plan's first legislative package. The package includes four proposals:
Additionally, the Commission established a Technical Expert Group on sustainable finance (TEG) in July 2018 to guide the action plan's implementation, including the development of a classification scheme for sustainable economic operations, an EU green bond standard, techniques for low-carbon indices, and metrics for climate-related disclosure.
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Furthermore, SFDR is also in line with the new EU Taxonomy aimed at levelling the playing field across the EU.
The EU Taxonomy is framed by the Taxonomy Regulation 2020/852, which is a system for defining businesses' activities as sustainable in terms of key objectives, including climate change mitigation.
The Taxonomy Regulation requires further disclosures which need to be made in addition to those set out in the SFDR.
The SFDR is a reaction to the Paris Agreement and the United Nations Sustainable Development Goals.
The Paris Agreement on Climate Change is a legally enforceable international treaty. It was approved by 196 Parties on 12 December 2015 at COP 21 in Paris and came into effect on 4 November 2016. Its objective is to keep global warming far below two degrees Celsius, ideally to 1.5 degrees Celsius, over pre-industrial levels.
The Sustainable Development Goals are a set of 17 interconnected global goals intended to serve as a "roadmap for achieving a more just and sustainable future for everyone." The United Nations General Assembly established the SDGs in 2015 to achieve them by 2030.
The SFDR is compatible with Europe's Green Deal. The Green Deal of the European Union (EU) is the EU's primary growth plan for transitioning the EU economy to a more sustainable economic model.
The EU Green Deal, which was unveiled in December 2019, has as its main goal for the EU to become the first climate-neutral continent by 2050, leading to a cleaner environment, more cheap energy, smarter transportation, new employment, and an overall higher standard of living.
Sustainability risks refer to environmental, social, or governance events, or conditions, such as climate change, which would cause an actual or potential material negative impact on the value of an investment.
The SFDR requires disclosure on how sustainability risks are integrated into the investment decision-making process at both entity-level and fund-level.
Sustainability factors mean environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters.
Adverse Impacts on Sustainability factors (also referred to as principal adverse impacts - PAIs) encompass negative externalities that investment decisions or advice have on environmental, social or governance factors.
The SFDR requires disclosure, in a PAI Statement, on how principal adverse impacts of investments on sustainability factors are considered at both entity-level and fund-level. Companies with less than 500 employees can explain why PAI are not considered.
Quantitative Disclosure: the PAI Statement must contain a description in the Regulatory Technical Standard (RTS) by the fund manager highlighting negative externalities on various dimensions of sustainability and associated actions planned or implemented.
In particular, fund managers are required to publish quantitative data on 14 key indicators (nine of which are environmental in nature, while the remaining five are social in nature) for evaluating adverse sustainability impacts across a spectrum of ESG factors, with additional indicators pertinent to sovereign and supranational investments, as well as real estate investments. Fund managers must also report on at least one extra environmental and one more social indicator in addition to the 14 major indicators mentioned above.
These indicators are collected and aggregated from portfolio companies. Mandatory indicators to be reported include carbon footprint, gender pay gap or compliance to OECD and UNGC guidelines by portfolio companies.
Qualitative Disclosure: the RTS requires the following for qualitative descriptions in the PAI Statement:
PAIs are some of the most complicated components of the SFDR regime for enterprises to comply with, but they aim to assure comparable data on the adverse potential effects of an investment activity on environment, social, and governance factors.
The “Do No Significant Harm” (DNSH) principle is to be applied for all “Sustainable Investments”, and stipulates that in addition to contributing to an environmental or social objective, the investment must prove it does not significantly harm any other environmental or social objective.
The European Securities and Markets Authority (ESMA) regularly publishes Q&A to clarify the grey areas of the regulation. The latest Q&A was released on November 17th, 2022.
The SFDR represents a significant step forward for the growth and development of sustainable and ESG investment in the EU.
As investor interest in sustainable and ESG investing continues to grow, the regulation provides investors with straightforward comparisons and advice on ESG and sustainable investments, enabling asset managers and advisers to direct capital toward investment products that promote a sustainable economy.
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