Background
By signing the Paris Climate Agreement, the European Union has committed itself to achieving the climate goals set out therein and has also committed itself to more sustainable development for society and the economy In this context, the EU Commission presented a roadmap in March 2018, which EU Action Plan, which includes an EU strategy for a sustainable finance with measures and work packages.
An essential component is the Sustainable Finance Disclosure Regulation (SFDR), also known as the Disclosure Regulation, which has been in force since 21 March 2021. The obligations arising from the SFDR are aimed at financial market participants (FMTs) and financial advisors. [1] The regulation aims to increase transparency, among other things, by standardising sustainability-related disclosures in the financial services sector, promote sustainable investments and minimise greenwashing.
The implementation of the SFDR took place in several phases. The staggered requirements and transition periods gave market participants time to adapt. While the so-called Level 1[2] Requirements have been in force since 21 March 2021, the Regulatory Technical Standards (RTS; Level 2) apply[3], which specify the disclosure obligations, since January 1, 2023.
requirements and scope
The SFDR establishes disclosure obligations at company level (e.g. AIFM) and product level (e.g. AIF).
The SFDR follows the approach of double materiality; known from sustainability reporting (CSRD) and already here In concrete terms, this means that in addition to the so-called adverse impacts on sustainability factors – Principal Adverse Impacts (PAIs) – the sustainability risks are also analyzed.
Inside-Out → impact of the investment → Sustainability Factor/PAI → e.g. contribution to climate change, measured by Scope 1, 2, 3 emissions
Outside-In → impact on the investment → sustainability risk → Financial risk, transition risk (e.g. regulatory) and physical risk (e.g. flood)
On product level There are extended disclosure obligations – depending on the product classification – in pre-contractual documents, annual reports and on the website.
- Pre-contractual information: In general, information about the consideration of sustainability risks and the adverse impacts of investment decisions on sustainability factors must be disclosed. A methodology for measuring the success of the Environmental, Social and Governance (ESG) goals/strategy is not specifically specified; rather, this must be presented by the FMT for sustainable financial products.
- Annual Financial Statements: The annual financial statements must disclose the extent to which environmental and/or social characteristics or sustainability objectives have been implemented, based on the methodology set out in the pre-contractual information.
- Website Disclosures: The website summarises and partially supplements the product-related ESG information, in particular with information on data collection processes.
At the company level, financial market participants must disclose sustainability-related information on their website. Specifically, they must explain whether, how and which ESG factors are taken into account; what impact these have on the financial product offered and how resulting risks are dealt with.
The term financial market participants includes a broad group of actors, including AIF/UCITS management companies and investment firms that provide portfolio management. Large FMTs (> 500 employees at group level) are obliged to disclose the material adverse impacts of their investment decisions on sustainability factors. This disclosure is made in accordance with Art. 4 SFDR in a sustainability report that must be published on the respective company's website. Small FMTs can choose whether to publish the PAIs at company level (“Comply or Explain” rule).
Principal Adverse Impacts
The PAIs are quantifiable listed indicators. The data based on them must be collected and disclosed partly at company level and (depending on the fund categorisation) also at product level.
A total of 64 ESG indicators are described, covering various thematic areas such as greenhouse gas emissions and biodiversity or employment and human rights.
An example PAI indicator relates to the topic of “energy from non-renewable energy sources”. The share of energy consumption and energy production of the portfolio companies from non-renewable energy sources compared to renewable energy sources must be indicated, expressed as a percentage of total energy sources.
If PAI indicators are taken into account at company level, at least 14[4] from Table I, Annex 1, as well as at least one further indicator from the environmental (Table II) and social (Table III) areas. [For a detailed overview, see here.]
The majority of PAIs relate to investments in companies and securities.
Our best practice tip: Often, not only is the PAI collected reported, but in practice, certain PAIs are prioritized (also based on data availability), thresholds are set and/or a targeted commitment to specific PAI is specified in order to achieve a reduction in impacts in the future. Corresponding strategies are published at company level in the annual PAI statement, while explanations can be found at product level in various places in the pre-contractual information and the annual financial statements.
product classification
The SFDR divides financial products into the following three categories:
- Article 9 Products ("dark green"): Financial products that pursue a sustainability goal (social and/or ecological)
Example: CO2 reduction or combating child poverty.
- Article 8 Products ("light green"): Financial products that promote social or environmental characteristics in the investment process
Example: Exclusion of certain “harmful” investments, consideration of ESG ratings or public declaration that funds are “sustainable”.
- Article 6 Products: Financial products that do not take sustainability aspects into account or which do not fall under Art. 8 or 9 SFDR.
The disclosure requirements are very limited for Art. 6 SFDR funds, whereas Art. 8 or 9 SFDR funds have disclosure requirements in the media described above. For all product categories, it must be disclosed whether and how PAIs are taken into account (“Comply or Explain”) – although in the case of pursuing a sustainable investment objective, consideration is mandatory.
The consideration of ecological or social characteristics or the achievement of sustainability objectives should be quantified using indicators (PAIs or individually defined) and compared on an annual basis.
Furthermore, data on investments in companies with economic activities that comply with the EU taxonomy must also be published, even if the percentage is 0%. You can read more about the EU taxonomy here.
Overview
challenges
Financial market participants are faced with a number of challenges, as the SFDR is a comprehensive regulation with detailed requirements, but at the same time does not contain sufficiently specific specifications due to the wide scope for interpretation of the requirements. This makes it difficult to classify products appropriately.
In order to meet the disclosure obligation(s), extensive sustainability-related data is also necessary, which must not only be collected and analyzed, but also compared annually and, if necessary, compared with reference values. In addition to problems with the availability of data (e.g. there is usually little data on the topic of "biodiversity"), quality assurance is also a challenge - especially when investing in different markets and sectors or countries outside the EU. Outside the EU, sustainability-related data is often not collected or is not collected to a sufficient extent.
Further challenges exist with regard to the time required and the allocation of human and financial resources.
How can we support?
Companies that familiarize themselves with the SFDR standards early on and align their sustainability efforts accordingly will not only meet the new requirements but can also benefit from increased trust from investors and stakeholders.
Is your company affected by the SFDR or is sustainability relevant to you?
At Moore TK, we are revolutionizing the way companies implement SFDR. With over 100 years of consulting experience, we offer not only a 360° approach, but also a dynamic ESG team dedicated to SFDR consulting. Our interdisciplinary teams combine expertise and technology to deliver customized solutions. We understand the complexity of SFDR requirements and offer tailored strategies to implement them effectively.
We will work with you to ensure successful implementation and execution.
Get in touch with us!
Sources
[1] These include investment advisors, insurance brokers and other financial service providers who offer investment advice. This blog post does not go into further detail about the requirements for consultants.
[2] REGULATION (EU) 2019/2088 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL
[3] COMMISSION DELEGATED REGULATION (EU) 2022/1288
[4] additionally two indicators each for investments in real estate and states
[5] Mandatory consideration of PAI in investment decisions for financial companies with more than 500 employees at company level. If there are 500 or fewer employees, PAI can be taken into account. If they are not taken into account, an explanation as to why they are not taken into account is sufficient.
[6] Appendix II RTS (p.52-56)
[7] Annex IV RTS (p.62-67)
[8] Appendix III RTS (p.57-61)
[9] Appendix V RTS (p.68-72)