The EU has put in place a transparency framework, the Sustainable Finance Disclosure Regulation (SFDR), to help investors make informed choices about sustainable objectives of investment products and understand how sustainability risks are integrated into those products.
The SFDR requires asset managers to provide prescript and standardized disclosures on how ESG factors are integrated at both an entity and product level. A significant portion of the SFDR applies to all asset managers, whether or not they have an express ESG or sustainability focus. The SFDR manifests in additional disclosures for financial market participants: on websites; in prospectuses and; in periodic reports.
A Quick Review of SFDR
The SFDR requires financial market participants and financial advisers to inform investors about how they consider the sustainability risks that can affect the value of and return on their investments (‘outside-in’ effect) and the adverse impacts that such investments have on the environment and society (‘inside-out’).
Market participants have to make this information available with regard to specific products, but also relating to their respective firm as a whole. They have to do so via their websites, in product pre-contractual documents and in annual reports. You can check the EU website here.
The sustainability‐related disclosures for the financial services sector defines a sustainable investment as follows:
‘sustainable investment’ means an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance;
Article 2 (Definitions), (17), Regulation (EU) 2019/2088
(Reference: https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32019R2088)
So in essence a fund must invest in entities that demonstrate three core principles for that investment to be considered sustainable, namely the underlying investment must:
Have a social or environmental objective;
Do no significant harm; and
Demonstrate good corporate governance
What are the key components of SFDR Directive?
The key pieces of legislation in the SFDR legislation are outlined below (you can access the legislation here).
Entity level information to be published on the participant website
Article 3 (Transparency of sustainability risk policies): information on ESG integration for investment and decision making.
Article 4 (Transparency of adverse sustainability impacts at entity level): comply or explain how they consider principal adverse impacts, supporting due diligence and actions taken against them.
Article 5 (Transparency of remuneration policies in relation to the integration of sustainability risks): how remuneration links to sustainability policies.
Product level information for pre-contractual disclosure (prospectus)
Article 6 (Transparency of the integration of sustainability risks): information on ESG integration into products and impact on financial return.
Article 7 (Transparency of adverse sustainability impacts at financial product level): comply or explain on whether financial products consider principal adverse impacts.
Article 8 (Transparency of the promotion of environmental or social characteristics in pre‐contractual disclosures) for financial products that promote ESG characteristics, details on how those characteristics are met, and the reference benchmark if applicable.
Article 9 (Transparency of sustainable investments in pre‐contractual disclosures): for financial products that have sustainable objectives, details on how the objective will be achieved, reference benchmarks if applicable,
Periodic reporting for Article 8 and 9 products
Article 11 (Transparency of the promotion of environmental or social characteristics and of sustainable investments in periodic reports): disclose level to which ESG characteristics are met (Art 8), sustainable impact of the product (Art 9) and a comparison with the benchmark if applicable (Art 9). This information should be presented in the annual reports or periodic reports depending on the entity type.
Article 8 versus Article 9 funds
For a fund to be categorized as Article 8, it must promote environmental and / or social characteristics. For a fund to be considered Article 9, the fund must have a sustainable investment objective which outlines a minimum percentage that the fund will invest in sustainable investments.
A sustainable investment means an investment in an economic activity that contributes to an environmental or social objective, provided that the investment does not significantly harm any environmental or social objective and that the investee companies follow good governance practices.
These sustainable investments can either be categorized as being (1) environmentally sustainable economic activity as outlined in the EU taxonomy, (2) environmentally sustainable economic activity that does not quality under the EU taxonomy, (3) or an socially sustainable economic activity.
SFDR reporting timeline
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