The European Union’s (EU) Sustainable Finance Disclosure Regulation (SFDR), which became mandatory in March 2021, aims to enhance transparency, reduce greenwashing, and channel capital into sustainable investments, products, and businesses. As part of the EU’s Financing Sustainable Growth Action Plan, the SFDR standardises Environmental, Social, and Governance (ESG) disclosures for financial market participants (FMPs) and financial advisers (FAs). It mandates transparency about sustainability and enforces mandatory ESG disclosure requirements.
What is the SFDR?
The SFDR elevates sustainability considerations in investments and financial products by requiring asset managers, fund managers, and investment managers to disclose the extent to which sustainability is incorporated within its investment decision making process.
Before the introduction of the SFDR, EU financial firms could set their own criteria or make broad claims about their ESG status without standardised reporting, leading to potential greenwashing. For instance, a firm could outwardly claim to be ESG-centric while financing projects which are harmful to the environment. The SFDR is the first regulation to introduce strict labelling standards for ESG-related products. Enhanced oversight and requirements from this regulation can reduce greenwashing and false claims that were previously unregulated. All participants in the EU’s financial industry, need to understand how and why the SFDR will impact their investment and financial activities.
Which Entities are Subject to SFDR?
The SFDR’s wide scope covers all FAs and FMPs that are based in the EU. According to the SFDR, FAs are entities offering investment or insurance advice. Such entities are obliged to incorporate sustainability risks into their advisory process. Examples of FAs include credit institutions offering investment advice, and insurance intermediaries advising on insurance-based investment products (IBIPs).
On the other hand, the SFDR defines FMPs as entities that create financial products, including portfolio management services. Examples of FMPs are investment firms offering portfolio management, insurance undertakings providing insurance-based investment products and Alternative Investment Fund Managers (AIFMs). Investment managers and advisers outside the EU must also comply if they market or appear to market products to EU clients.
Frequently Used Terms in the SFDR
Core Disclosure Requirements
Under the SFDR, sustainability impacts must be disclosed at both the product and entity level.
Entity-level disclosures refer to disclosures that an entity falling within the scope of the SFDR is obliged to share on its website. The SFDR requires companies falling under its scope to share information on their website about how their advisers, financial services, pension products, and alternative investment funds amongst others consider sustainability.
Whilst product-level disclosures serve to classify how green an investment or activity is. These disclosures mandate that FAs and FMPs provide sustainability information for both ESG-oriented and non-ESG products. The SFDR categorises the funds into three categories:
- Article 6,
- Article 8,
- Article 9.
Entity-Level Disclosures
The SFDR mandates transparency in sustainability practices requiring entity-level disclosures to ensure clients are well-informed about the integration of ESG risks and policies. The SFDR required firms to inform clients by disclosing on their website:
- The firm’s policies on integrating sustainability risks into its investment decision-making process, investment advice, or insurance advice,
- Remuneration policies that detail how they align with the integration of sustainability risks.
If the firm does not have an ESG focus or strategy, this must be disclosed, and the firm must indicate when it expects to adopt an ESG strategy. The policies must state whether or not the principal adverse impacts of investment decisions on sustainability factors are considered.
The firms must also amend their relevant pre-contractual information documents to disclose:
- How sustainability risks are integrated into investment decisions and advice,
- The results of the firm’s assessment of the likely impacts of sustainability risks on return.
Based on the principle of “comply or explain” these pre-contractual disclosure requirements apply regardless of the firm’s ESG focus. If sustainability risks are considered not relevant, the pre-contractual disclosures must clearly explain why.
Product-Level Disclosures
The SFDR establishes mandatory ESG disclosure requirements for asset managers to enhance transparency in their investment strategies and prevent greenwashing. Under the SFDR classification, funds are categorised as Articles 6, 8, or 9 based on their characteristics and level of sustainability.
Article 6
Article 6 includes products that either fail to incorporate ESG considerations into the investment decision-making process or do not clarify why such integration is not relevant.
Funds that fall under Article 6, must include descriptions in pre-contractual disclosures, including:
- How sustainability risks are integrated into their investment decisions,
- The results of assessing the likely impacts of sustainability risks on the returns of the financial products they offer.
If financial market participants consider sustainability risks, the disclosures outlined above must provide a clear and concise explanation of the reasons for this. This implies that the fund’s prospectus must already include provisions for these disclosures. If sustainability risks are relevant for a fund, asset managers must:
- Declare that they have integrated sustainability risks into investment decisions,
- Develop a process to assess and identify the most significant risks,
- Implement a disclosure policy to mitigate and act on these risks,
- Describe the approach for achieving this and track the implementation and results.
Article 8
Article 8 encompasses products that promote environmental and/or social characteristics, along with other characteristics, and invest in companies with good governance practices. This indicates that ESG investing is not central to these products.
When a financial product promotes environmental or social characteristics, or a combination of these characteristics, and invests in companies with good governance practices, the information disclosed pursuant to Article 6 must include:
- Details on how these characteristics are met,
- If an index is used as a reference benchmark, information on whether and how this index aligns with those characteristics.
Financial market participants must also disclose where the methodology used for calculating the index can be found.
Thus Article 8 applies to funds that promote environmental and social objectives, considering more than just the sustainability risks required by Article 6. However, Article 8 funds do not have ESG objectives or core objectives necessary to be labelled as Article 9 funds.
Article 9
Article 9 includes products that have sustainable investment as their primary objective.
When a financial product has sustainable investment as its objective and uses an index as a reference benchmark, the information disclosed according to Article 9 must include:
- Information on how the designated index aligns with that objective,
- An explanation of why and how the designated index aligned with that objective differs from a broad market index.
When compared to Article 8 funds, which promote environmental or social characteristics and follow good governance practices. Article 9 funds aim to make a positive impact on society or the environment through sustainable investment and have non-financial objectives at their core. Both Article 8 and Article 9 funds are considered ESG-aligned, but Article 9 funds are further advanced in sustainability.
Implementation and Considerations for FMPs and FAs
For FMPs and FAs operating in the EU to be able to market investments as Article 8 or 9, they must review the entire lifecycle of their products, from initial product development and marketing to contracting, monitoring, and reporting, and update their policies and processes accordingly.
In summary, the following areas need to be addressed:
- Marketing and Communications,
- High-Level Product and Investment Policies,
- Supporting Infrastructure,
- New Product Development,
- Risk Management,
- Due Diligence Process and Investment Research.
How Can We Help
At Zampa Partners, our services help companies navigate the SFDR by integrating sustainability considerations into investment decision-making processes and ensuring transparent disclosure of sustainability risks. We conduct SFDR GAP analysis to assess compliance and identify areas for improvement. By leveraging our expertise, your organisation can meet SFDR requirements, enhance the credibility of your products and build trust with stakeholders and investors.
Mark Wirth
Partner
