What is SFDR?
The Sustainable Finance Disclosure Regulation (SFDR) is part of the European Commission’s package of reforms to implement its sustainable finance strategy. The strategy focuses on three areas:
- Strengthening the foundations for sustainable investment by creating an enabling framework. The Commission believes many financial (and non-financial) companies still focus excessively on short term financial performance instead of long-term development and sustainability-related challenges and opportunities.
- Increasing opportunities to have a positive impact on sustainability for citizens, financial institutions and corporates – enabling them to “finance green”.
- Integrating climate, environmental, and social risks into financial institutions and the financial system as a whole.
To that end SDFR introduces a series of disclosure requirements for investment firms to address environmental, social and governance (ESG) concerns. It applies to asset and fund managers (e.g. MiFID investment managers, alternative investment fund managers (AIFMs), and UCITS managers), and investment firms, as well as credit institutions and insurers. The SFDR entered into force in December 2019 and its implementation date is on 10 March 2021.
How does it apply to UK firms?
The UK government has opted not to implement the SFDR into UK domestic law following the end of the UK’s Brexit transition period. However, SFDR will most likely still be relevant for UK firms either as a requirement under the regulation or in practical terms. For example, if a UK-based private equity firm wants to market into the EU or manage EU-based funds, it will be subject to the SFDR in its capacity as an Alternative Investment Fund Manager (AIFM). Additionally, we are likely to see firms complying with the SFDR for commercial reasons, particularly due to client or investor pressure
Even if a UK firm does not have to comply with the SFDR, the UK government plan to put green finance high on its agenda. In November 2020, UK Chancellor Rishi Sunak announced the government’s plans for the financial services sector ahead of the end of the Brexit transition period. The plans included the introduction of “more robust environmental disclosure standards so that investors and businesses can better understand the material financial impacts of their exposure to climate change, price climate-related risks more accurately, and support the greening of the UK economy”.
A HM Treasury spokesperson said: “[Last] year the Chancellor announced the UK’s intention to be the first G20 country to make disclosures that are aligned with the recommendations of the Task Force on Climate Related Financial Disclosures fully mandatory across the economy by 2025, going beyond the “comply or explain” approach adopted under the SFDR. We are considering the requirements for legislation relating to the SFDR and will set out further details in due course.”
For asset managers, the Financial Conduct Authority (FCA) is consulting in H1 2021 on potential TCFD-aligned client disclosure rules, aimed at providing ESG information at the firm, fund, and portfolio level to aid decision-making for investors. The UK regime is therefore likely to overlap substantially with SFDR.
What changes will SFDR bring?
The SFDR disclosure requirements involve a number of potentially challenging compliance hurdles for firms to overcome. There is a requirement to disclose “principal adverse impacts” (PAIs) of investment decisions on sustainability factors on a “comply or explain” basis. PAIs are defined as impacts of investment decisions and advice that result in negative effects on sustainability factors. The key challenge will be the collection of data. Firms will need to collect data from various sources, then map that data into a singular and robust data model. Data quality checks and transparency will be important compliance factors. Challenges like these will be costly and time consuming.
At the very least, firms now should be getting up to speed with the SFDR and the related Taxonomy Regulation and understanding where they fall within the scope of the regulation and what changes that will entail to their current practice. In light of the requirements, firms should start reviewing marketing materials and website disclosures. Firms should prepare their position on PAIs. If PAIs are voluntary then firms may wish to implement a phased approach, whereby they explain in March 2021 that they are not ready to disclose against the rules but will be reporting later in the year.
Firms should not wait to start making implementation plans. Client and investor demand remains a key developing driver of ESG changes and firms need to make headway in this area or risk being left behind.
The text of the SFDR can be viewed here.
The EU’s regulation on sustainability disclosures in the financial services sector, also known as the SFDR, came into effect on 10 March 2021. The UK government has elected not to implement the regulation in legislation since Britain left the EU’s regulatory umbrella at the beginning of 2021. However, the UK government is considering implementing similar rules. Advisers should also consider following SFDR regulation as good practice, even if it is not UK law because the regulation could be an example of good practice and a competitive advantage.
It will be key to understand clients’ ESG requirements and to research innovative solutions. While the government chose not to implement the SFDR, the regulation would apply to advisers if they have clients living in Europe, according to adviser trade body Pimfa. Those with only UK clients, meanwhile, would not have to apply the regulation.
The UK government is due to introduce its own version of the SFDR but there is currently no information on when that will be, whether it will simply mirror the SFDR or if it will differ in certain ways.
The expectation is that it will be at least one year before the UK will launch its own version of the SFDR so the requirement(s) around sustainable finance is still some way off.
The rules would have required advisers to ask clients about sustainability preferences in their suitability checks as part of the advice process. They also require financial advisers to publish on their websites information about how they integrate sustainability risks into their investment or insurance advice.
The Climate-related Financial Disclosures (TCFD or Task Force) recommendations are designed to solicit consistent, decision-useful, forward-looking information on the material financial impacts of climate-related risks and opportunities, including those related to the global transition to a lower-carbon economy.
Disclose the organisation’s governance around climate-related risks and opportunities.
Disclose the actual and potential impacts of climate-related risks and opportunities on the organisation’s businesses, strategy, and financial planning where such information is material.
Disclose how the organisation identifies, assesses, and manages climate-related risks.
Metrics and Targets
Disclose the metrics and targets used to assess and manage relevant climate-related risks and opportunities where such information is material.