The Sustainable Finance Disclosure Regulation (SFDR):
This article serves to help investors understand the SFDR and why it is important as at 10 March 2021 with update as at 17 March 2021.
What do Investors want?
Investors increasingly want to take a more environmentally and socially conscious – or sustainable – approach to investing. The good news is that the choice of sustainable products is growing; however, the wide range of products and a lack of common standards across the sustainable finance industry can make it difficult to compare sustainable investing options.
What is the purpose of the SFDR?
The European Union Sustainable Finance Disclosure Regulation (SFDR) is designed to make it easier for investors to distinguish and compare between the many strategies that are now available, and by extension, to support the move to sustainable investing. The SFDR helps investors by providing more transparency on the degree to which financial products have environmental or social characteristics, invest in sustainable investments, or have sustainable objectives. This information will now be presented in a more standardised way.
The SFDR requires specific firm-level disclosures from asset managers and investment advisers regarding how they address two key considerations: Sustainability Risks and Principal Adverse Impacts. In addition, it helps investors to choose between products by classifying funds into three distinct groups, according to the degree that sustainability is a consideration and binding investment criteria, with specific disclosures required for each. These disclosures are determined based on the type of fund:
- “Article 6” strategies either integrate environmental, social or governance (ESG) considerations or explain why sustainability risk is not relevant, but do not meet the additional criteria of Article 8 or Article 9 strategies.
- “Article 8” strategies promote social and/or environmental characteristics, and may invest in sustainable investments, but do not have sustainable investing as a core objective.
- “Article 9” strategies have a sustainable investment objective.
This post explains the SFDR and the importance of this new regulation and how it will impact asset managers, advisers and investors alike. The disclosures, effective from 10 March 2021, apply to many financial products, including UCITS, AIFs and segregated mandates.
Why important?
Re-orienting capital towards sustainable growth
European Union (EU) governments and business leaders realise that one of the best ways to achieve the sustainability goals is to encourage capital to flow towards efforts that promote a more sustainable economy. Many investors also want to support a more sustainable economy, but often lack enough information to assess and compare investment options on the basis of standards. To that end, the EU has put together a sustainable finance action plan (EU Action Plan on Sustainable Finance).
This action plan is a major step towards redirecting capital to the sustainable economy. The plan features a series of interlinking regulations designed to encourage sustainable investing, including the SFDR.
Helping clients make better sustainable investing choices
The primary goals of the SFDR are to provide greater transparency on sustainability within the financial markets and create standards for reporting and disclosing information related to sustainable investing.
Increasing transparency and introducing standards promotes two important additional effects. First, it makes it hard for private banks and asset managers to “greenwash” their products – in other words, they cannot simply brand a product with an ESG or sustainable label, without actually having the process and portfolio to back it up.
Second, investors enjoy a significantly improved ability to compare investment options in terms of sustainability and ESG factors, which helps them make informed decisions that align with their investing goals.
Who is affected and what types of products and services does it apply to?
The SFDR applies to all financial market participants and financial advisers based in the EU. A financial market participant is any firm creating investment products, or generally, an asset manager. Financial advisers are individuals providing investment or insurance advice.
Investment managers or advisers based outside of the EU, who wish to market their products to clients in the EU under Art. 42 AIFMD, will also need to follow the SFDR disclosures.
Disclosures will apply to UCITS, AIFs, separately-managed portfolios, sub-advisory mandates and financial advice.
The UK is currently out of the scope of the SFDR and the UK as yet does not intend to adhere to the regulation as set out by the EU. In time, the UK may decide on a different set of sustainability disclosure rules for UK legal entities and products, or elect to replicate the SFDR requirements. We will need to wait and see.
What are the new sustainability and ESG product categories and disclosures?
Investors are navigating record-breaking growth in assets and product choices
Sustainable and ESG investing are among the fastest growing types of investment strategies. 2020 was a record-breaking year: assets under management in European sustainable funds rose over 50% to reach EUR 1.1 trillion; meanwhile over 500 new sustainable funds were launched and over 250 repurposed or rebranded, bringing the total number of European sustainable funds to almost 3,200 at year end according to Morningstar, European Sustainable Funds Landscape: 2020 in Review, 3 February 2021.
The tremendous growth in products spans all asset classes and product ranges – from equities to bonds and from ETFs to separately managed accounts. Even more critical for investors is the wide range of how sustainability and ESG strategies are managed. Some strategies are explicitly focused on sustainability and have specific impact goals. At the other end of the spectrum are passive ESG ETFs. In between are thousands of strategies with widely varying levels of sustainability or ESG integration into their investment processes.
Differentiating between Article 6, Article 8 and Article 9 products
One of the goals of the SFDR is to help investors better differentiate between the many sustainability and ESG products by creating classifications and disclosures. The SFDR specifies three distinct categories for investment products with regards to sustainable and ESG considerations:
Article 6 products are “other” investment products that either integrate considerations or explain why sustainability risk is not relevant, but do not meet the additional criteria of Article 8 or Article 9 strategies. Article 6 products will need to disclose the manner in which sustainability risks are integrated into their investment decisions as well as an assessment of the likely impacts of sustainability risks on the returns of the financial products.
Article 8 products promote environmental and/or social characteristics, and may invest in sustainable investments, but do not have sustainable investing as a core objective.
Article 9 products have sustainable investment as their core objective. The SFDR defines sustainable investment as 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. Article 9 products must invest primarily in sustainable companies or companies that demonstrate improving sustainable characteristics that contribute positively to a particular outcome, such as a low carbon economy.
Principal adverse impacts of investment decisions and investment advice on sustainability factors
The EU’s Sustainable Finance Disclosure Regulation (“SFDR”) requires financial market participants and financial advisers to publish and maintain on their websites a statement on whether they consider principal adverse impacts of investment decisions and investment advice respectively on sustainability factors. Principal adverse impacts are not currently considered in relation to investment decisions or advice in accordance with SFDR as the corresponding regulatory technical standards have not yet been finalised. Ongoing monitoring for further regulatory guidance and the development of industry and market practice is in place and it is expected to consider such adverse impacts from 30 June 2021.
Outstanding points regarding SFDR
The first set of SFDR disclosures are effective 10 March 2021. There remain a few areas for investors to watch, where the guidance is not finalised:
- The draft Level 2 regulatory technical standards (RTS) disclosures were released 4 February 2021. Approval for these proposed standards remains outstanding but is expected in the medium term.
- Following the completion of Brexit, it is not yet known whether the UK will adopt the SFDR or a different set of regulations for UK-based asset managers and advisers.
- Third party data providers, such as MSCI, which are not directly covered under the SFDR, will need to clarify how they will incorporate the new SFDR disclosures into their sustainability-related data, research and rankings.
- Third party ESG related industry standards will need to the reviewed as they get updated to align with SFDR and the EU Taxonomy Regulation.
- The adoption of amendments to the delegated acts (DAs) under the UCITS, AIFMD, MiFID II, IDD and Solvency II frameworks on the integration of ESG considerations remains outstanding, but is expected to be confirmed in the medium term. Guidance for handling data requests from individual clients, such as insurance and sub-advised business, is not yet finalised.
Next Steps
The SFDR is a positive step in the growth and development of sustainable investing. As investor interest in sustainable investing continues to grow, the regulation offers clients clear comparisons and advice on sustainable investments, encouraging private banks, asset managers and advisers to help capital flow towards sustainable investment products. Commencing January 2022, this regulation will be followed by the EU Taxonomy Regulation. More information on this regulation, and how it interacts with the SFDR will made available in due course.
ESAs consult on bringing Taxonomy disclosures and SFDR disclosures together into one ‘rulebook’
On 17 March 2021, the European Supervisory Authorities (ESAs) published a consultation paper with an updated version of the draft SFDR RTS (updated from the version included in the previous 4 February SFDR Final Report) – but this time to include Level 2 provisions proposed under the Taxonomy Regulation.
I have been helping clients achieve their sustainable investing goals. If you would like further information or have questions about the SFDR, sustainable investing and/or ESG in general, please contact me at info@mirandabrawn.com.