As a cornerstone piece of legislation under the EU Sustainable Finance Action Plan, the Sustainable Finance Disclosure Regulation (SFDR) has been at the forefront of discussion among financial market participants in Europe recently.
After delaying the release of their final report on the regulatory technical standards (RTS) for the SFDR, the European Supervisory Authorities (ESAs) published the full details of the disclosures in February of this year, with the SFDR itself becoming directly applicable from March 10.
The previous version of this report provoked much concern among market participants, so it seems that this delay was in many ways a good thing – more questions have been answered than asked and there are notable improvements to the first draft.
As the most extensive piece of work so far in helping investors navigate the growing choice of sustainability products, the SFDR is undoubtedly an ambitious and complex regulation - yet one that’s worth getting familiar with.
Here’s a closer look at some of the key updates from the ESA’s final report:
Principle Adverse Impacts (PAIs)
The SFDR, above all else, raises the bar for financial products seeking to promote ESG credentials. Under the regulation, managers must disclose how sustainability risks are considered in their investment process, what metrics they use to assess ESG factors, and how they consider investment decisions that might result in negative effects on sustainability factors - or Principal Adverse Impacts (PAIs) in the regulators’ jargon.
The PAI concept threw up quite a few questions in the initial report due to both the volume and complexity in terms of definition and reporting. In the final report from the ESAs, these have been refined and will start to be published in 2023. More immediately, a narrative-based explanation is required.
By the end of June 2021, large public interest firms with more than 500 employees will be required to disclose policies, processes, and, ultimately aggregated metrics about the PAIs that their investments have on environmental and social issues. The number of mandatory PAI indicators have been reduced significantly from 34 to 18, although the comprehensive list, including voluntary indicators, is largely the same as before.
Other firms will retain an option to do the same, or instead will need to place a prominent notice on their website that they do not consider PAIs and why that is the case – a ‘comply or explain’ basis applies to companies with less than 500 employees.
Article 8 & 9 Products
For investors, the most visible effect of SFDR will be the assignment of individual products to one of three categories based upon the degree of sustainability they aim for. So-called Article 8 (or ‘light green’) and Article 9 (or ‘dark green’) products take their name from the respective sections of the regulatory text and will see the bulk of the reporting obligations.
Article 9 products will be those with a sustainable investment objective and must meet the high threshold of substantially all their holdings meeting the definition of sustainable investments. Article 8 funds may choose whether or not to invest a portion of their portfolio in ‘sustainable investments’ and are expected to be the larger universe, encompassing all products promoting any environmental or social characteristics.
Starting in 2022, all of these products will add extra pages to their prospectus and annual report. In the former will be more explanation about its ESG objectives and how they will be realised, measured and benchmarked. The latter will provide the progress made against those targets in the prior accounting period.
Getting to Grips with the SFDR
The new disclosures laid out this week from financial market participants herald just the start of a lot more targeted ESG information for investors.
In the next two months, the European Commission will endorse or amend the regulatory technical standards laid out in the draft RTS and their associated effective dates. While that won’t be before January 1 2022, there’s now a lot more clarity and guidance to help firms prepare.
To read more about the short, medium and longer-term information that will materialise as a result the SFDR, you can download our latest policy report.