The Sustainable Finance Disclosure Regulation (SFDR) was introduced by the European Commission to ensure the more uniform protection of investors. By harmonising the reporting, the regulation aims assist investors by making it easier for them to benefit from a wide range of financial products, while at the same time providing rules to enable investors to make informed investment decisions.
Through the SFDR, the EU has created a harmonised framework for disclosures, and it is targeted on Financial Market Participants (FMP). This wide-ranging term encompasses asset managers, financial advisors, investments funds, providers of pan‐European personal pension products (PEPPs), MiFID investment managers, alternative investment fund managers, UCITS management companies, and so forth.
Mandatory in nature, the regulation’s ‘Level One Disclosures’ – the most substantive provisions – became effective on 10 March 2021, and the ‘Level Two Disclosures’ intended to be finalised for 1 January 2022.
It is important to note that the regulation must not be considered in isolation, but rather it is part of the Taxonomy Regulation and the Low Carbon Benchmarks Regulation, themselves the result of the European Commission’s Action Plan on Sustainable Finance.
The purpose of the SFDR is to inform investors on four key areas: the integration of sustainability risks, the consideration of adverse sustainability impacts, sustainable investment objectives, and the promotion of environmental or social characteristics of any investment considered.
The regulation was designed because it was realised that existing investment decision‐making and in advisory processes were inadequate because of a lack of harmonised requirements. With the SFDR, investors will have access to comparable market data regardless of the member state in which the product or service originates.
The Taxonomy Regulation, also effective from 1 January 2022, extends beyond the scope of the SFDR, but it operates in parallel. While the SFDR is framed in terms of ESG (Environment, Social, and Governance), the Taxonomy Regulation aims to bring an end to so-called ‘greenwashing’, the making of unsubstantiated or unverifiable claims as to a product, service, or entity’s environmental or social impacts.
While retaining all prior criteria to protect investors, FMPs are now obliged to include all relevant sustainability risks that might have a relevant material negative impact on the financial return of an investment or advice.
Therefore, financial market participants and financial advisers should specify in their policies how they integrate those risks, and they must publish those policies. Where no risk is perceived, the reasoning for reaching such a conclusion must be stated.
To enhance transparency and inform investors, the investors must be made aware of relevant sustainability risks, whether already material, or likely to be material. The guidance of the investor’s decision-making processes must include the organisational, risk management, and governance aspects of the investment processes.
As the graphic from the TCFD shows, metrics, risk, strategy, and governance each form a crucial part of the whole, and all must be addressed in full. Echoing the TCFD reporting principles, the SFDR also requires FMPs to offer this information in a concise form as policies published on their websites.
By harmonising the climate-related reporting of investment products across the European Union, those firms which offer genuinely sustainable products will gain an advantage which compensates for the time, effort, and diligence in complying with accurate reporting.
In support of this ambition, the EU aims to direct more than €1 trillion over the next decade into green investments, and so create a global leadership role, the impacts of which will be felt in all financial markets.
“The crucial point is that this covers any entity or financial product,” Lucian Firth, a partner at the law firm Simmons & Simmons, recently told Reuters. “It doesn’t matter if you market all of your products as sustainable or none of them—it covers all of them.”
Naturally, any UK-based FMP offering products or services to the EU has immediate compliance obligations, as will EU entities marketing to the UK.
Another area to watch, though is investor pressure upon UK firms, especially those which are part of a global group with EU-based entities. In many cases we will see these firms implement SFDR as a global standard.
Brexit halted the UK’s adoption of the SFDR, but there is no question that the UK doesn’t agree with the EU that a voluntary approach to climate related financial disclosures is insufficient.
The EU SFDR takes a ‘comply or explain’ approach, while the UK went further by becoming the first country in the world to force disclosures to be aligned with the Task Force on Climate related Financial Disclosures (TCFD). These will be mandatory by 2025, and the exceed the SFDR by a significant degree.
The Financial Conduct Authority (FCA) is approaching finalisation of the TCFD requirements and implementation will be phased-in for the largest firms in 2022, with additional requirements for smaller firms to enter force in 2023.
With the EU and the UK taking similar, but albeit different, approaches to financial market regulation and ESG reporting, the consequences are destined to be considerable. Already, numerous public and private firms are removing their ESG claims and clamouring for consultancy so they can produce verifiable reports.
The number of firms ‘in-scope’ for reporting under both SFDR and TCFD has skyrocketed, and the exemptions are few. For example, the SFDR applies to any firm of financial planners with more than two staff.
No doubt about it, the time for every firm engaged in the sale of financial products and services must begin their reporting journey with urgency.
Leads the daily operations at ESG PRO, he specialises in matters of corporate governance. Humperdinck hails from Bermuda, has twice sailed the Atlantic solo, and recently devoted a few years to fighting poachers in Kenya. Writing about business matters, he’s a published author, and his articles have been published in The Times, The Telegraph and various business journals.
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