Sustainable Finance and related regulations such as SFDR gained momentum in recent years as investors and financial institutions are becoming increasingly interested in understanding how their investments align with environmental, social, and governance (ESG) criteria. This reflects a growing awareness that ESG factors can have a material impact on the long-term performance of investments and the resilience of the financial system. The SFDR implementation timeline like many other regulatory initiatives foresees a staggered roll-out.
As a consequence, there has been a growing demand for transparent and consistent information on how financial market participants are integrating ESG considerations into their investment decision-making processes. In response to this trend, the European Union (EU) has adopted the Sustainable Finance Disclosure Regulation (SFDR) in 2020. The objective is to increase transparency and consistency in the disclosure of sustainability-related information by financial market participants.
Overview of the Sustainable Finance Disclosure Regulation
SFDR is a new regulation adopted by the European Union (EU) in 2020 that aims to increase transparency and consistency in the disclosure of sustainability-related information by financial market participants and financial advisors. The regulation aims to provide investors with more information about how sustainability risks and opportunities are integrated into the investment decision-making process and encourage financial institutions to improve their sustainability practices.
SFDR also introduces a product-level categorization system, which allows investors to better identify products that have environmental or social characteristics, and make it easier for issuers to market such products (“Article 8 and Article 9 products”). SFDR complement the EU’s existing sustainability-related regulations, such as the Non-Financial Reporting Directive (NFRD) and Corporate Sustainability Reporting Directive (CSRD) and is part of the EU’s broader action plan on sustainable finance. Beside the points outlined above, SFDR also changes existing laws by introducing sustainability related aspects. This affects mainly MiFID II, AIFMD and UCITS.
To whom does SFDR apply?
SFDR applies to a wide range of financial market participants, including investment managers, financial advisers, insurance companies, and banks. This means that any financial institution operating within the European Economic Area (EEA) has to comply with SFDR. This includes companies that manage assets on behalf of their clients, such as investment managers and financial advisers, as well as firms that offer financial products or services to customers, such as banks and insurance companies. SFDR also applies to firms that market products as environmentally or socially sustainable, regardless of whether they are considered to be financial market participants in the EU.
What are the requirements of SFDR?
SFDR requires financial market participants (in short FMPs) to disclose information on how they integrate sustainability risks and opportunities into the investment decision-making processes. In addition, disclosures on how products align with environmental, social, and governance (ESG) criteria have to be put in place. This includes information on how companies identify, assess and manage sustainability risks, as well as their approach to integrating sustainability considerations into their investment strategies and products. Furthermore, it requires financial market participants to provide a description of the sustainability characteristics of any products in case the product is marketed as environmentally or socially sustainable. Details on the methodology used to determine these characteristics has to be included as well.
The regulatory EU framework also includes requirements for companies to provide information about their policies for assessing and managing the ESG risks and opportunities. The requirement to disclose information is not limited to company websites but should be included in the financial reports (pre-contractual disclosures such as the fund prospectus). SFDR provides a comprehensive set of templates which aim to standardized the disclosures and to make them comparable across financial institutions.
Specific requirements for products making sustainability claims
SFDR includes specific disclosure requirements for products that make sustainability claims. These products, which are often marketed as environmentally or socially sustainable, will be subject to additional disclosure requirements designed to provide investors with a clear and consistent understanding of the sustainability characteristics of these products.
The regulation distinguishes between Article 8 and Article 9 products. Article 8 products promote environmental and/or social characteristics whereas Article 9 products have sustainable investments as their objective. As a consequence, Article 9 products are only allowed to invest in sustainable assets as defined in the regulation. Not many assets quality as sustainable under this definition which resulted in a limited number of Article 9 products being available on the market.
The SFDR also requires firms to provide information on how the sustainability characteristics of the product have been determined, including the specific assessment framework that has been used. Additionally, firms will be required to disclose any material deviations from the assessment framework and any other relevant information that may be useful for investors to understand the sustainability characteristics of the product.
SFDR Implementation timeline (compliance dates)
SFDR provides a phased implementation timeline, with the first set of disclosure requirements becoming applicable by March 10, 2021. Due to the lack of clear guidance and regulatory clarity, financial institution could comply with the first phase by implementing a principal-based, generic disclosure. Information on the so-called Principal Adverse Impacts (PAIs) need to be published latest by June, 30 2021. The second phase of SFDR (deadline 01.01.2023) required financial institutions to implement the detailed templates provided by the regulation for product specific disclosures (e.g. fund prospectus). The first periodic disclosures according to the pre-defined templated for financial products must also be published in 2023 for the first time. In addtion, the entity level statement on Principal Adverse Impacts (PAI) needs to be published on the company website no later than June, 20 2023.
SFDR is an important step forward in increasing transparency and standardization in disclosing sustainability-related information by financial market participants. The regulatory framework requires many financial market participants, including investment managers, financial advisers, insurance companies, and banks to disclose information on how they integrate sustainability risks and opportunities into their investment decision-making processes, as well as how their products align with environmental, social, and governance (ESG) criteria. Complying with all requirements puts an enormous pressure on the financial services- and insurance industry as ESG data is not always available and the quantitative disclosures require significant investments into the IT infrastructure.
SFDR encourages financial institutions to improve their sustainability practices and to provide investors with more accurate and transparent information on the sustainability characteristics of financial products. This will enable investors to make more informed investment decisions that align with their own ESG criteria, and ultimately to support a more sustainable financial system. Although the regulation entered into force on March, 10 2021, it is still a long way to go until all uncertainties are resolved, regulatory definitions are clear and the SFDR implementation timeline can be considered as fully completed.
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