Greening the financial sector is a crucial step towards building a carbon-neutral economy. It’s therefore critically important that when investors go shopping for financial products, they see a clearly defined list of ingredients. SFDR- the Sustainable Finance Disclosure Regulation – is all about getting the ingredients on the side of the packet, making it easier to choose the sustainable option. It is part of the Sustainable Finance Action Plan from the EU – one of the pillars of the European Green Deal positioning Europe as a leader in climate-neutrality and sustainability.

The overriding objective is to redirect capital flows towards investments and activities across the EU and its business partners towards sustainable initiatives. Sustainable investment urgently needs to be the most obvious choice, rather than a ‘nice-to-have’ option. For that to happen, everyone has to agree on what defines sustainable investment and what level of sustainability it denotes. Investors need to make informed decisions in an easily comparable and transparent market. Therefore, alongside the non-financial disclosures that make up SFDR, the EU’s Green Taxonomy will categorise economic activity according to sustainability activities. This in-theory should provide an easy-to-read sustainability rubric that cannot be greenwashed. As well as being supported by the Taxonomy, supplementary Regulatory Technical Standards (RTS) were published in February 2021, pending endorsement from the European Commission.

SFDR demands some initial work from companies that create financial products but, after some short-term grappling with disclosure and categorisation, there will be benefits in making the sustainability profile of funds much more comparable and easier to assess. The first reference period of SFDR started in March 2021 and ends in December 2021. After that, each reference period begins on 1st January each year. By June 2024, there should be year on year comparative disclosure.

Which companies have to disclose?

The people that need to know about it are Financial Market Participants (FMPs) operating in the EU, defined as investment firms, such as asset managers. Financial products fall within the scope of the regulation. Examples of which include investment and mutual funds, insurance-based investment products and private and occupational pensions. Additionally the SDFR applies to advisors who offer either insurance or investment advice. The UK regulatory framework is likely to follow suit or at least be very similar. UK based FMPs may wish to implement SFDR in any case, to achieve a competitive advantage due to the gold standard of ESG disclosure that the EU often denotes, or to simply make sure they can sell financial services products into the EU.

Clearly, it will become increasingly difficult to invest in FMPs that fail to make SFDR disclosures. Investors are becoming much more aware that long-term value for shareholders and stakeholders correlates strongly with healthy ESG values, typically outperforming those that don’t. Recent history shows that big names in the sector are being held to account by highly effective environmental campaigns targeting their alleged climate change ‘sins’ in their own operations as well as those of their business interests. This creates a more-than-decent incentive for FMPs to take a proactive approach to sustainability, keeping ahead of the requirements of this or any other ESG regulation and to be able to meet the exacting demands of investors.

This may also lead to an indirect impact on the level of disclosure from companies FMPs invest in. Firstly an organisation ahead of the curve on sustainability is likely to be more attractive to investors and with a reduced cost of capital when compared to its competitors, this would also mean companies failing to disclose are likely to suffer from additional costs when looking to raise capital. Secondly, increased engagement with investors and higher levels of disclosure is likely to improve overall transparency and quality of disclosures in the market, which will then push the average of their competitors up.

What is the scope of SFDR?

Larger organisations (defined as those with an average number of 500 employees or which are parent undertakings of a large group which has an average number of 500 employees) must comply with the disclosure obligations. However, management companies with less than an average of 500 employees can either choose to comply with this disclosure obligation or alternatively explain to investors why they do not consider adverse impacts of investment decisions on sustainability factors.

By proposing to require all relevant financial market participants to report against the same indicators and to use a template form of principal adverse impact statement, policymakers are hoping to encourage investors to compare the approaches to sustainable investment taken by different financial market participants so that they make more informed investment decisions.

Ultimately comparability is a key driver of effective markets and capital allocations and as noted by many, the “alphabet soup” of ESG is currently getting in the way of this. Thus, SFDR should represent a key step in improving capital transparency markets for all stakeholders.

Define your terms

There are now three defined categories of sustainable investments. By separating these out into three distinct groups, it aims to provide a simpler choice for investors and to distinguish and compare different options more easily. These are colour-coded as follows:

  • Top of the class are ‘Dark Green’ products, as defined by Article 9 of SFDR, and they must generally invest solely in ‘Sustainable Investments’ and must contribute substantively to one of the six sustainable activities as defined by the EU’s Taxonomy.
  • ’Light Green’ financial products (defined by Article 8) are promoting ESG characteristics but are not sustainable. They must indicate if they invest a proportion in sustainable investment. Holdings should generally help attain the environmental or social characteristics promoted.
  • All the rest are defined by Article 6. Unfortunately, this category has not been assigned a colour but if it was, it would probably be a murky grey. These financial products are ‘neutral’ in that they are not defined by either Articles 8 or 9, there are no sustainability controls and can include stocks that are excluded by ESG-focused funds, such as tobacco companies or coal producers.

We’ll all have a piece of PAI

For an investment to be deemed ‘sustainable’, FMPs must report the ‘Principal Adverse Impacts’ (PAI) any investment decision might have on sustainability factors. Those factors relate to climate and the environment and social and employee matters, respect for human rights, anti-corruption and anti-bribery measures. As well as PAIs, FMPs must communicate their sustainability risks and how they are managed through specific policies which are integrated into the investment decision making process. This applies at the product level, but also requires an assessment of how likely a sustainability risk is to impact the product’s return on investment.

SFDR timeline & key dates

SFDR timeline and key dates
Adapted from Bloomberg.

Conclusion

Although there has been some criticism over SFDR, it must be worth noting it is one component of what the EU hopes will be a well-oiled sustainable finance regulatory machine. A typical criticism of the EU has been a lack of policy harmonisation, one of which the SFDR breaks said criticism, being interconnected with the Green Taxonomy and rumoured Sustainability Reporting Directive (replacing the Non-Financial Reporting Directive) under the umbrella of the Sustainable Finance Action Plan. The other main criticism, the lack of time to become compliant, must be considered alongside the fact that when it comes to the climate crisis, there is simply no time to lose. SFDR’s targeting of FMPs is a critical mechanism to drive the capital mobilisation the EU desires, whilst also elevating the quality of non-financial disclosure and thus should not only be seen as a necessary piece of regulation, but a welcome one.

The EU regulation landscape is an ever-shifting scene, with old features barged out of the way and new or updated ones taking their place in dizzying succession. And there are many, many more to come. It’s no surprise that it is difficult to keep track of what is applicable to your organisation. Avieco will help you make sense of it and keep you ahead of the waves of initiatives. It will also help you turn them into an opportunity to become a market leader and gain the first-mover competitive advantage. If you would like to hear more, please contact jake.atkinson@avieco.com for an initial conversation.

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We get that change is not easy. But we must be brave, challenge old ways, set new habits, embrace new thinking.

sustain-ability.
more than a word.

We get that change is not easy. But we must be brave, challenge old ways, set new habits, embrace new thinking.