SFDR: The ‘comply or explain’ Regulation

SFDR: The ‘comply or explain’ Regulation

The Sustainable Finance Disclosure Regulation (“SFDR”), applicable as from March 10, 2021, requires the financial market participants (“FMPs”), i.e. (i) asset managers, institutional investors, insurance companies, pension funds, and in general all entities offering financial products where they manage the client’s funds, as well as the manufacturers of financial products and (ii) the financial advisers, to disclose sustainable pre-contractual and contractual information on financial products toward end-investors.

The SFRD is supplemented by regulatory technical standards (“RTS”), which have been developed by the European Supervisory Authorities (“ESA”). It is envisaged that these RTS will be applicable as from January 1, 2023.

What are the objectives of the SFDR? The SFDR aims (i) to make the sustainability factors of financial products easily understandable and comparable by investors and (ii) to mitigate and prevent greenwashing (i.e. firms try to appear more environmentally responsible than they are). To this end, the SFDR also integrates the sustainability and environmental, social, and governance (“ESG”) factors into financial products.

The SFDR will therefore enable investors to make better informed decisions.

How does the SFDR works in practice? The SFDR defines three categories of financial products, from least to most sustainable:

  • Article 6 of the SFDR: Financial products with no ESG characteristics;
  • Article 8 of the SFDR: Financial products promoting ESG characteristics; and
  • Article 9 of the SFDR: Financial products having ESG characteristics as their objectives.

The SFDR distinguishes financial products through the distinction of the following key metrics:

  • The Sustainability Risks: ESG events or conditions, which cause a material negative impact on the value of the investment (e.g. climate change); and
  • The Principal Adverse Impacts (“PAIs”): Indicators which assess the (potentially) negative or material effects that result from, worsen, or are directly related to investment choices or advice (e.g. greenhouse gas (“GHG”) emissions, carbon footprint, hazardous waste ratio emissions to water, board gender diversity, etc.).

This distinction aims to make the financial products understandable and comparable via, among others, the pre-contractual information, which shall be made available and annexed to the offering documents for the product.

The pre-contractual information related to the investment products that promote ESG characteristics must specify, for example, how the ESG characteristics are complied with via a selected benchmark index. In addition, the periodic reports must also contain a description of the extent to which the ESG characteristics have been complied with.

With respect to the pre-contractual information related to the investment products with the objective of sustainable investment, this information shall specify how this objective is to be achieved, either by informing how this objective is aligned with the selected benchmark index or, if the objective is a reduction in carbon emissions, an indication of its compliance with the objectives set out in the Paris Agreement, as long as no EU “Climate Transition Benchmark” or EU “Paris Agreement Benchmark” index exists. Furthermore, the periodic reports shall describe their sustainability impact. If there is a benchmark index, the FMPs will also have to compare the performance of this index with another, broader market index.

As a practical matter, FMPs should collect readily available information from the investee companies. If the required information is not readily available, FMPs should make efforts to obtain it directly from the investee companies. If, despite these efforts, the information cannot be obtained directly, FMPs should describe in detail the additional efforts made, including cooperation with third-party data providers.

How and in what form should the reporting be prepared? All FMPs, including ETF providers, will have to disclose this information on their websites, prospectuses and periodic reports.

Who shall comply with the SFDR? All FMPs and FAs based in the European Union will have to comply with the SFDR. FMPs and FAs, based outside of the European Union, who are selling products to clients in the European Union are also affected.

When will the SFDR be applicable ? The information will have to be disclosed between January 1, 2023, and June 30, 2023, but specific information and metrics will need to be captured frequently throughout the periodic reports. The consequence of the SFRD RTS applying as from 1 January 2023 is that the PAIs and sustainability features should be disclosed for the first time by June 30, 2023, which covers the reference period January 1, 2022 to December 31, 2022. Consequently, although the SFDR will only be applicable from January 1, 2023, entities should already start gathering all the relevant information required by the SFDR as from this year (2022) in order to be ready to comply with this new regulation next year.

What is the impact on the other non-financial market participants? Although there is no direct impact on the non-financial market participants, indirectly they might feel an impact as well. The companies in scope will need more data from the companies they invest in or lend funds to. So non-financial market participants should prepare themselves to share this data. For that reason the SFDR regulation is linked to the CSRD and EU Taxonomy regulation, new rules that will become applicable to the non-financial market participants. We refer to our separate blog posts on these topics.