SFDR - The regulation aimed at eliminating greenwashing.
If you've opened this article, chances are you're trying to figure out how the EU regulations will affect your private investment fund. The good news is - you're in the right place. This article is the first of a series we are creating that is specifically designed to provide clarity in SFDR-related compliance requirements. Keep reading and let us walk you through the context behind this regulation and the general requirements and applications behind SFDR.
The Context Behind SFDR
Although consumers’ and investors’ interest in sustainability is increasing, businesses are still debating what “sustainability” really means in practice. In fact, the lack of a single regulatory standard to define it gave room to greenwashing becoming a common reality. This ultimately affects investors' trust in a company's sustainability claims - some surveys show that up to 90% of investors don't trust them.
In response to this, the European Commission developed the EU Taxonomy and related documents that add up to over a thousand pages of formal text. The documents aim to define and categorize precise activities across industries and how green they are based on specific criteria. This regulation is still a work in progress and is expected to evolve to cover both environmental and social impacts in the coming years. The first publications released by the EU commission are the EU Taxonomy and Sustainable Finance Disclosure Regulation (SFDR) as part of the Action Plan on Sustainable Finance legislative package. Here are some noteworthy tidbits for these two: - provides a classification system of economic activities. Companies under the scope of the NFDR (Non-Financial Reporting Directive) have to report on whether their activities are in alignment with the EU Taxonomy.
Applies to companies under the scope of the Non-Financial Reporting Directive (NFRD) - listed and large public-interest companies with 500+ employees and €40M+ turnover and/or €20M+ in total assets.
Enforced since June 2020.
Sustainable Finance Disclosure Regulation (SFDR) - defines non-financial reporting obligations. The reporting requirements vary based on the funds' scope of activities.
Applies to all financial market participants based in the EU or participating in EU financial markets. This includes institutional investors, asset managers, insurance companies, and pension funds, among others.
Financial market participants with over 500 employees need to disclose if and how they consider sustainability in their investment strategy. If the fund chooses not to consider any sustainability factors, it must explain why.
Financial market participants with fewer than 500 employees are not required to produce a principal adverse impact statement - A description of how their investments affect a range of sustainability factors.
Enforced since March 2021 with a full rollout mandatory since January 1st 2023.
SFDR Rollout & General Requirements
As mentioned earlier, SFDR defines what a sustainable investment is. What is important to note is that it extends the definition beyond the environmental objectives included in the EU Taxonomy. According to SFDR, a sustainable investment is “an investment in an economic activity that contributes to an environmental objective or an investment in an economic activity that contributes to a social objective.” Therefore, if your firm is subject to the SFDR jurisdiction, you must comply with specific disclosure obligations. These obligations apply to both the entity level and product level of your organization, and the required information needs to be clearly and prominently visible on your business website.
Entity-Level Disclosures:
Sustainability risk policy: a statement outlining how sustainability risks are considered in your investment choices.
Primary negative impact: A description of how your investments may manage a variety of sustainability factors.
Sustainability risk remuneration policy: A statement outlining how sustainability risks are accounted for in your company’s remuneration policy.
If you choose not to consider environmental impacts as part of your investment decision, you are required to publish a clear statement explaining the rational behind this decision. In a way, this requirement holds funds accountable to their lack of effort to invest in impactful environmental projects. When it comes to major negative impacts at the entity level, the SFDR requires companies to report on 14 different sustainability factors, including indicators related to climate and social issues. Out of these 14 factors, 6 are related to greenhouse gas emissions. More importantly, companies must report the emissions volume of the beneficiary companies. This includes not only Scope 1 and 2 emissions, but also - since January 1, 2023 - Scope 3 emissions.
Product-Level Disclosures:
The SFDR requires financial market participants and financial advisors to disclose the sustainability profile of the financial products they manufacture or promote. They must classify financial products as:
Widespread or mainstream products.
Products as having a sustainable investment goal
Products that promote environmental and social characteristics.
As with entity-level information, companies are required to disclose how they address sustainability risks and what the main negative impacts are. If not made public, the reason must be explained. If a financial product is classified as promoting environmental or social characteristics, it should be specified which specific characteristics and sustainability metrics are used to measure whether they are achieved or not. Similarly, if a financial product has a sustainability investment objective, it should be clearly specified which sustainability metrics are to be used.
Reporting & Compliance
Now that you know the essentials, the work to create compliance-grade reports begins. This can be a very challenging task, and we’re here to help you through this process. At Treety, we created a solution with impact investment funds and their portfolio companies in mind. As of today, impact funds have to do extra work to prove they are, in fact, creating a positive impact.
We understand the challenge and are driven to help funds and their portfolio companies focus on what they do best - creating a positive impact on people and the planet. To discover how we can help you through your SFDR journey, contact us. We’re here to help!
