The Basics of SFDR Reporting
The EU has developed the Sustainable Finance Action Plan in order to avoid green-washing in the financial sector and to reach Net Zero emissions by 2050. In order to achieve these targets, they have developed different pieces of regulation, wherein two of the most comprehensive ones are the EU Taxonomy and SFDR (Sustainable Financial Disclosure Regulations).
The ultimate aim of the EU Action Plan is to reorient capital flows towards a more sustainable economy, foster long-termism and manage the increasing importance of sustainability risks. This is outlined in their 10 key action points:
Reorienting capital flows toward a more sustainable economy
Establishing an EU classification system for sustainable activities
• This classification system helps differentiate environmentally sustainable business activities from non-sustainable ones.
Creating standards and labels for green financial products.
• These standards and labels will maintain trust and integrity in sustainable financial products and enable investors to easily access such products.
Fostering investment in sustainable projects.
• Steps will be taken to improve the efficiency and impact of aforementioned instruments, so as to attract more capital.
Incorporating sustainability when providing financial advice
• Financial advisers are now required to provide details of sustainability risks and information about the ESG issues as part of the financial advice, rather, ask investors about their preferences on the same and then respond to the same.
Developing sustainability benchmarks.
• The European Commission seeks to make benchmarks a reliable tool for investors. They will create a new category of benchmarks, which will contain 2 types of benchmarks, low carbon benchmark, and positive carbon benchmark.
Mainstreaming sustainability into risk management
Better integration of sustainability in ratings and market research.
• The European Commission is exploring requiring credit rating agencies to explicitly integrate sustainability factors into their assessments.
Clarifying the duties of institutional investors and asset managers.
• The European Commission has mandated that institutional investors and asset managers must integrate ESG factors into their decision-making processes. Institutional investors and asset managers will also have to show how their investments relate to their ESG targets and explain how they comply with these. This will help remedy the fact that in many cases, end investors do not always have the best and most complete information at hand.
Incorporating sustainability in prudential requirements.
• The Commission will explore the feasibility of the inclusion of risks associated with climate and other environmental factors in institutions’ risk management policies. Ignoring such risks would create bigger risks in the long term for banks and insurance providers whose assets are exposed to said risks.
Fostering transparency and long-termismStrengthening sustainability disclosure and accounting rule-making.
Fostering sustainable corporate governance and attenuating short-termism in capital markets.
• The Commission will consult with relevant stakeholders about developing and disclosing more sustainable strategies, along with complete due diligence across the supply chain. They may also consult with directors and come up with certain to make sure they act in the company’s long-term interests.
DOUBLE MATERIALITY
Simply put, double materiality implies that a company must collect data and report on both how its business is affected by sustainability issues (“outside-in perspective”) and how its activities impact society and the environment (“inside-out perspective”). Companies are expected to examine the entire value chain, both, upstream and downstream, while studying the effects of its activities on the environment and society.
SFDR is expected to provide a standardized method for reporting data regarding environmental and social objectives and get rid of greenwashing. It will force participants to take a position on sustainability, thus increasing accountability on all fronts.
WHO DOES SFDR APPLY TO?
Primarily, every financial market participant or financial advisor based in the EU must comply with SFDR reporting (as mentioned below). Additionally, this regulation also applies to players based outside of the EU but selling/marketing products to clients inside the EU including:
An insurance company that makes available an insurance-based investment product
Investment firms that provide portfolio management
An Institution for occupational retirement provision (IORP)
A manufacturer of pension products
An alternative investment fund manager (AIFM)
A pan-European personal pension product PEPP) provider
Manager of a qualifying venture capital fund
A manager of a qualifying social entrepreneurship fund
A management company for Undertakings for the Collective Investments in Transferable Securities (UCITS), or,
A credit institution that provides portfolio management
See here to learn more about the SFDR timeline.
Although external audits and verification are an implicit requirement, currently, there are no explicitly announced penalties or sanctions for SFDR non-compliance.
The official EU document talks about what the SFDR disclosure looks like. Here is a glimpse of that:
Level 1: Organizational-level disclosure
This is the disclosure on the holistic level, covering the firm’s entire portfolio. Firms must report not only on the sectors they invest in but also on their portfolio companies.
All financial marketing participants (and financial advisers, taking due account of their size, the nature, and scale of their activities, and the types of financial products they advise on) are expected to publish and maintain the following disclosures on their websites:
Where they consider principal adverse impacts of investment decisions on sustainability factors
Information about their policies on the identification and prioritization of principal adverse sustainability impacts and indicators;
A description of the principal adverse sustainability impacts and of any actions to be taken with regard to improving the situation, if not already.
Remuneration Policies: Financial market participants and financial advisers shall include in their remuneration policies information on how those policies are consistent with the integration of sustainability risks and shall publish that information on their websites.
Integration of Sustainability Risk: Financial market participants (and financial advisers) shall include descriptions of the following in pre‐contractual disclosures:
How are sustainability risks integrated into their investment decisions
The results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available.
Where financial market participants (and financial advisers) deem sustainability risks not to be relevant, they shall include a clear and concise explanation of the reasons for the same. This is where the “comply or explain” strategy comes into play. This is all done in lieu of keeping everyone accountable for their actions and decisions.
PAI Statements: Companies are expected to provide consistent annual reports of data of at least 16 PAIs (14 mandatory and 2 voluntary PAIs). There is no doubt that it is difficult to collect and compile relevant data, but nevertheless, we must push through because this is how we will move closer to the main goal. To make things easier and reduce the load, companies must try and collect data on a quarterly basis. This will require being on top of all types of internal communication between stakeholders and making sure they hold themselves accountable so that this process is carried out smoothly.
Smaller firms (with less than 500 employees) can opt out of disclosing the above information, although, they will need to give clear reasons as to why they chose to do so. They must also mention if they plan to change their disclosure strategy in the future.
Level 2: Product-level disclosures
Disclosures on each product or fund within a portfolio. Here a company justifies, or better yet, proves to the authorities, how sustainable each individual investment is. To do so, they need to classify each investment into one of the following categories:
ARTICLE 6
Items that fall under Article 6 include funds that do not consider any sustainability factors in their investment decisions. These investments could include industries like tobacco, coal, or other toxic substances which typically have adverse environmental and/or social impacts. It is imperative that asset managers mark these investments as Article 6 products as they do not have any contribution to sustainability factors.
Financial market participants shall include descriptions of the following in pre‐contractual disclosures:
The manner in which sustainability risks are integrated into their investment decisions.
The results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available.
Financial advisers shall include descriptions of the following in pre‐contractual disclosures:
The manner in which sustainability risks are integrated into their investment or insurance advice.
The result of the assessment of the likely impacts of sustainability risks on the returns of the financial products they advise on.
ARTICLE 8
These are items that support environmental and social characteristics, meaning these are products that encourage positive environmental or social activity. They may even invest in sustainable initiatives, but that is not necessarily their primary purpose. Products in this category are often referred to as “Light Green” products.
Financial market participants shall publish and maintain on their websites the following information:
A description of the environmental or social characteristics of the sustainable investment objective and how they are met.
Information on the methodologies used to assess, measure and monitor the environmental or social characteristics, or the impact of the sustainable investments selected for the financial product. This includes its data sources, screening criteria for the underlying assets, and the relevant sustainability indicators used to measure the environmental or social characteristics of the financial product.
ARTICLE 9
These are products or investments that have clear sustainability goals and are motivated by sustainable development. Each one of the investments in this category serves or contribute to 1 or more sustainability objectives. Products in this category are referred to as “Dark Green” products.
Financial market participants shall publish and maintain in their annual reports, the following information:
the overall sustainability‐related impact of the financial product by means of relevant sustainability indicators
The difference between the fund’s designated index and other mainstream ones. (A lot of funds are named Article 9 funds even though they use a mainstream index. A mainstream index doesn’t transition into a more sustainability focused one fast enough and allows for a huge chance of error
The terms “Light green” and “Dark green” tell us the extent to which the products are sustainable. Article 8 and 9 products have some extra requirements, beyond the Article 6 funds. Companies need to report how these sustainability characteristics or impact is achieved through quantitative indicators. They also have to be transparent about their investment methods and process, regarding how they follow up on the sustainability characteristics and report them annually in an impact report. This report should contain both positive and negative impacts.
To learn more about this classification of products, please read this article!
All financial market participants are expected to keep all of the above reported information up to date on their website and annual reports.
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