By Cary Springfield, International Banker
The European Union’s (EU’s) Sustainable Finance Disclosure Regulation (SFDR) came into effect on March 10, marking a major milestone in the bloc’s efforts to ensure financial firms such as fund managers, insurers and banks that provide financial products and services within the region are comprehensively disclosing just how committed to sustainability they truly are.
The directive falls under the European Union’s/United Nation’s 2030 Agenda for Sustainable Development and aims to push around €1 trillion into green investments over the next decade, address the lack of consistency in the climate-related information that’s currently being provided by financial-market participants and provide a competitive edge to those firms offering genuinely sustainable products. “Those that already have a good offering in place are going to stand to benefit,” explained Alexandra Mihailescu Cichon, executive vice president of sales and marketing at ESG data firm RepRisk.
According to the official wording, the SFDR “lays down harmonised rules for financial market participants and financial advisers on transparency with regards to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products”. It aims to achieve such objectives by imposing more stringent requirements on sustainability-related disclosures made by financial-services institutions such as banks, insurance companies, pension funds and investment firms with regards to sustainability risks, as well as by focusing on how to account for any adverse impacts on sustainability through the investment decisions being made or the financial advice being issued. “To be clear, this is not just about climate change but is focused on a much broader topic of sustainability,” Kate Hodson, head of ESG at law firm Ogier, recently noted. “In short, we are talking about an environmental, social or governance event or condition that, if it occurs, could cause a negative material impact on the value of the investment.”
As such, the SFDR applies to financial-market participants (FMPs), defined as professional entities such as pension funds, asset managers, insurance companies, banks, venture-capital funds, credit institutions offering portfolio management or financial advice, all of which must publish on their websites information about their policies on the integration of sustainability risks in their investment decision‐making processes. “SFDR sets out rules on transparency and requires FMPs to disclose how they consider sustainability risks in their investment processes and products and how they deal with principal adverse impacts of their investment decisions on sustainability factors, ” said Rebecca Macé-Balebs, senior associate at Ogier.
It will also apply to financial advisors, who are similarly mandated to publish on their websites information about their policies on the integration of sustainability risks in their investment or insurance advice. And both FMPs and financial advisers are now required to include in their remuneration policies information on how those policies are consistent with the integration of sustainability risks and publish this information on their websites.
Among the directive’s key parts is its focus on preventing “greenwashing”, which is the practice by financial firms of exaggerating their environmental commitments on paper without necessarily following through on those commitments in practice. An example of greenwashing would be a fund that is being marketed as focused on sustainability or ESG (environmental, social and governance) goals but actually contains companies emitting substantial carbon volumes. According to Andy Pettit, director of EMEA policy research at Morningstar, the new rules will “go a long way on the greenwashing front… (it will be) much easier to compare different products”.
And as far as the disclosure requirements are concerned, they will apply to adverse sustainability impacts at two distinct levels: the entity level and product level. The former requires that financial-market participants publish and maintain on their websites statements about the principal adverse impacts of investment decisions on sustainability factors and due-diligence policies with respect to those impacts—taking into account the size, nature and scale of their activities and types of financial products they make available. Wherever they do not consider the adverse effects of investment decisions on sustainability factors, they must disclose clear reasons for not doing so, including, where relevant, information on whether and when they intend to consider such adverse impacts.
The latter, meanwhile, requires a clear and reasoned explanation of whether a financial product considers principal adverse impacts on sustainability factors, and if so, how it does. As per the SFDR, financial products are divided into three categories:
- Financial products promoting environmental or social characteristics (Article 8), with disclosure requiring information on how those characteristics are met; and if an index has been designated as a reference benchmark, information on whether and how this index is consistent with those characteristics;
- Financial products with a targeted sustainability objective, such as a reduction in carbon emissions (Article 9);
- Other products not covered by the above two articles.
“The crucial point is that this covers any entity or financial product,” Lucian Firth, a partner at the law firm Simmons & Simmons, recently told Reuters. “It doesn’t matter if you market all of your products as sustainable or none of them—it covers all of them.”
By the end of the year, funds will have to decide to classify themselves as either being fully focused on sustainable objectives; fully or partly focused on environmental, social issues or sustainability issues; or not at all focused on sustainability. At this stage, reports suggest that some investment managers remain reluctant to decide on this classification at present and will wait until later in the year to determine whether they are fully sustainable.
In the meantime, companies can still take action in support of the new legislation. According to US law firm Morrison & Foerster, there are three key steps that companies can look at taking in this initial phase of the SFDR coming into effect in order to align with regulatory requirements and anticipate the sustainability disclosure requirements of their capital providers:
- Assess sustainability risks that may impact their own activities with quantitative and qualitative data and produce internal reports;
- Evaluate principal adverse impacts stemming from their own activities based on sustainability factors, including what actions were taken or are planned to remedy these impacts by applying standardised due-diligence guidance;
- Define the strategic sustainability targets for their own economic activities, either as promoting environmental and/or social characteristics or contributing to an environmental or social objective based on quantitative and qualitative data.
In addition, the Joint Committee of the European Supervisory Authorities (EBA, EIOPA and ESMA–ESAs) published a final draft of regulatory technical standards (RTSs) in February, which acts as a supplemental guide to the SFDR and provides further clarity for firms with respect to their sustainability disclosures. The standards are expected to be adopted in May 2021.