The proliferation of new regulations designed to foster a more sustainable, responsible, and digital economy in the European Union (EU) continues. The EU remains focused on moving toward sustainable growth and reaching net zero emissions by 2050, in alignment with the Paris Agreement.
A more recent entrant, the Sustainable Finance Disclosure Regulation (SFDR), is one of four policies focused on advancing transparent and accountable private sector investment as part of the European Green Deal and EU Action Plan for Financing Sustainable Growth. These policies aim to improve private sector transparency and accountability on ESG impacts and risks, encouraging sustainable economic growth and investment in the EU.
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What is the Sustainable Finance Disclosure Regulation (SFDR)?
The European Commission introduced the SFDR to promote and facilitate sustainable private sector investment. The SFDR imposes disclosure obligations on financial market participants and financial advisors with 500+ employees that are either based in the EU or marketing to clients in the EU. Organizations must disclose information about their ESG policies, risks, impacts, and performance at the entity and product levels. Companies impacted by the SFDR include banks, insurance companies, institutional investors, asset managers, and pension funds.
The SFDR disclosure regulation aims to prevent “greenwashing” and improve transparency in the market for sustainable investment products. Companies will no longer be able to present an environmentally responsible public image or overstate the sustainability characteristics of investment funds; instead, they must categorize and disclose them.
The SFDR requires financial market participants and financial advisors to disclose the following entity-level ESG information on their websites:
- Sustainability risk policy – A statement on how they consider ESG sustainability risks when making investment decisions.
- Principal adverse impact (PAI) – A description of how their investments affect various sustainability factors as specified in the EU Taxonomy.
- Sustainability risk remuneration policy – A statement on how they consider ESG sustainability risks when setting their staff remuneration policies.
These firms must also disclose the sustainability profile of the investment products they produce or market in pre-contractual disclosures and fund prospectuses using the following three SFDR product-level disclosure requirements:
- Article 6 covers transparency of integrating sustainability risk into investment decisions into the fund’s prospectus and applies to investment products without a sustainability scope. Entities must explain any financially material sustainability risk considerations that went into the decision-making process or why sustainability risk is not relevant to a specific product.
- Article 8 covers transparency in promoting environmental or social characteristics in pre-contractual disclosures. Products in this category may promote social or environmental characteristics and follow good governance practices, but sustainable investing is not a core objective.
- Article 9 covers transparency of products in pre‐contractual disclosures for products with a sustainable investment objective. Funds in this category should positively impact society or the environment through sustainable investment and have a non-financial objective at the core of their offering.
The SFDR bases its transparency requirements on the degree of sustainability of a financial entity and its products in the form of core and enhanced disclosures. Core disclosures (Level 1) apply at the entity level to sustainability risks and principal adverse impacts and at the product level according to Articles 6, 8, and 9. Enhanced disclosures (Level 2) apply at the entity level to principal adverse impacts and at the product level to Articles 8 and 9. Sustainability profiles of investment products should specify the precise environmental and sustainability characteristics considered when assessing each asset fund or product.
When will the SFDR go into effect?
The EU scheduled initial effective dates for entities to comply with specific aspects of the SFDR. However, it became necessary to reschedule some of those dates to allow adequate time for industry compliance and for the EU to prepare additional disclosure documentation. Here’s a list of milestone dates for entities to comply with the SFDR.
- March 10, 2021 – The EU required information on whether an entity complied with the regulation.
- January 1, 2022 – Level 1 of alignment with the EU taxonomy classification framework went into effect; the EU required climate-related disclosures. Entities also needed to start collecting and monitoring principal adverse impacts at the firm and product levels.
- January 1, 2023 – Level 2 of alignment with the EU taxonomy went into effect; entities must provide additional disclosures for environmentally aligned funds according to the Regulatory Technical Standards. These standards specify the disclosure’s exact content, methodology, and presentation.
- June 30, 2023 – Entities must publish their first annual PAI statement on their website, disclosing their PAI, due diligence policies, and plans for reducing their investments’ negative social impact and environmental footprint. If an entity does not, as a matter of practice, consider the adverse impacts of investment decisions on sustainability factors, it must disclose this information. The entity must publish and maintain clear reasons why it does not do so on its website and, where relevant, share information as to whether it intends to do so and when.
As of April 2023, EU authorities have proposed amendments around improving disclosures on how sustainable investments meet the “do not significantly harm” (DNSH) criteria and technical adjustments to simplify disclosures around financial products.
How can companies comply with the EU SFDR?
Entities must disclose information on their sustainability investment policies and how they prioritize their impacts at the entity level on their website and in pre-contractual disclosures and fund prospectuses at the product level. Each year, entities must report the PAI from the prior calendar year by June 30, starting with June 30, 2023, for 2022.
Financial firms must also disclose what percentage of each investment product aligns with the EU taxonomy — a classification system that defines what economic activities can be considered environmentally sustainable. If products don’t meet the criteria, companies must explain why not.
The Taxonomy Regulation sets out criteria companies use to identify if an activity is environmentally sustainable, including whether the activity contributes to, or does significant harm to, one or more of the following environmental objectives:
- Climate change mitigation
- Climate change adaptation
- Sustainable use and protection of water and marine resources
- Transition to a circular economy (including waste prevention and recycling)
- Pollution prevention and control
- Protection of health ecosystems
By requiring the EU Taxonomy as a reference, the SFDR aims to encourage financial market participants and financial advisors to consider the ESG impacts of the products and services they offer and to grow the financing of sustainable economic activities. Another source of information is the EU Corporate Sustainability Reporting Directive (CSRD), which will require large companies and public-interest entities operating in the EU to disclose information on their ESG performance annually. Once implemented, starting in 2025, this information will be available to financial market participants and financial advisors when evaluating which investment products to include in sustainable funds and at what level.
If your company is a financial market participant or financial advisor, meeting these extensive disclosure requirements will require a company-wide effort across multiple business units to establish the workflow for collecting, analyzing, and storing the necessary data — internally and from investment fund partners — and preparing the disclosure forms. Once completed, save the documents as pdfs to share with prospective investors as a pre-contractual disclosure and publish on an entity’s website. Selecting and onboarding ESG reporting software can help your company streamline the data collection and reporting process.
Learn how OneTrust ESG program management helps remove complexity and reduce manual processes required to comply with SFDR and the continuous stream of new regulations going into effect worldwide.
