SFDR: What it means for ESG
SFDR: What it means for ESG
The demand for ESG (Environmental, Social, Governance) investing is one of the fastest-growing investment strategies around the world. The rise of climate-related disasters, social unrest, and a global pandemic have all shed light on the harsh realities of ESG risk unpreparedness. In turn, everyone, from investors to fund managers to corporations, has begun increasing their commitment to sustainability, particularly in the European Union (EU).
According to OpenInvest, assets under management in European sustainable funds in 2010 averaged around EUR 112 billion. A decade later, that number has grown to EUR 1,101 billion across all asset classes and products, from equities to ETFs to separately managed accounts.
As investors demand common ESG and sustainability standards across the finance industry, the EU is tightening regulations in order to shift capital flow toward a more sustainable economy. To do this, the European Commission made major strides towards standardizing ESG terminology, reporting, and disclosures with the development of the Sustainable Finance Disclosure Regulation (SFDR), a core pillar of the Commission’s flagship Sustainable Finance Action Plan.
SFDR marks a big step for ESG investing as the EU seeks to enforce and align sustainability requirements. Although non-EU companies are not legally obligated to disclose sustainability-related data, this shift in the industry could also impact U.S. markets and set the standard for the future.
The aim of SFDR
SFDR aims to ensure that EU investors have the disclosures they need to make investment choices that are in line with their sustainability goals. By providing more sustainability related information, SFDR seeks to eliminate the practice of "greenwashing" financial products and financial advice.
To do this, SFDR will require all funds, both sustainable and non-sustainable, to disclose their ESG considerations to potential investors. Firms will have to improve business operations to comply with these mandatory terms and remain relevant in an increasingly ESG-focused market.
Ultimately, with greater corporate transparency, investors will be able to make more-informed investment decisions that steer the flow of investment dollars toward sustainable investments and increase the growth of a sustainable economy.
The basics of SFDR
SFDR is taking a phased implementation approach over an extended timeframe. Phase 1 went into effect on March 10th, 2021. This phase sets specific rules for how and what sustainability-related information companies need to disclose. Firms must now comply with the SFDR’s high-level disclosure requirements, including:
- Sustainability risks: ESG events or conditions, such as climate change, that could impact the value of an investment.
- Principal Adverse Impacts (PAI): the negative effects an investment decision or advice might have on sustainability, such as carbon emissions and waste, diversity and inclusion, employee well-being, human rights, anti-corruption, and anti-bribery.
- Accurate sustainability claims: anyone marketing and promoting ESG characteristics or sustainable investments must disclose the accuracy of their statements.
SFDR also established three classifications of investment products to help investors understand the different kinds of sustainable investing. All European funds will need to fall into one of these three classifications:
- Article 6: Funds that don’t integrate sustainability considerations and/or don’t consider the sustainability risks relevant, or don’t meet Article 8 or 9 criteria.
- Article 8: Funds that are promoting environmental or social characteristics but don’t necessarily have sustainable investing as their core objective.
- Article 9: Funds that have sustainable investment as their core objective, meaning they are investing in companies that clearly show positive sustainable outcomes as part of their business model.
Phase 2 will go into effect at a later stage, possibly in 2022, and will provide important details on the content and presentation of disclosures, as well as the indicators for PAIs.
The impact of SFDR on investors
SFDR applies to all EU financial market participants, including portfolio managers, fund managers, pension providers, and financial advisors, and impacts everyone differently. For example:
- Asset managers will have to disclose their policies at both the firm and product level and break down how they consider PAIs.
- Advisors will have to explain how they consider factors such as ranking, selection methodology, and the potential impact of sustainability factors on the returns to their clients as part of their investment advice.
- Larger firms will be required to disclose how they consider PAIs.
While a seemingly huge administrative burden, the new regulations are good news for investors everywhere for multiple reasons:
- New regulations set the standard for disclosures and help investors compare and contrast sustainable investments equally.
- Investors will have transparency and clarity regarding what ESG objectives and funds companies claim to support.
- Investors will have access to quality data and information that help measure their portfolio, analyze risk, and achieve sustainable objectives over time.
- Investors will have a greater understanding of the potential sustainability risks that could pose a threat to their investments.
- Better disclosures provide investors with more control, allowing them to actively pick and choose the advisors, managers, and funds that are meeting their new standards.
SFDR and the United States
While SFDR does not directly apply to the U.S. financial market, there are instances in which U.S. financial market participants will need to comply with SFDR. U.S. financial market participants affected by SFDR include:
- All asset managers that raise money in the EU, even if they are based in the U.S.
- Investment managers or advisors based outside of the EU who market or plan to market their products to EU clients.
- Any firm in the U.S. that also offers funds in Europe will now have to disclose its sustainability risks and PAI.
However, even if U.S. companies aren’t directly affected by these regulations, SFDR is raising the bar for sustainable investing and changing the future of ESG investing. With pressure from both the Biden administration and increasing demand from investors, these regulations are expected to ignite conversations in the United States around developing a similar set of standards to better measure and encourage ESG investing.
SFDR: An ESG transformation
The potential impact of SFDR extends worldwide and is a momentous step in the right direction for sustainable investing. In time, SFDR may help standardize ESG terminology and disclosure requirements beyond the EU, something that is desperately needed in the ESG investing world.
This move greatly improves the chances for investors to achieve sustainable objectives and gives investors more control over their investments and the impact those investments have on the world. SFDR will also enable greater transparency and authenticity for clients and, ultimately, transform the playing field for the financial industry.
ESG materiality assessments
With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.
An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.