This blog post was initially published in March 2021. Almost one year since SFDR came into effect, we have updated the article to reflect the state of play around the European rules framework.
The European Union’s push to embed sustainability criteria in financial markets is leading to a surge in ESG uptake both inside and outside the bloc, and rules became tighter with the introduction of the Sustainable Finance Disclosure Regulation (SFDR) almost one year ago.
SFDR is one of three regulatory pillars in the EU’s sustainable finance action plan from 2018, which aims to reorient capital towards more sustainable businesses and has been a driving force in reshaping financial market behavior across the globe. The action plan is completed by the regulation on climate benchmarks and sustainability-related disclosures for benchmarks, and the EU Taxonomy Regulation. Initial SFDR requirements started to apply on March 10, 2021.1
In summary, SFDR outlines entity-level disclosure rules relating to sustainability risks, the consideration of principle adverse impacts (PAIs)2 of investment decisions on sustainability factors, as well as, on a product level, the publication of sustainability-related information where a sustainability objective is targeted. It covers financial market participants3 and financial advisers by imposing pre-contractual, website and periodic reporting obligations. The rules apply to investment vehicles including mutual funds, ETFs and derivatives.
At the center of SFDR, three articles define respective reporting obligations:
- Art. 6: The regulatory baseline. It applies to all financial market participants and advisors, regardless of product strategy. Product manufacturers and advisers need to inform users and clients whether and how they integrate sustainability risks into their products and advice (a practice commonly known in the market as ‘ESG integration’).
- Art. 8: Products that seek to promote environmental (E) or social (S) characteristics.
- Art. 9: Products that seek to contribute to the achievement of an E or S objective while doing no significant harm to another E or S objective.4
Market participants need to categorize their product universes into baseline-only, Art. 8 or Art. 9. Because Art. 9 products are more ambitious in their E/S imprint, they carry more demanding disclosure requirements.
So where does all this leave market participants?
Given its scope and ambition, SFDR is not without questions and doubts around responsibilities and implementation.5 On top of the work involved in complying with the requirements, there have been complaints from industry members about a lack of harmonization between new and existing sustainable finance legislations, and on the misalignment between SFDR definitions and market practitioners’ own terminology. Such definitions include the concepts of double materiality, sustainable investment and PAIs on sustainability factors.
Investment firms could therefore be forgiven for feeling anxious in the face of a regulatory burden that already seems daunting before confusion is added to the mix.
Some important points may help lessen those initial concerns.
First off, SFDR is not a product label but a framework that aims to provide harmonized disclosure requirements to strengthen investor protections against greenwashing.
This is a shared journey for everyone – the spirit of the regulation is important to bear in mind when navigating the sometimes-unclear wording in it. Firms that are genuine about facilitating the transition to a low-carbon and more equitable world should use that as a guiding principle when revising existing fund methodologies and developing new ones.
A perfectly aligned and smooth introduction of the rules would have taken years in preparation. Luckily, policymakers realize that, when dealing with sustainability, we no longer have the luxury of time.
Initial SFDR disclosure obligations (‘Level 1’) started on March 10, 2021 and must be applied by regulated entities following a principles-based approach. ‘Level 2’ technical standards requirements are scheduled to come into effect on January 1, 2023 (postponed by one year last November).
Few products are currently seen as aligned with Art. 9 and its more stringent do-no-significant-harm criteria. According to Morningstar research, as of September 30, 2021, Art. 9 funds represented 4% of EU fund assets, while Art. 8 funds accounted for 33%, with both having a growing share of total fund inflows.6
The role of Qontigo
SFDR and other EU initiatives have resulted in a reassessment of our index solutions at Qontigo, which we have taken on in following the spirit of the interventions. This comes at a time when we have extensively grown our ESG, Sustainability and climate offerings. One of the main developments in the near future will be the roll-out of impact-oriented strategies.
To facilitate the reporting obligations of clients and index end users, Qontigo has worked to determine where and how our indices align with the essence of the regulation. We are also working on a solution with Clarity AI to support disclosures on topics such as Taxonomy alignment and PAIs on sustainability factors.
We partner with Clarity AI, the global, leading sustainability technology platform, which leverages big data and machine learning to provide impact and sustainability analysis, and reporting capabilities. Through its EU Regulatory Solutions, which include over 40,000 organizations, Clarity AI can help you comply with EU Taxonomy and SFDR disclosure requirements.
Indices, and the precise description of their approach and methodology, play a key role in the disclosure obligations for products that use them as a reference benchmark. The regulation requires that market participants explain how an index is consistent with either the promotion of, or objective of, contributing to the improvement of environmental or social characteristics.
A few methodological proxies are currently necessary to assess the likely alignment of indices with the SFDR classifications:
- Using an index designed around an overarching ESG score, business activity or carbon intensity exclusions, can be aligned with the concept of ‘promoting environmental and/or social characteristics.’
- To align with Art. 9 requirements, a product methodology needs to strive to increasingly contribute to the E/S objective over time. For example, the decarbonization path and decreasing weight of companies with no carbon targets in the Qontigo Paris-Aligned Benchmarks satisfy that obligation.
- Good governance is loosely defined around four pillars within the regulation: sound management structure, employee relations, staff remuneration and tax compliance. As of today, the absence of violation of global societal norms such as the U.N. Global Compact, the OECD Guidelines for Multinational Enterprises or the U.N. Guiding Principles on Business and Human Rights may meet that requirement; but this may change over time. Here, we’ll also be watching the European Commission’s initiative on sustainable corporate governance, which may be adopted later this year.
- ‘Do no significant harm’ (DNSH) is a key SFDR mandate. The absence of ESG controversies may be a good proxy, although as with other criteria, this may change and become more detailed over time. Qontigo’s Paris-Aligned Benchmarks are future-proofed in this sense by having gone above and beyond the letter of the climate benchmarks regulation and included an indicator for ‘lack of significant obstruction’ of Sustainable Development Goal No.13 — Climate Action.
For questions regarding the implementation of SFDR, please contact us.
No pain, no gain
SFDR seems like a burden for market participants. The incorporation of such a detailed set of rules can feel arduous at first. Yet, as the regulation is interpreted, clarified and harmonized, practice cultivated and confusion eliminated, complying with it should become a more practical and pragmatic task with time. The end goal is worth all the work.
*Anna Georgieva is Senior Sustainable Investment Specialist at Qontigo.
This article is purely informative and does not constitute any legal advice.
1 The European Supervisory Authorities (ESAs) in early February 2021 published a final report on draft Regulatory Technical Standards (RTS) with regards to the content, methodologies and presentation of sustainability-related disclosures under empowerments in the SFDR. While the requirements in the SFDR on Level 1 apply since March 10, 2021, the ESAs suggest that the RTS will not apply until January 1, 2023 (postponed from January 1, 2022), following a letter from the EC in November 2021. Moreover, in October 2021 the ESAs published a final report on draft rules for how investors should disclose their products’ EU Taxonomy-alignment under the SFDR, improving on previous templates with the aim to establish a single rulebook and comparable format for sustainable disclosures under the SFDR and the EU Sustainability Taxonomy. Research for this blog was underpinned by ECOFACT’s regulatory database.
2 PAI disclosures are focused on a set of indicators for both climate and environment-related adverse impacts and adverse impacts in the field of social and employees matters, respect for human rights, anti-corruption and anti-bribery matters. See: ESMA, ‘Final Report on draft Regulatory Technical Standards,’ February 2021.
3 Financial market participants include pensions and asset managers, insurance providers, and corporate and investment banks.
4 Both Arts. 8 and 9 products require that investee companies follow good governance practices.
5 As an illustration, the ESAs, in charge of policing implementation of SFDR, wrote a letter to the EC in January 2021, requesting clarification on ‘several important areas of uncertainty in the interpretation of SFDR.’ In response, the EC published a Q&A in July 2021, providing guidelines for interpreting the meaning of ‘promotion’ under Art. 8 and explaining the scope of both entity- and product-level SFDR requirements (Art. 9). In November 2021, the EU Commission corrected the Q&A. Although helpful, this Q&A did not fully alleviate industry concerns, with Arts. 8 and 9 still largely seen as too broad.
6 Morningstar, ‘SFDR Article 8 and Article 9 Funds: Q3 2021 in Review,’ November 3, 2021.