The Sustainable Finance Disclosure Regulation (SFDR) is a European Union regulation that came into effect in March of 2021 to increase transparency and accountability in the financial market so investors can make clear decisions based on factual data about supporting companies with regards to ESG factors whether or not ESG is their primary focus.
The SFDR requires financial market participants (FMPs) and financial advisors (FAs) in the EU to disclose specific information through SFDR classifications on how they integrate ESG risks into their investment decisions and advisory processes.
What is more, implementing the SFDR contributes to the EU’s alignment with the Paris Agreement and makes it easier to prevent greenwashing. It also shifts the focus towards investing in the green economy.
There are entity-level and product-level disclosure requirements.
These (Article 4) disclosures are based on a “comply or explain” basis stating that FMPs must decide if they consider the principal adverse impacts on sustainability factors of these particular investments, and include a statement on their due diligence policies in regard to such impacts. FMPs which do not consider these PAIs are obliged to explain why and if it’s necessary to consider them in the future.
Here are the key components of entity-level disclosures under the SFDR:
1. How firms factor in the integration of sustainability risks regarding their investment decision-making process or investment advice. This includes how those risks are identified, assessed, and managed, as well as the expected impact of these on the returns of the financial products they offer.
2. Financial market participants are required to disclose the Principal Adverse Impacts (PAI) of investment decisions on sustainability factors. A detailed statement is required for both entity and product disclosures, outlining how these impacts are considered, the actions taken to address them, and the outcomes of such actions. 6 out of 14 mandatory PAI indicators are climate-related. 2 additional PAI indicators must be chosen out of 46 voluntary indicators.
3. Entities must describe how their remuneration policies are consistent with the integration of sustainability risks. This is intended to show whether incentives for staff are aligned with sustainable investment objectives.
4. Much of the entity-level information must be published on the firm's website, ensuring accessibility and transparency for investors and the public. This includes the firm's policies on the integration of sustainability risks, the consideration of principal adverse impacts on sustainability factors, and if applicable, information on their adherence to internationally recognized standards for due diligence and reporting.
Products could apply to different topics such as the Undertakings for Collective Investment in Transferable Securities (UCITS), which is the EU’s framework for the management and selling of mutual funds, which are well-regulated investments.
The SFDR categorizes financial products into three main classifications based on their sustainability characteristics or objectives, and each SFDR classification requires articles of disclosure which we’ll discover in detail in the next section.
A summary of what we’ll explain below:
Article 6: Funds that aren’t focused on sustainability
Article 8: Funds that highlight the ES (environmental or social characteristics) in ESG which are referred to as light green
Article 9: Funds that promote sustainable investment at their core which are referred to as dark green
These products don’t hold sustainability at their center according to the Green Taxonomy, but those reporting on SFDR must disclose how sustainability risks are integrated into their investment decisions and the likely impacts of sustainability risks on the returns of the product. These do not integrate sustainability into their investment decisions beyond the basic level of ESG risk assessment.
For such products, if there is no PAI compliance, there must be an explanation in a statement as to the sustainability impact that will happen as a result of the product on this business and inevitably how that would impact the investment.
According to Deloitte article 7 adheres to, “Disclosure on a product-level (article 7 SFDR), by publishing PAI information in pre-contractual financial product documentation, such as fund information memoranda or prospectuses, this requirement applies to financial market participants only.”
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PAI disclosures specifically require entities to report on how their investment decisions have adverse impacts on sustainability factors. These sustainability factors include environmental, social, and employee concerns, respect for human rights, and anti-corruption and anti-bribery matters. The aim is to provide end investors with clear information on the sustainability impact of their investments, helping to promote more sustainable investment choices. These disclosures must be clear on websites and on pre-contractual information.
PAI disclosures are detailed and require reporting on a set of mandatory indicators for all financial market participants and advisers who are subject to the regulation, regardless of their size. For larger entities (those with more than 500 employees), additional and more detailed disclosures are required. The indicators cover a broad range of issues, such as greenhouse gas emissions, water consumption, waste production, and impacts on biodiversity, as well as social and employee matters, human rights, and anti-corruption practices.
Entities required to comply with the PAI disclosures must collect data, assess their investments against the set indicators, and report annually on their findings. This process involves a significant effort in data collection, analysis, and reporting to meet the regulatory requirements. The disclosures are designed to encourage more responsible investment practices and to ensure that investors have access to the information needed to make informed decisions based on sustainability criteria.
There are PAI templates supplied by the SFDR in order to assist in what should be included.
The PAI publication deadline is 30 June 2024 for the data of the calendar year of 2023. SFDR delegated regulation applies.
6 climate-related PAIs
8 ESG-related PAIs outside of climate
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SFDR filings must be submitted by 30 June for the preceding year. All PAI indicators must be calculated at the end of every quarter and then averaged for the annual submission.
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