The SFDR is part of the EU Commission’s “Action Plan on Sustainable Growth”, and is intended to complement the EU Taxonomy Regulations and the EU Regulatory Technical Standards. The SFDR is designed to enable investors and consumers to make informed investment decisions with respect to the ESG credentials of the funds, assets, or products they are investing in/purchasing, with a view to investors making decisions that contribute to sustainable growth in the financial sector. It is hoped that its adoption will provide clarity and consistency as to the language used by FMPs when selling investment products, especially those described as ‘sustainable’ or ‘ESG focused’, or a number of other adjacent terms. In particular, the Commission hopes to eliminate ‘greenwashing’ from the investment landscape, and force FMPs to make undertake proper due diligence as to the nature of the underlying products they are selling and/or providing.
Product level classification
The SFDR requires FMPs, whenever they are offering financial products purporting to be one of the below, to make certain disclosures as to the natures of the relevant products, which will either fall into Articles 8 or 9 of the Regulation:
- Those promoting environmental and/or social characteristics, and those for which the investee company follows ‘good governance practices’ (Article 8 products)
- The Regulation does not specifically define ‘environmental and/or social characteristics’, nor ‘good governance practices’, but gives a number of examples of activities that would be regarded as contributing to each area.
- Those having sustainable investments as an objective (Article 9 products)
- Sustainable investments products specifically relating to carbon emissions reductions (Article 9(3) products).
The mandatory disclosure requirements for FMPs to promote Article 8 and Article 9 products differ substantially, with Article 9 products subject to more stringent disclosure obligations. Distinguishing between Article 8 and Article 9 products is critical for FMPs to ensure they adhere to the requirements of the SFDR. The disclosure rules are complex, with disclosure at a granular level required, particularly for Article 9 companies, the detail of which is beyond the scope of this note. For more information, see details of the regulation here.
Firm level classification
Article 3 of the Regulation also requires in scope entities/individuals to publish, on their website, three broad categories of information in relation to the integration of sustainability risks into their investment process, both at the firm and product levels:
1. Principal adverse impact (Article 4) - how investments might create or lead to possible adverse impacts in relation to a range of sustainability factors. This requirement is by far and away the hardest and most complicated for firms to navigate, as it requires access to detailed ESG data, which most firms do not generate during the normal course of their business. A notable feature of Article 4 is the requirement to explain the provenance of the ESG data, or, where data is unavailable, explain why the data is unavailable, and provide best estimates in its place.
Under this heading, in-scope companies must report on 14 different sustainability related factors, ranging across a spectrum of ESG risks.
Included in this is the key requirement for in scope entities to understand and report on the Scope 1, 2, and 3 emissions for companies they have invested in. As detailed elsewhere on the GVT, Scope 1 emissions are those directly produced by the company, Scope 2 emissions are those produced by energy it purchases for its direct use (for example, the emissions deriving from the purchase of electricity), and Scope 3 emissions are those for which the company is responsible for up and down its value chain. For FMPs, the vast majority of their emissions will be categorised as Scope 3, given their economic activities do not involve energy intensive means of production.
Scope 3 emissions are also the most difficult to track and assess. For more information on Scope 1/2/3 emissions measuring, see here.
2. Remuneration (Article 5) – in scope FMPs must publish a statement stating how sustainability risks are taken into account in their remuneration policy.
3. Sustainability risk policy (Article 6) - how ESG risk is considered in the investment process and how these risks are taken into account in any and all investment decisions. This must detail the ‘likely impacts’ of those risks on the returns of the products they are providing or advising on. Even in circumstances where there are no risks identified, or where the risks are ‘not relevant’, FMPs must make clear why these risks are not relevant.
These Article 4-6 disclosures must be made:
- in the relevant documentation for a specific financial product; and
- on the FMP’s website.
Comply or explain policy
Under the comply or explain rule, if an FMP does not consider the ESG/sustainability impact(s) of its decisions/investments, it must publish a statement this effect on their website and give clear and detailed reasons for failing to comply with the requirement under the Regulation.
The Regulation may also require additional disclosure of sustainability information in relation to certain financial products purporting to promote ESG objectives.
Stakeholder consultation
In late 2023, the Commission launched a consultation through which stakeholders could provide feedback on the implementation of the SFDR, alongside their suggestions for future changes/amendments. On 3 May 2024 the Commission published a summary of the responses received, which highlighted the need to ensure consistency across EU sustainability regulation and legislation, as well as providing clarity on the exact disclosures required under the SFDR. For more detail, please see the summary here, as well as this article. It is anticipated that further consultations will follow.
For more information generally, please see these articles (and this analysis piece):