Part three in a series of four articles by Svarmi on the European Union's green action plan, taxonomy and what these policies mean for the reporting and transparency requirements for companies in 2022 and beyond.
Based on the EU 10-Point Action Plan, the EU adopted the Sustainable Finance Disclosure Regulation (SFDR)¹. It was introduced to improve transparency in the market for sustainable investment products, to prevent greenwashing and to increase transparency around sustainability claims made by financial market participants. It imposes comprehensive sustainability disclosure requirements covering a broad range of environmental, social & governance (ESG) metrics at both entity- and product-level. The SFDR is a fundamental pillar of the EU Sustainable Finance agenda, having been introduced by the European Commission.
The SFDR requires that asset-management companies provide information about their investments' ESG risks as well as their impact on society and the planet. The goal is to channel capital flows towards sustainable investment while managing financial risks stemming from ESG issues.
The regulation applies to Financial Market Participants (FMPs) and Financial Advisers (FAs). Financial market participants are defined as:
- An insurance company that makes available an insurance-based investment product
- Investment firms that provide portfolio management
- An institution for occupational retirement provision
- A manufacturer of pension products
- An alternative investment fund manager
- A pan-European personal pension product provider
- A manager of a qualifying venture capital fund
- A manager of a qualifying social entrepreneurship fund
- A management company for UCITS (Undertakings for the Collective Investments in Transferable Securities)
- A credit institution that provides portfolio management
The products that it applies include (not exhaustive): investment and mutual funds, UCITS, insurance-based investment products, private and occupational pensions and insurance and investment advice.
Practically speaking, this means that manufacturers (FMPs) and financial advisers (FAs) will need to provide ‘entity level’ information on their public websites. And for ´products´ (funds, managed products, models, etc.), it means additional information will need to be added to pre-contractual documents and periodic publications as noted below:
Entity-Level Disclosure Requirements
The SFDR sets out requirements for FMPs and FAs to disclose sustainability information at the legal entity level. When FMPs and FAs disclose, they will be required to provide policies detailing how they will integrate sustainability risk into the investment decision-making process, information and considerations on adverse sustainability impacts, and consistency of remuneration policies with sustainability risks. A firm must publish a statement of intent on their website to demonstrate which Article they intend to align to.
SFDR sets out that FMPs shall publish and maintain their policies for due diligence over the adverse impacts of their investment decisions on sustainability factors on their websites. There are also four disclosures required at the entity level on the website:
- Information on policies to identify and prioritize Principal Adverse Impacts (“PAI”). PAI are negative, material, or potentially material effects on sustainability factors that result from, worsen, or are directly related to investment choices or advice performed by a legal entity. Examples include GHG emissions and carbon footprint.
- A description of such impacts and any actions taken.
- Summaries of engagement policies regarding the prevention and management of potential conflicts of interests.
- Reference to responsible business conduct codes and standards for due diligence and reporting.
Pre-contractual disclosures cover similar areas to the entity-level disclosures around the integration of sustainability risks and principal adverse impacts, e.g., through contractual documentation.
For all qualified products, there must be a disclosure of the principal adverse impacts on sustainability factors. Additionally, there are more sustainability disclosures for products that promote environmental and/or social characteristics amongst other characteristics and the companies in which the investments are made have good governance practices (this implies that ESG investing is not core to these products) and products that have sustainable investment as their core objective concerning the extent to which environmental and social characteristics are met and a comparison between the product impact and the impacts of a designated index.
- There are also requirements for green taxonomy-related disclosures and products that have sustainable investment as their core objective need to disclose the criterion Do Not Significant Harm (“DNSH”) and taxonomy objectives based on sixty-four indicators which can be broken down into mandatory and optional. Mandatory indicators include greenhouse gas emissions, fossil fuel sector exposure and board gender diversity, while optional indicators include things like water recycled and reused, land degradation and incidents of discrimination. Of the optional indicators, one indicator must be chosen from both social and environmental where applicable.
- Website product disclosures – For each product that promote environmental and/or social characteristics amongst other characteristics and the companies in which the investments are made have good governance practices (this implies that ESG investing is not core to these products) and products that have sustainable investment as their core objective, the entity must disclose its characteristics, how the characteristics are measured and monitored, due diligence on the underlying assets, data sources and any limitations met.
Sustainable Finance Disclosure Regulation (SFDR) came into effect in March 2021. On June 30, 2023, FMPs need to report for the first time, through the Adverse Sustainability Impacts Statement and other forms of disclosures under SFDR, their performance on entity level on various ESG indicators accompanied with textual explanations and commentaries. On June 30, 2024, FMPs need to report for the second time. At this point, they’ll need to make a comparison between the first and second reference period. The UK will implement its own principles-based version of the SFDR (and the EU Taxonomy Regulation) which the Financial Conduct Authority (FCA) will disclose at the right time.
Just as the Corporate Sustainability Reporting Directive (CSRD), the SFDR is generating a demand for more widely available and accurate information on wide aspects of sustainability. At Svarmi, we believe that in order to build high quality reporting metrics at the entity and product levels, companies need to establish consistent data collection at the asset level.
This is why we strive to help companies assess their nature & biodiversity impact by locating, prioritizing, and digitally evaluating their Areas of Influence, driving alignment to existing and emerging regulatory requirements as well as voluntary reporting frameworks.
¹ Source: Sustainable Finance Disclosure Regulation (SFDR) (https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32019R2088&from=EN)