Organizations across the globe are integrating sustainable finances into their operations. As a part of the transition towards a low-carbon and resource-efficient economy, the European Commission has implemented new and updated regulations to strengthen its action plan on sustainable finance. The EU Taxonomy is regarded as the key component of the action plan. There are a handful of other regulations that are being introduced for organizations to get familiar with. One of those is the Sustainable Finance Disclosure Regulation, or SFDR assists in reorientating capital toward more sustainable businesses and increasing transparency on sustainability among financial institutions.
So, how does the SFDR framework help in improving the transparency and sustainability of businesses within the European Union? Let's find out.
What is SFDR?
The first regulation set up by the EU, SFDR, or the Sustainable Finance Disclosure Regulation, aims to reorientate capital flow toward sustainable finance. Sustainable Finance Disclosure Regulation (SFDR) provides transparency on sustainability within the financial market to prevent greenwashing.
When did SFDR come into force?
The European Union (EU) has been taking sustainability and climate change seriously and joined the net-zero movement to implement financial disclosure requirements through the NFRD and the CSRD. The European Union presented the Sustainable Finance Disclosure Regulation, or SFDR, to put the EU's sustainable finance back in focus. The SFDR framework was implemented on March 10th, 2021, to incorporate important actions for organizations to comply in time.
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SFDR Article 6, 8 & 9 and their Disclosure Requirements
The Sustainable Finance Disclosure Regulation (SFDR) framework presented mandatory ESG data disclosure requirements that asset managers have to comply with. The aim of the articles is to establish more transparency in the investment strategies of organizations and prevent greenwashing. It also helps in defying claims made by organizations stating their products are sustainable.
As per the SFDR’s classification, a fund can either be classified as an Article 6,8 or 9 fund, based on its characteristics along with its level of sustainability:
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Article 6: Funds with no sustainability scope
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Article 8: Funds promoting environmental or social characteristics
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Article 9: Funds with sustainable investment as their core objective
In essence, Article 6 mandates asset managers to present the integration of sustainability risks in their funds, irrespective of whether the fund is promoted as ESG or not. On the contrary, investments promoted as ESG are required to classify as either an Article 8 or 9 fund.
What is SFDR Article 6?
SFDR Article 6 encompasses transparency of the integration of sustainability risks requiring financial market participants to include information on the following pre-contractual disclosures:
The pattern in which sustainability risks are integrated into investment decisions
The results of the assessment and the impacts of sustainability-associated risks on the returns of financial products.
If sustainability risks are relevant for a fund, assets managers must:
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Declare the integrated sustainability risks into their investment decisions.
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Develop a framework to assess and identify the significant risks.
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Design a disclosure policy to mitigate and act on the risks.
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Describe how the objectives will be achieved,
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Track the implementation process and results.
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What is SFDR Article 8?
For a fund to comply with Article 8, there needs to be transparency in the promotion of environmental or social characteristics defined in the pre‐contractual disclosures. It requires the following: information on how the characteristics are met;
If the designated index has been used as a reference benchmark for the information on how the index is consistent.
Financial market participants should include in the information articles 6(1) and (3) an indication of the methodology used to calculate the index.
Article 8 applies to funds promoting environmental and social objectives and sustainability risks. However, Article 8 funds do not incorporate ESG or core objectives.
What is SFDR article 9?
For a specific fund to comply with Article 9, there needs to be established transparency of sustainable investments in pre‐contractual disclosures. It further mandates the following:
Information on the designated index and how it is aligned with that objective.
An explanatory report on why and how the designated index aligns with that objective and differs from a broad market index.
Compared to Article 8 funds, which promote environmental or social characteristics and include governance practices, Article 9 funds are recognized to impact society and the environment through sustainable investment positively.
Article 9 funds have a non-financial objective at the very core of their offering.
The European Union (EU) regulation mandating ESG disclosure - Sustainable Finance Disclosure Regulation (SFDR) - presents obligations for asset managers and financial market participants. Effective from 10 March 2021, it aims at increasing transparency and boosting environmental and social responsibility in the industry. The framework mandates banks, investment firms, insurers, and other financial institutions to disclose their sustainable investment practices in a standardized format to the investors for them to make informed decisions. Non-compliance with SFDR will likely have adverse consequences, such as a negative impact on the firm's reputation, disciplinary action from financial authorities, and negative signaling to clients and investors.
Read more: ESG and Impact Investing: The Future of Responsible Finance
Sustainable Finance Disclosure Regulation (SFDR) Objectives
By envisioning the removal of barriers, inhibiting access to requisite sustainability data for investment decisions, the Sustainable Finance Disclosure Regulation (SFDR) framework aims to achieve three main objectives:
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To enhance disclosures for institutional investors and retail customers to comprehend, compare, and monitor the sustainability features of their products.
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To maintain a level playing field inside the EU, thus ensuring that the enterprises within the EU are not subjected to unfair competition from non-EU firms.
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To counteract greenwashing.
The EU SFDR framework's fundamental objective is to enhance the openness about environmental and social aspects of sustainability in financial markets. The framework further helps to establish consistent criteria for sustainable reporting and disclosing information related to these issues. With the incorporation of the framework, businesses and financial institutions can increase openness and establish a standard that helps contribute to the following critical factors.
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It makes greenwashing tougher for firms and asset managers, thereby making it tougher for companies to brand their products with an ESG or sustainable label.
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It enhances investors' ability to evaluate investment choices in terms of the ESG aspects throughout the decision-making process.
SFDR Framework: To whom does it apply?
The SFDR framework is applicable to two distinct types of financial institutions:
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Financial advisors provide investment or insurance advice related to insurance-based investment products.
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Participants in the financial markets produce or sell financial goods, along with portfolio management services.
Institutions that fit these two groups include:
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Investment and Fund Managers
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Banks
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Consultancy firms
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Insurers
The SFDR framework is primarily applicable to financial institutions that function in the EU. Non-EU firms are also impacted indirectly due to EU subsidiaries and services offered in the EU market. Investment managers or advisors outside the EU who advertise their products to EU customers must comply with the SFDR disclosures.
Read more: An Ultimate Guide: Understanding ESG Data Providers
Conclusion - What is SFDR
The European Union (EU) is taking sustainability and climate change seriously and has joined the net-zero movement to implement financial disclosure requirements through the NFRD and the CSRD. In 2021, the European Union presented the Sustainable Finance Disclosure Regulation, or SFDR, to focus on the EU's sustainable finance.
To comply with the SFDR framework, financial institutions must declare their PAI, which involves greenhouse gas emissions, biodiversity, waste management, and human rights. Disclosures on PAIs are becoming more important, and businesses that fail to report or meet the specified basic requirements can face multidimensional consequences in the short as well as long term. The higher the quality of the information presented is available to fund managers, the more confidently they can include firms in Article 8 or 9 funds.
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