The disclosure requirements embedded in the European sustainable finance disclosure regulation (commonly referred to as ‘SFDR’), constitute a key building block of the European sustainable finance framework.

         
                                                                                                       
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The SFDR stands for the Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector.

The rules of the SFDR were designed to enhance investor confidence and further support this market growth.

Moreover, the intention of the SFDR is to introduce consistency and clarity on how institutional investors, such as asset managers, insurance companies, pension funds, or investment advisors should integrate environmental, social and governance (ESG) factors in their investment decision-making process.

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SFDR applies since:

10 March 2021.

 

Detailed rules contained in the implementing measures of SFDR will apply from:

1 January 2023.

 

This is accentuated in Recital 12 of the SFDR, which requires that in order to comply with their duties under those rules, financial market participants and financial advisers should integrate in their processes, including in their due diligence processes, and should assess on a continuous basis not only all relevant financial risks but also including all relevant sustainability risks that might have a relevant material negative impact on the financial return of an investment or advice.


Therefore, financial market participants and financial advisers should specify in their policies how they integrate those risks and publish those policies.

The Regulation requires financial market participants and financial advisers which provide investment advice or insurance advice with regard to insurance‐based investment products (IBIPs), regardless of the design of the financial product and the target market, to publish written policies on the integration of sustainability risks and ensure the transparency of such integration (Recital 13).


Exact requirements will be further specified through delegated acts, which will be adopted by the European Commission at a later stage.

ESA’s Joint Consultation Paper of 23 April 2020 identified as a challenge that the negotiations were on-going on the draft Taxonomy Regulation while Article 2(17) SFDR defined “sustainable investments” without reference to the Taxonomy Regulation.

 

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Steven Maijoor, ESMA Chair, the three (apparent) paradoxes of sustainability reporting and how to address them, 8 December 2020, ESMA32-67-765

To be effective, a set of international standards will need to be modular to cater for the needs of jurisdictions that are at different stages of progress in the area of sustainable finance, rather than merely set a minimum common denominator; they will need to build on the most advanced standards already developed in international and regional fora.

 

Recital 29 of the Commission Delegated Regulation of 6 April 2022 supplementing SFDR underlines the need to ensure comparability of the principal adverse impacts statement, the pre-contractual disclosures and the periodic disclosures and for this purpose sets out standard templates for the presentation of that information (the templates also contain summary explanations of key terms applied).

 
The SFDR refers to (environmental and social) “characteristics” (Article 8), alongside “objectives” (Article 9).

 

 

Entry into force and implementation, transitory issues

 

 

SFDR applies from 10 March 2021 (Article 20).

The exception are some of its provisions applying from 29 December 2019 and from 1 January 2022.

 

The Taxonomy Regulation in Article 25 empowerd the ESAs, by amending the SFDR, to develop further RTS on “taxonomy-related product disclosures”.

 

The deadlines for the taxonomy-related product disclosures RTS ranged from 1 June 2021 to 1 June 2022.

 

Article 8, 9, 11 RTS on pre-contractual and periodic product disclosures for environmental taxonomy products were due to be delivered to the European Commission by 1 June 2021 for the “climate change mitigation” and “climate change adaptation” environmental objectives and by 1 June 2022 for the “sustainable use and protection of water and marine resources”, “transition to a circular economy”, “pollution prevention and control” and “protection and restoration of biodiversity and ecosystems” environmental objectives.

 

The transitory issues have been explained in the Joint ESA (European Supervisory Authorities) Supervisory Statement of 25 February 2021 on the application of the Sustainable Finance Disclosure Regulation (JC 2021 06) as follows:

 

  • while financial market participants and financial advisers are required to apply most of the provisions on sustainability-related disclosures laid down in the SFDR from 10 March 2021, the application of the Regulatory Technical Standards (RTS) will be delayed to a later date;

 

  • the European Commission’s Directorate-General for Financial Stability, Financial Services and Capital Markets Union in a letter sent to the ESAs on 20 October 2020 stated that “in terms of substance, the application of the Regulation is not conditional on the formal adoption and entry into force or application of the regulatory technical standards as it lays down at Level 1 general principles of sustainability-related disclosures”;

 

  • in order to provide financial market participants and financial advisers with sufficient time to gather the information necessary and adjust their practices to apply the specific requirements of the RTS, and in order to provide for the alignment of the application of the RTS with the application of the amendments in the Taxonomy Regulation to the SFDR as well as the application of periodic reporting in the SFDR, the ESAs have proposed in their draft RTS to delay the application date of the RTS to 1 January 2022.


The said Supervisory Statement of 25 February 2021 ESAs also reads:


“For the sake of applying the provisions of the SFDR without the RTS during the interim period, national competent authorities are encouraged to refer financial market participants and financial advisers to the requirements set out in the draft RTS of the final report that has been submitted to the European Commission on 4 February 2021. The draft RTS can be used as a reference for the purposes of applying the provisions of Articles 2a, 4, 8, 9, and 10 of the SFDR in the interim period”.

 

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Joint ESA Supervisory Statement of 25 February 2021 on the application of the Sustainable Finance Disclosure Regulation (JC 2021 06)


Application timeline for entity-level principal adverse impact statement

While the requirements in the SFDR relating to the entity-level disclosure of principal adverse impacts apply from 10 March 2021 on a comply or explain basis, except for financial market participants referred to in Article 4(3)-(4) SFDR who must start reporting from 30 June 2021, the additional detail specified by the entity-level ‘principal adverse sustainability impacts statement’ set out in the RTS is to be phased in. In particular, the RTS establishes a framework of reporting on principal adverse impacts by 30 June each year with a reference period of the previous calendar year. As the ESAs propose that the RTS should apply from 1 January 2022, this means that the additional detail specified in the RTS must be reported in accordance with the RTS from that date. However, where a financial market participant publishes the principal adverse sustainability impacts statement in accordance with the RTS for the first time, the RTS does not require the disclosure of information relating to a previous reference period (the section in Table 1 of Annex I “Description of principal adverse sustainability impacts”). Information that must be published in the first statement not related to reference periods includes the following sections in Table 1 of Annex I: “Summary”, “Description of policies to identify and prioritise adverse sustainability impacts”, “Engagement policies” and “References to international standards”. This means that the earliest information relating to a reference period to be disclosed in accordance with the RTS would not be made until 2023 in respect of a reference period relating to 2022.
 

 

It is to be noted that the aforementioned draft RTS submitted to the European Commission on 4 February 2021 has been replaced by the ESA’s Final report of 22 October 2021 on taxonomy-related product disclosure RTS with regard to the content and presentation of disclosures pursuant to Article 8(4), 9(6) and 11(5) of Regulation (EU) 2019/2088 (JC 2021 50), and the Updated Joint ESA Supervisory Statement of 24 March 2022 on the application of the Sustainable Finance Disclosure Regulation (JC 2022 12) adopted the same stance as regards the latter document.

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On 6 April 2022 the Commission Delegated Regulation supplementing Regulation (EU) 2019/2088 of the European Parliament and of the Council with regard to regulatory technical standards specifying the details of the content and presentation of the information in relation to the principle of ‘do no significant harm’, specifying the content, methodologies and presentation of information in relation to sustainability indicators and adverse sustainability impacts, and the content and presentation of the information in relation to the promotion of environmental or social characteristics and sustainable investment objectives in pre-contractual documents, on websites and in periodic reports has been adopted by the European Commission.

European Commission's Explanatory Memorandum to this Regulation reads:

"On 3 February 2021, the ESAs submitted draft regulatory technical standards to the Commission, combining draft regulatory technical standards developed under Articles 2a, 4(6) and (7), 8(3), 9(5), 10(2) and 11(4) of the Sustainable Finance Disclosures Regulation.

On 22 October 2021, the ESAs submitted draft regulatory technical standards to the Commission, combining draft regulatory technical standards developed under Articles 8(4), 9(6) and 11(5) of the Sustainable Finance Disclosures Regulation.

In view of the interconnectedness of the 13 draft regulatory technical standards and to ensure that the requirements they introduced are fully consistent, the Commission has bundled the 13 standards in a single legal act. A single legal act also makes it easier to locate provisions on sustainability-related disclosures in the financial services sector.

The Commission carried out legal review of the submitted draft regulatory technical standards and, whilst not changing any substantive requirements, adapted the provisions of the standards to ensure legality and legislative quality of this Regulation as well as consistency of the rules in this Regulation with the Sustainable Finance Disclosures Regulation. In order to avoid duplication of rules in enacting terms and annexes to this Regulation certain provisions in enacting terms were dropped".

 

The RTS after the adoption by the European Commission must be submitted to the European Parliament or the Council which may object to the draft RTS within a period of three months from the date of notification of the RTS adopted by the Commission. Therefore, the final RTS may be different to the draft RTS in the ESAs’ final report as well as to the Commission Delegated Regulation of 6 April 2022.

Recital 40 of the said Regulation reads:

"It is necessary to enable financial market participants and financial advisers to adapt to the requirements laid down in this Delegated Regulation. Its date of application should therefore be deferred to 1 January 2023. It is, however, necessary to require financial market participants that have considered principal adverse impacts of investment decisions on sustainability factors as referred to in Article 4(1), point (a), of Regulation (EU) 2019/2088, or as required by Article 4(3) or (4) of that Regulation, by 31 December 2022, to publish the first time the information on those impacts on their websites in separate sections titled ‘Statement on principal adverse impacts of investment decisions on sustainability factors’ by 30 June 2023 for the period of 1 January 2022 until 31 December 2022",

 

Application timeline for products’ periodic reporting

 

 

Periodic reports referred to in Article 11(2) of the SFDR must comply with the requirements laid down in that Article from 1 January 2022.

 

The SFDR applies other sustainability-related disclosure requirements after 10 March 2021.

 

This means that financial market participants must draw up in 2022 respective periodic reports referred to in Article 11(2) in compliance with the SFDR, irrespective of reference periods.

 

For the requirements relating to those periodic reports, the draft RTS can also be used as a reference for the purposes of preparing for the application of Article 11 of the SFDR.

 

The ESAs proposed that the requirements of Chapter V of the RTS would only apply to periodic reports published in or after 2022 in relation to reference periods starting from 1 January 2022, while the periodic reports published in 2022 in relation to reference periods starting before 1 January 2022 would apply the high level and principle based requirements in Article 11(1) of the SFDR.

 

In particular, Articles 8(2a) and 9(4a) of the SFDR apply in respect of the environmental objectives referred to in points (a) and (b) of Article 9 of the Taxonomy Regulation from 1 January 2022 and in respect of the environmental objectives referred to in points (c) to (f) of Article 9 of the Taxonomy Regulation from 1 January 2023.

 

 

Application of the 500-employee threshold for principal adverse impact reporting at entity level to parent undertakings of a large group

 

 

Article 4(3) SFDR applies to financial market participants exceeding on their balance sheet dates the criterion of the average number of 500 employees during the financial year.


 
Article 4(4) SFDR requires, from 30 June 2021, “financial market participants which are parent undertakings of a large group as referred to in Article 3(7) of Directive 2013/34/EU5 exceeding on the balance sheet date of the group, on a consolidated basis, the criterion of the average number of 500 employees during the financial year shall publish and maintain on their websites a statement on their due diligence policies with respect to the principal adverse impacts of investment decisions on sustainability factors”.

 

The application of the 500-employee threshold for principal adverse impact reporting raised some doubts, which have been voiced in the European Supervisory Authorities (ESAs) letter of 7 January 2021 to the European Commission (Priority issues relating to SFDR application, JC 2021 02).

The issues to be settled in this regard by the European Commission are:

  • Must the calculation of the 500-employee threshold to the parent undertaking of a large group be applied to both EU and non-EU entities of the group without distinction as to the place of establishment of the group and/or subsidiary?
  • Does the due diligence statement include impacts of the parent undertaking only or must it include the impacts of the group at a consolidated level?

The clarity in the above areas are absolutely vital for the proper application of the SFDR.

 

 

Integration of sustainability risks in pre-contractual disclosures

 

 

According to Article 3 SFDR:

 

1. financial market participants are required to publish on their websites information about their policies on the integration of sustainability risks in their investment decision-making process;

 

2. financial advisers are required to publish on their websites information about their policies on the integration of sustainability risks in their investment advice or insurance advice.


According to Article 6 of SFDR:

 

1. financial market participants are required to include descriptions of the following in pre-contractual disclosures:

(a) the manner in which sustainability risks are integrated into their investment decisions; and

(b) the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available;

 

2. financial advisers are required to include descriptions of the following in pre-contractual disclosures:

(a) the manner in which sustainability risks are integrated into their investment or insurance advice; and

(b) the result of the assessment of the likely impacts of sustainability risks on the returns of the financial products they advise on.

 

Where financial market participants or financial advisers deem sustainability risks not to be relevant, the descriptions referred to above must include a clear and concise explanation of the reasons therefor.

However, it needs to be noted that the scope of application of these requirements is very broad, in particular, it is not restricted to products or funds labelled as an “ESG” or “green”.

For a financial product with a diverse strategy, that is widely marketed, it will be difficult to definitely prejudge that sustainability risks are not relevant.

The possible reasons for such an exclusion of sustainability risk can potentially be:
- the bespoke purpose of the product or fund,
- short shelf life of the product or fund,
- specific investment strategies, particularly accommodating investor’s needs.

 

 

Principal adverse impacts (PAI)

 

 

The said ESA’s Joint Consultation Paper of 23 April 2020 observes that “while ESG products are becoming more popular in Europe, justifying common harmonised product disclosure rules, the area of principal adverse impact reporting is relatively new”.

 

According to Recital 8 of the SFDR “financial market participants and financial advisers should be required to disclose specific information regarding their approaches to the integration of sustainability risks and the consideration of adverse sustainability impacts”.


Recitals 18 and 20 of the SFDR read: 

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Arrow-right PAI

 

 

"Where financial market participants, taking due account of their size, the nature and scale of their activities and the types of financial products they make available, consider principal adverse impacts, whether material or likely to be material, of investment decisions on sustainability factors, they should integrate in their processes, including in their due diligence processes, the procedures for considering the principal adverse impacts alongside the relevant financial risks and relevant sustainability risks.

The information on such procedures might describe how financial market participants discharge their sustainability‐related stewardship responsibilities or other shareholder engagements.

Financial market participants should include on their websites information on those procedures and descriptions of the principal adverse impacts";

 

"Financial market participants which consider the principal adverse impacts of investment decisions on sustainability factors should disclose in the pre‐contractual information for each financial product, concisely in qualitative or quantitative terms, how such impacts are considered as well as a statement that information on the principal adverse impacts on sustainability factors is available in the ongoing reporting. Principal adverse impacts should be understood as those impacts of investment decisions and advice that result in negative effects on sustainability factors." 

 

 

Application of Article 8 SFDR

 

 

Article 8 SFDR aims to enhance transparency on products “promoting environmental or social characteristics” in pre-contractual disclosures.

 

It applies: “Where a financial product promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics” (so-called "light green funds").

 

ESAs’ letter of 7 January 2021 to the European Commission (Priority issues relating to SFDR application, JC 2021 02) identifies the following questions regarding the application of Article 8 of the SFDR and the meaning of “promotion” in the context of products promoting environmental or social characteristics:

  • Can the name of a product, which may include words like “sustainable”, “sustainability”, or “ESG” be considered to qualify a product to be promoting an environmental or social characteristic or to be having sustainable investment as its objective?
  • While a financial product to which Article 8 applies does not need to explicitly promote itself as targeting sustainable investments (within the meaning of Article 2(17) SFDR), would a reference to taking into account a sustainability factor or sustainability risk in the investment decision be sufficient for Article 8 to apply? If the answer is yes, how can financial market participants that disclose mandatory information according to Article 6(1) or Article 7(1) SFDR ensure that this is not automatically considered as “promoting environmental or social characteristics”.
  • Must a product to which Article 8 applies invest a minimum share of its investments to attain its designated environmental or social characteristic in order to be considered to be promoting environmental or social characteristics?
  • In the absence of active advertising of an environmental or social characteristic of the product, would an intrinsic characteristic of the product, such as a sectoral exclusion (e.g. tobacco) which is not advertised, also qualify as “promotion”?
  • In addition, would complying with a national legal obligation, which applies to the financial market participant, such as a ban on investment in cluster munitions, also bring the product into the scope of Article 8?

 

Application of Article 9 SFDR

 

 

Article 9(1) and (2) SFDR apply: “Where a financial product has sustainable investment as its objective” - so-called "dark green funds").

 

In addition, Article 9(3) requires:

Where a financial product has a reduction in carbon emissions as its objective, the information to be disclosed pursuant to Article 6(1) and (3) shall include the objective of low carbon emission exposure in view of achieving the long-term global warming objectives of the Paris Agreement.

By way of derogation from paragraph 2 of this Article, where no EU Climate Transition Benchmark or EU Paris-aligned Benchmark in accordance with Regulation (EU) 2016/1011 of the European Parliament and of the Council ( 1 ) is available, the information referred to in Article 6 shall include a detailed explanation of how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the long-term global warming objectives of the Paris Agreement.

The above ESAs’ letter of 7 January 2021 identifies the following questions regarding the application of Article 9 of the SFDR:

  • Must a product to which Article 9(1), (2) or (3) SFDR applies only invest in sustainable investments as defined in Article 2(17) SFDR? If not, is a minimum share of sustainable investments required (or would there be a maximum limit to the share of “other” investments)?
  • Where an EU Climate Transition Benchmark (EU CTB) or EU Paris-aligned Benchmark (EU PAB) exists, is it necessary for a product to track an EU PAB or an EU CTB on a passive basis for Article 9(3) SFDR to apply to it?
  • If the questions above are answered in the affirmative and if the minimum standards of an EU PAB or an EU CTB do not require the index components to be sustainable investments, can the product fall within the scope of Article 9(3) SFDR?

 

 

Application of SFDR product rules to MIFID portfolios and other tailored products

 

 

The SFDR applies to financial market participants and financial advisers, investment firms which provide portfolio management, including.

The above ESAs’ letter of 7 January 2021 emphasises the following ambiguities regarding the application of SFDR product rules to MIFID portfolios and other tailored products:

  • For portfolios, or other types of tailored financial products managed in accordance with mandates given by clients on a discretionary client-by-client basis, do the disclosure requirements in SFDR apply at the level of the portfolio only or can they apply at the level of standardised portfolio solutions?
  • If the disclosure requirements of SFDR apply at the portfolio level, how is it possible to maintain confidentiality obligations to the client in view of the disclosures required, especially the website disclosures required by Article 10 SFDR?