The Sustainable Finance Disclosure Regulation (SFDR) is a mandatory European Union (EU) regulation that requires increased disclosure on environmental, social, and governance (ESG) and sustainability claims for sustainable investment products, primarily through enhanced product labeling. The SFDR defines a "sustainable investment" as an investment in an economic activity that contributes to an environmental or social objective.
The SFDR is the first product labeling regulation of its kind to introduce strict labeling for ESG-related products. Improved oversight and requirements from this regulation can mitigate greenwashing and false claims that have been previously unrestricted.
All participants in the EU's financial industry, including those who market products into the EU, should understand why and how the SFDR will affect their investment and other financial activities. Entities should keep up with updates as there have been notable delays with SFDR implementation.
Our high-level guide will go over information businesses should know about the SFDR. Review the EU’s official SFDR text (Regulation (EU) 2019/2088) for more detailed information.
Who Needs To Follow The SFDR?
The SFDR's broad scope applies to all financial advisers (FAs) and financial market participants (FMPs) based in the EU.
The SFDR defines FAs as entities that provide investment or insurance advice. FAs with fewer than three employees are not required to provide information. However, the SFDR requires FAs to consider and factor in sustainability risks in their advisory process.
Examples of FAs include credit institutions that provide investment advice,
investment firms that provide investment advice, and insurance intermediaries that provide advice concerning insurance-based investment products (IBIPs).
The SFDR defines FMPs as entities that manufacture financial products, including portfolio management services.
Examples of FMPs include investment firms that provide portfolio management, insurance undertakings that make available an insurance‐based investment product, and Alternative Investment Fund Managers (AIFMs).
Investment managers and advisers outside the EU must also comply if they market or appear to market products to EU clients.
On the product level, SFDR applies to various categories like Undertakings for Collective Investment in Transferable Securities (UCITS), alternative investment funds, and pension schemes or products.
The SFDR includes some exemptions in Article 17, but EU member states may still apply SFDR requirements to exempt entities.
What Are The Main Goals Of The SFDR?
The SFDR aims to change the financial sector's behavior when making ESG-related claims, promote sustainable and responsible investments, and discourage greenwashing.
Mandated transparency surrounding ESG-related claims can combat ambiguity and hold firms accountable for those claims. The SFDR achieves this transparency through comprehensive technical reporting and disclosure standards through the Regulatory Technical Standards (RTS).
This provides both FAs and FMPs guidelines to evaluate and label products accurately. Mandated compliance provides an additional layer of accountability not present before the SFDR.
Standardized requirements and thorough reports can also provide users with better information to understand and compare the sustainability characteristics of financial products and firms. As a result, investors and other stakeholders will be provided with more transparency over the ESG performance of the financial product and or advice.
These advancements can also help combat greenwashing related to financial products, as FAs and FMPs must now comply with the SFDR before making claims or applying labels.
What Are The SFDR's Requirements?
The SFDR sets requirements for three overarching areas:
- How FMPs and FAs should communicate to inform end investors about sustainability risks
- How FMPs and FAs should disclose an investment's impact on the environment and society
- How financial products marketed as sustainable meet that objective
These requirements are segmented and released in two phases: level 1 (already in effect) and level 2.
Level 1 focuses on broad entity-level disclosures around topics such as the entity's policies regarding principal adverse sustainability impacts (PASIs) and related actions.
Level 1 does not include technical details on calculating and presenting this information—details will be included in level 2. At this point, firms can report on a "comply or explain" basis.
Level 2 focuses on more detailed entity- and product-level disclosures. Specifically, it will center around sustainability factors, risks, and technical disclosure for sustainability products.
This article includes only a broad overview of the SFDR's requirements. The original text of the SFDR, the RTS, and other updates will have more technical explanations that companies can refer to for details.
For example, the three European Supervisory Authorities (ESAs) provided key clarification of the SFDR’s RTS in June 2022. This update included information on the use of sustainability indicators and more clarity on "do not significantly harm" disclosures.
Sustainability Risks And Principal Adverse Impacts
Firms should understand the definitions of these two terms before reviewing the requirements.
- Sustainability risks refer to how ESG events or conditions can bring potential or real negative impacts on an investment's value.
- Principal adverse impacts (PAIs) refer to the negative effect that investment advice or decisions can have on sustainability factors.
The SFDR specifies "sustainability factors" as respect for human rights; anti-corruption and anti-bribery matters; and employee, social, and environmental matters.
Entity-level Disclosure Requirements
FMPs and FAs must follow disclosure requirements to keep investors and other customers informed of their processes. Find an overview of these entity-level requirements below.
FMPs must publish and maintain information on their websites where they consider PAIs on sustainability factors for investment decisions. They must also include a statement on their due diligence policies, considering the nature and scale of their activities, size, and the types of financial products they make available.
FMPs that are parent undertakings of a large group with more than 500 employees (on a consolidated basis) must also publish this same statement. FMPs with fewer than 500 employees are not required to create and publish these statements, but they must explain their reasoning on their website.
FMPs must include the following information at minimum when creating the above statements:
- Policies on how they identify and prioritize PASIs and indicators
- Description of PASIs and related actions or (if relevant) planned actions
- Summaries of engagement policies aligned with Article 3g of Directive 2007/36/EC, where applicable
- Reference to the reporting entity's alignment to responsible business conduct codes and internationally recognized standards for due diligence and reporting
- Level of alignment with the Paris Agreement's objectives, where relevant
- Assessment results of the likely impacts of sustainability risks on the returns of financial products they make available/advise on
FMPs must also publish when and why they don't consider PAIs on sustainability factors. If they plan to consider them, they must also disclose that intention and when they will do so.
FAs must publish and maintain information on their website about whether they consider PAIs on sustainability factors in their investment or insurance advice, taking into account the nature and scale of their activities, size, and types of financial products they advise on.
If they don't currently consider those, FAs must explain why they don't consider PAIs of investment decisions on sustainability factors in investment or insurance advice. If they plan to consider them, they must also disclose that intention and when they will do so.
The RTS includes more detailed information on the content, presentation, and methodologies of all required information regarding the sustainability indicators related to PAIs on:
- Climate and other environment-related adverse impacts
- Respect for human rights
- Anti-corruption and anti-bribery matters
- Social and employee matters
In remuneration policies and on their website, FMPs and FAs must also include how their remuneration policies are consistent with the integration of sustainability risks.
In pre-contractual disclosures, FMPs and FAs must include descriptions of how they incorporate sustainability risks into investment decisions or investment and insurance advice. They must also include results of the assessments they've made on the likely effect of sustainability risk on the returns of financial products they make available or advise on.
FMPs and FAs must include a succinct explanation of when they decide sustainability risks are irrelevant. Article 6, paragraph 3 of the SFDR goes into more detail about how specific firms can present and disclose this information.
Additional Requirements For Information Disclosure
The SFDR also includes details on how firms must disclose information in different media, like websites and reports, along with other requirements for maintaining that information.
For example, the information listed on websites must be in an easily accessible area of the site and presented in a simple, concise, and accurate way. Marketing communications must not contradict any of the information disclosed.
Businesses can find more detailed information on different topics in the following articles from the SFDR:
- Article 10 includes requirements for posting product-related information on websites.
- Article 11 includes requirements for including information in periodic reports, with technical requirements included in the RTS.
- Article 12 includes guidance for maintaining and updating disclosures.
- Article 13 includes guidance for marketing communications, with technical requirements included in the RTS.
Businesses should first understand product classifications to understand product-level requirements. Below are the three main classifications:
- Article 6 refers to products that don't integrate sustainability considerations into the investment process, including non-ESG funds. Asset managers must disclose how sustainability risks are integrated or explain why they weren't integrated.
- Article 8 (labeled light green) refers to products with some investment strategy focused on environmental and/or social objectives, given that the investment companies have good governance practices.
- Article 9 (labeled dark green) refers to products with a full investment strategy toward an environmental or social objective.
Level 1 established these categorizations. Level 2 brings stricter interpretations and additional requirements for each category.
Businesses should be aware that these product categories are subject to change while technical standards are finalized. For example, the new standards may establish additional requirements for verification or requirements for auditors.
Product-level Disclosure Requirements
Product-level SFDR requirements primarily focus on Article 8 and 9 products. The RTS establishes technical requirements for the content and presentation of this information.
For products classified under Article 8, firms must provide information on how these objectives are met. If an index is identified as a reference benchmark, firms must include information on how the index is consistent with the product's characteristics.
For products classified under Article 9, different criteria apply:
- If an index is identified as a reference benchmark, firms must include information on how it aligns with the product’s objective and explain how and why it differs from a broad market index.
- If an index is not identified as a reference benchmark, firms must explain how the product’s objectives will be met.
- If the financial product includes an objective to reduce carbon emissions, the reporting entity must present those objectives in the context of reaching the Paris Agreement’s long‐term global warming objectives.
For Article 8 and 9 products, firms must identify where users can find the methodology used to calculate the index.
If an FMP has marketed their product as Article 8 or 9, the SFDR requires them to disclose the fund's performance against each PAI, based on the four quarter ends (with the first reference period from January 1, 2022 to December 31, 2022). Entities must publish this information by June 30, 2023.
FMPs must also explain if financial products consider PAIs on sustainability factors and, if so, how this consideration is determined products determine. FMPs must also include a statement that information regarding PAIs on sustainability factors will be available in the relevant format stated in Article 11(2). When FMPs don't consider PAIs for investment decisions on sustainability factors, FMPs must include a statement explaining their reasoning.
How Does The SFDR Contribute To Other EU Initiatives?
The SFDR complements corporate disclosure rules from the EU's Non-Financial Reporting Directive (NFRD) and the expanded requirements under the NFRD's successor, the Corporate Sustainability Reporting Directive (CSRD).
These laws are part of a larger sustainable finance package the European Commission adopted to increase financing toward climate-friendly activities in the EU. This contributes to the EU’s larger effort to become climate neutral by 2050.
The SFDR is in the phased implementation process, with additional developments anticipated in the coming year. Below are key milestones for the SFDR.
- May 2018: SFDR proposed as part of the European Commission's Sustainable Finance Action Plan
- November 2019: SFDR draft introduced
- March 2021: Level 1 requirements took effect
- January 2023: Level 2 requirements (including finalized RTS) anticipated to take effect
- June 2023: Deadline to report performance for the first reference period through the PAI statement and other Level 2 SFDR disclosure requirements
Below are additional questions businesses may have related to the SFDR.
How Does The SFDR Work With EU Taxonomy?
The EU Taxonomy's classification system will primarily impact product-level disclosures, more so for article 9 products. It designates accepted definitions for environmentally sustainable economic activities. Businesses can see examples of the EU Taxonomy's impact as some firms continue to downgrade Article 9 products to Article 8.
Does SFDR Apply To The US, UK, And Other Non-EU Areas?
The SFDR doesn't apply to non-EU entities unless they are marketing or appearing to market to EU clients. However, other countries may develop similar requirements as more countries adopt forms of company carbon disclosure mandates. For example, the U.K.'s Sustainability Disclosure Requirements (SDR) is similar to the EU's SFDR.
How Can Organizations Prepare For SFDR Compliance?
Reporting organizations can prepare for SFDR compliance by keeping up with news on clarifications or additions, understanding how the SFDR applies to their organization and products or services and evaluating how their firm's current integration of sustainability risks compares to the SFDR's requirements.
European authorities have been rolling out additional technical requirements as the European Commission evaluates the effectiveness of this new regulation, with the most recent update in November. Awareness and education are two ways to keep teams informed and prepared for compliance.
A FA or FMP previous processes for ESG-related classification and due diligence may fall short of the SFDR's in-depth requirements, and collecting data and performing analyses to remain compliant can become a daunting task without adequate tools.
Climate Management and Accounting Platforms (CMAPs) are one solution businesses can use to streamline data collection and reporting. Persefoni's CMAP can support investor-grade reporting for the carbon emissions metrics needed to comply with the SFDR. Namely, it's equipped to help with scope 1, 2, and 3 emissions calculations needed for product labeling.
Meaningful SFDR-aligned reporting needs actual calculations for each of the PAIs. Persefoni's CMAP focuses on driving the move from proxy data and assumptions to actual data-supporting entities reporting against SFDR.
Learn more about how Persefoni’s carbon accounting solution can help your organization comply with SFDR and other sustainability disclosures.