While international environmental, social and governance (ESG) voluntary standards and frameworks have been around for a while, new European ESG-related regulatory requirements impacting most industries have substantially emerged in recent months.
The EU Sustainable Finance Action Plan is one of the most significant examples. With a series of regulations, directives and standards, the Plan aims to reorient capital flows towards a more sustainable economy and integrate ESG factors into risk management processes. One of the key components of this plan is the Sustainable Finance Disclosure Regulation (SFDR).
SFDR from 2021 to 2023: a rapidly changing regulatory framework to which players have to adapt
Regulation (EU) 2019/20881 on sustainability‐related disclosures in the financial services sector (often referred to as “SFDR Level I”) has been applicable since March 2021 and aims to improve transparency and standardization of ESG disclosures for financial products and services. Its purpose is to enable investors to make more informed investment decisions by requiring financial market participants and advisors (financial entities) to provide reliable and comparable ESG data. SFDR also introduced the classification of financial products which is now widely accepted by the market. Article 8 refers to financial products promoting E and S characteristics with no sustainability objective (“light green”) whereas Article 9 classifies financial products with a sustainability objective (“dark green”). Article 6 is used for all other financial products.
SFDR Level I establishes core disclosure requirements but does not directly expand on all technical details. As such, it has since been supplemented by the Commission Delegated Regulation (EU) 2022/12882 (also known as “SFDR Level II” or “SFDR Regulatory Technical Standards - RTS”) which entered into force in January 2023. SFDR Level II further clarifies disclosure requirements for financial market participants, advisors and their related financial products, mandating specific reporting templates and granular data points.
On 20 February 2023, further amendments to SFDR Level II came into force, with Commission Delegated Regulation 2023/3633. These amendments enable financial entities to disclose, and investors to identify, any environmentally sustainable fossil gas and nuclear related activities that their financial products invest in.
As per the SFDR RTS requirements, in scope financial entities should disclose how they take sustainability risks into account, either in qualitative or quantitative terms, when manufacturing, or distributing their financial products. This means that pre-contractual disclosures by financial advisors should, for example, account for risk assessment outcomes in addition to the associated pre-contractual disclosures by financial market participants. Financial entities are also expected to communicate on the environmental and social characteristics of their financial product and the level of achievement of the product’s ESG objectives, describing the sustainability indicators used.
Furthermore, financial players must disclose additional aspects, such as principal adverse impacts (PAIs), and how well they “do no significant harm” (DNSH) to any environmental or social investment objectives. Top investments and the related economic sectors and subsectors should be clearly explained, together with the specification of whether any investments are aligned with the EU Taxonomy4. Finally, financial products may also designate an index as a reference benchmark in order to further reinforce the attainment of their environmental and social characteristics or sustainable investment objective(s). This information follows the initiative of the EU to ensure sustainable clarity to end investors.
The SFDR requirements lay down harmonized rules for financial market participants and financial advisors. SFDR introduces mandatory ESG disclosure requirements for all asset managers (IFMs) and other financial entities (including AIFMs, UCITS fund managers, management companies, credit institutions, insurance companies, portfolio managers and financial advisors) and their related financial products (e.g., UCITS, AIFs, insurance and pension products).
The CSSF actively supervises the application of SFDR. Starting in March 2021, the Luxembourgish regulator regularly published relevant releases and guidance to support financial participants in interpreting the latest updates regarding sustainable finance regulations. As clarified in the most recent communication on6 April 20235, the CSSF strives to accompany the transition of the financial sector and its players in a proactive way.
Navigating SFDR RTS in practice
As stated earlier, financial products classified as Article 8 or 9 under SFDR have been obligated to comply with the SFDR Level II disclosure content and structure since January 2023. This requires the update of pre-contractual, periodic and website documentation in line with new regulatory templates. The recent nature and evolving changes of this regulation have triggered significant challenges in its application for the majority of financial market participants.
First and foremost, the latest regulatory templates (so called “Annexes II, III, IV, V”) with gas and nuclear amendments (in force as of 20 February 2023) have led to a general struggle with disclosures felt by financial entities, predominantly due to the strict structural requirements and unavailability of editable versions (only recently released by ESMA6 ).
Identification of the relevant sustainability indicators and collection of ESG data in a timely manner emerged as the most burdensome aspects to be addressed. The reason is that even with access to the third-party data providers, measurement of generated positive impact or avoided negative externalities remains non-trivial.
An additional point of attention is the extent to which financial market players aim to target EU Taxonomy-related investments. An EY survey7 undertaken in 2022 found that in the case of credit institutions, for example, the potential contribution to the EU’s environmental objectives, expressed in eligible assets ranges from 0% to 55%, with an average of 30%, suggesting that the integration of EU Taxonomy criteria in investment decisions is set to expand further.
Another common challenge encountered by many financial entities is related to the PAIs disclosure. The PAIs became a driving force of the sustainable finance regulation as they represent the key metrics to assess the impact of investments on social and environmental factors. However, this concept remains challenging for many stakeholders. For that reason, the European Commission published a series of Q&As to answer the queries raised by the European Supervisory Authorities (ESAs) to clarify the applicability of PAIs, the method of calculations, and standards of disclosures.
The use of a reference benchmark and broad market index remains rarely utilized by entities’ products, with the exception of few market leading players. This is likely due to its non-mandatory nature within SFDR.
What’s expected next?
It is important to highlight that SFDR is constantly evolving. Crucial changes are being continuously reviewed and discussed at the regulatory level to enhance the Regulation. For instance, the EU Commission has mandated the Joint Committee of the ESAs to review the SFDR RTS to broaden the disclosure framework and to address technical issues that have arisen since SFDR was originally adopted. The outcome of the Joint Consultation Paper8 issued on 12 April 2023 is mainly focused on a potential extension of the list of social indicators for PAIs, the inclusion of greenhouse gas emission reduction targets disclosures, a simplification of the templates, the upgrade of DNSH disclosures and the technical revision of the PAI framework.
Some of the above-mentioned complexities have also led, in part, to the market-wide reclassifications from financial market participants who proceeded, in certain occasions, with the downgrades of Article 9 products to Article 8. From September to December 2022 for example, 307 financial products (representing approximately 40% of the Article 9 category) were shifted to Article 89 . This observation suggests that whilst new regulation helps investors compare available sustainable investment options and better understand the extent to which products integrate social and environmental considerations, a lot is yet to be done in relation to the availability of reliable ESG data, building internal processes and clear disclosures to ensure investments are ultimately aligned with investors’ sustainability goals.
To conclude, SFDR supports investors in making better sustainable investing choices by establishing more clarity and standardization in the financial markets. Although achieving full transparency in financial markets remains a challenging task, regulations such as SFDR are significantly contributing towards this goal.
Voluntary limited assurance over SFDR disclosures is envisaged to become an important instrument by market players who would like to ensure that not only are their disclosures prepared in a transparent, precise and efficient manner, but that the processes and controls behind them are fully operational and robust in nature.
[1]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, Official Journal of the European Union
[2] Commission delegated regulation (EU) 2022/1288 of 6 April 2022, Official Journal of the EU
[3] Commission delegated regulation (EU 2023/363 of 31 October 2022, Official Journal of the EU
[4]Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088, Official Journal of the EU
[5]« The CSSF’s supervisory priorities in the area of sustainable finance », 6 April 2023, CSSF
[6] ESMA, Cross sectoral work, templates in rubrique « Sustainable Finance Disclosure Regulation »
[7] EY EU Taxonomy Barometer 2022
[8] Joint consultation on the review of SFDR Delegated Regulation From 12 April 2023 to 04 July 2023, ESMA
[9] SFDR Article 8 and Article 9 Funds: Q4 2022 in Review, Morningstar
