What is the Sustainable Finance Disclosure Regulation (SFDR)?
The past few years have seen initiatives to ensure transparency and accuracy of sustainable finance on multiple fronts. An important one for investors is the SFDR, which helps redirect capital towards sustainable businesses and prevent greenwashing by requiring all EU asset managers and non-EU companies that market products in the EU to detail their sustainability processes (including the risks and impacts) at a product, service and entity level.
It can be very challenging to get ESG investing right but the SFDR should give investors confidence that the funds they allocate will make a tangible difference in the fight against climate change. This is a major step for European markets and sustainable finance.Trevor Allen, Sustainability Research Analyst
BNP Paribas Markets 360
What does the SFDR cover?
The SFDR concerns:
- Financial market participants (FMPs), who manufacture or provide certain “financial products”, i.e. portfolio managers, fund managers and pension providers
- Financial advisers (FAs), i.e. providers of investment or insurance advice
One article of the regulation in particular relates to the ‘Principal Adverse Impacts’ – a statement that FMPs or FAs are required to publish on their websites. This statement describes the adverse impacts of their investment decisions on sustainability factors and details the due diligence policies of those investments (accounting for size, nature and scale of the activities), or a detailed explanation of why the FMP is not complying with the regulation. This creates a robust transparency and accountability detailing the potential impact an investment has on the environment.
This new regulation will impact the way firms manage and market their sustainable investment in the EU and potentially globally. EEA (the European Economic Area) firms and companies will most likely have to oblige to ESG disclosure. Banks and investors can work together to smoothly implement these requirements, they will need to act relatively fast.Anne-Laure Dorkel, Deputy Head of Global Markets Regulatory
Entity level disclosures represent the first round required by the SFDR, which is live today. The second part of this legislation, which covers the labelling and disclosure requirements of ESG and impact investments, is set to go live in January 2022. In addition, by 30 June 2023, FMPs must complement that disclosure with details related to a choice from 20 suggested data points (18 that are mandatory and 2 indicators that can be selected from a choice of 46 social and environmental data points) as well as any others that the FMP deems relevant to their investment decisions.
What are the benefits and limitations?
Benefits: the SFDR will strengthen transparency and comparability between ESG funds with standardised data thereby directing more capital towards sustainable businesses. It will also drive companies to reinforce their overall investment strategy, reducing the risk of greenwashing.
Limitations: as the SFDR standards leave some discretion to fund managers; further standardisation may be required, increasing alignment with other sustainability frameworks like the EU Taxonomy, and expanding its tools for assessing how sustainable specific activities are. The descriptive key performance indicators listed in the annex of the SFDR appear to have a predilection towards reducing emissions and waste from business activities, benefiting companies that are already in a position to begin their transition today. However, with current data limitations, social factors could still be a struggle to quantify while we await a social taxonomy reference point.
Two of the main global challenges of SFDR are the lack of data consistency and a unified ESG disclosure. Without the latter, companies could face multiple guidelines from exchanges, local governments and national organisations, potentially causing confusion on which to follow and ultimately lowering confidence in sustainably labelled products. Since foreign funds labelled as ESG or impact funds, and that are sold into Europe, will be subject to this regulation, the SFDR could become a reference to help harmonise ESG and impact fund standards globally.
With SFDR, the EU is pushing firmly ESG into the mainstream. Clearly, ESG integration is no longer “a nice to have” in Europe. The regulation is also reshaping the EU sustainable investing landscape with some large players having already announced that they are repositioning majority of their funds in Europe according to Article 8 or 9. However, it is fair to say that the hardest part is yet to come with fund managers required to soon disclose against a raft of complex and varied indicators both at entity and at product levels.Emmanuelle Aubertel, Global Markets ESG Advisor
The SFDR is a key milestone for EU financial markets, as it will help give more credibility and transparency to EU asset managers and non-EU companies providing products and services in the region, lowering the risks of greenwashing. Even though it is not a global initiative, in the future we could see the SFDR create regional harmonisation, and become a reference for financial markets as regards sustainability standards.
Global initiatives to enhance sustainable finance regulatory frameworks:
- US: The Securities and Exchange Commission (SEC) has not mandated disclosure of ESG criteria. However, it has announced that a mandatory framework is under development. The International Organization of Securities Commissions (IOSCO) has also appointed the SEC and the Monetary Authority of Singapore (MAS) as co-leads of a new technical expert group for sustainability reporting standards.
- UK: The government is aiming for mandatary disclosures aligned with the Task Force on Climate-related Financial Disclosures (TCFD) across non-financial and financial sectors by 2025. UK asset managers with asset under management in excess of GBP50bn are to be subject to TCFD disclosure from 2022.
- China: Heavily polluting companies have a mandatory obligation to disclose their environmental impact. China was planning to extend the rule to all companies by 2020, but postponed it due to the pandemic and is now expected to implement it this year. ESG reporting is mandatory for companies listed on the Stock Exchange of Hong Kong (SEHK).
- Japan: The Governance Code has been incorporated into the Tokyo Stock Exchange’s (TSE) listing rules. It includes disclosure on corporate governance structure and measures on sustainability issues.
- Korea: The Korea Exchange (KRX) announced new mandatory ESG disclosure requirements in January 2021. Companies listed on the main Kospi market with more than KRW2trn in assets will have to disclose ESG reports by 2025. This will be extended to all companies in 2030.
- India: The Securities and Exchange Board of India (SEBI) requires the 500 largest listed companies to publish annual business responsibility reports. It recently extended the requirement to 1000 companies on a voluntarily basis from fiscal 2022, and compulsory from fiscal 2023.
Initiatives to strengthen sustainable finance up to date
- The launch of a global Task Force for Climate-Related Financial Disclosures (TCFD) framework in 2017, to improve and increase reporting of climate-related financial information, which the UK last year agreed to adopt between 2022-25.
- Central bank discussions and actions focussing on climate change, including recent climate scenario stress testing by the European Central Bank (ECB), and the 2021 Network for Greening the Financial System (NGFS) technical paper that outlines ways central banks could help combat climate change.
- The Biden administration’s swift reversal of the US climate policy. This includes re-joining the Paris Agreement (2021), co-chairing sustainable finance working groups with Singapore (IOSCO) and China (G20), and the SEC investigating instances of greenwashing.
- China’s commitment to work on a sustainable taxonomy, harmonised with the EU’s, and advocating a global taxonomy.
- Net-Zero Asset Manager initiative – a group of 73 firms managing one-third of global AUM (USD32trn), targeting net-zero emissions by 2050 across all their holdings.
- Net-Zero Bank Alliance – a United Nations Environmental Programme Finance Initiative – which BNP Paribas joined – bringing 35 firms managing USD 5.6 trn, targeting net-zero emissions by 2050 across all their investment
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