What is SFDR?: Understanding the Sustainable Finance Disclosure Regulation

Many investors nowadays are eager to embrace sustainable practices and take part in sustainable transactions. However, the complex and ever-changing EU regulatory landscape might be a bottleneck. That’s why we are breaking down the basics of the Sustainable Finance Disclosure Regulation (SFDR) – one of the cornerstones of EU sustainability regulations in the world of finance.

In this blog, we’ll start by defining SFDR and outlining the three key criteria for a “sustainable investment.” Then, we’ll explore how SFDR connects with the other significant sustainability regulation: the EU Taxonomy. Lastly, we’ll delve into the complexities and possibilities of SFDR within the sustainable finance realm.

Let’s start with a definition. 

What is SFDR?

SFDR is a framework created by the EU to promote openness and transparency in sustainable finance transactions. In essence, it requires Financial Market Participants (FMPs) to share the environmental and social impact of their transactions with stakeholders.

The goal of the framework is to help investors make informed decisions and understand how sustainability risks may affect their investments. SFDR’s disclosure requirements ward against ‘greenwashing’—making false claims about sustainable impact— ultimately making it easier for so-called ‘end-investors’ in funds to distinguish between authentic sustainable efforts and greenwashing attempts.

Essentially, SFDR is meant to build trust and confidence in sustainable finance, fostering a responsible and resilient financial sector that is committed to positive environmental and social outcomes.

What makes an investment “sustainable”?

In simple terms, the SFDR defines “sustainable investments” as those that aim to make a positive impact on the environment and society, while meeting predefined criteria to ensure they do not cause significant harm.

For an investment to qualify as “sustainable” under SFDR, FMPs must demonstrate alignment with three core Elements.

3 Elements of SFDR

To be deemed “sustainable,” an investment must:

• Contribute to an environmental or social objective
• Do-no-significant-harm to any other environmental or social objectives
• Uphold good governance practices.

Notice how these principles align with the well-known concept of Environment, Social, and Governance (ESG).

Examples of environmental objectives encompass carbon neutrality, renewable energy adoption, waste reduction, and water conservation. Under the Social objectives umbrella, you can find diversity and inclusion, employee well-being, human rights protection, and the like. Lastly, good Governance practices entail robust management structures, positive employee relations, fair staff remuneration, and adherence to tax compliance.

By adhering to these Elements, investments can be defined as genuinely “sustainable,” bolstering the pursuit of a more responsible and impactful approach to financial decisions.

Now that we have a clear definition of sustainable investments, lets talk about sustainability at both product and entity levels.

SFDR, ESG or EU taxonomy?

SFDR works in conjunction with other significant sustainability regulations being implemented by the EU, primarily the EU Taxonomy. So in order to understand SFDR to its full extent, it is essential to place it within the broader context of EU sustainability regulations.

Differences between SFDR and EU Taxonomy

While SFDR and the EU Taxonomy are distinct legislations serving different purposes, they share cross-references and touch points where they complement each other, particularly in defining what qualifies as sustainable.

The EU Taxonomy is designed to classify and provide a clear definition of the elements and criteria necessary for an economic activity to be categorised as sustainable. It lays out a comprehensive framework to guide investments toward environmentally sustainable objectives. By establishing common language and criteria, the EU Taxonomy aims to enhance transparency and ensure that investments genuinely contribute to sustainable development.

On the other hand, SFDR focuses on the disclosure of sustainable investments by Financial Market Participants (FMPs). Under SFDR, FMPs are required to provide transparent and consistent information on how they integrate environmental, social, and governance (ESG) factors into their investment decisions. This regulation fosters greater accountability and empowers investors to make informed choices based on a company’s sustainability performance.

In short:

• EU Taxonomy: Offers a clear definition of “sustainable” economic activities.
• SFDR: Mandates that FMPs prove their sustainable impact to stakeholders.

What framework to use?

The EU Commission clarified that FMPs are free to use any framework and methodology to conduct their own sustainability assessments, as long as they transparently disclose the chosen approach and how conclusions are reached. Whether referring to EU Taxonomy, SASB, GRI in your SFDR reports, what matters most is having robust data to support your sustainability claims. Ultimately, the diverse frameworks work in tandem, facilitating a holistic approach to sustainability reporting, fostering responsible investments, and driving positive environmental and social outcomes.