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.
- 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.
Navigating the landscape of SFDR implementation comes with three key challenges that require careful consideration:
- Data challenges
- Danger of greenwashing
The SFDR regulatory documents are extremely long and go into specific technical detail. Given the many other policies, standards, frameworks and criteria surrounding these sustainable finance frameworks, it can be difficult for FMPs, particularly those in the mid-market segment to find clarity and direction.
The data gap
It is up to FMPs themselves to demonstrate adherence to SFDR. Therefore, it is vital that the companies receiving investments provide clear and transparent information about their sustainable practices and how they align with the regulation’s criteria.
As the availability of data widens due to new collection methodologies and technologies, it may be that in the future the European Commission will release another wave of technical criteria to further improve the definition of what counts as a sustainable investment.
These changes/this uncertainty has deterred many FMPs from creating Article 9 funds categorisation in fear that they will be ‘demoted’ back to Article 8 as the definitions get stricter.
Danger of Greenwashing
Given the inherent difficulty of selecting, collecting and monitoring ESG data, greenwashing remains a risk.
SFDR Level 2 was launched at the start of 2023, which came with more detailed transparency requirements regarding sustainability. The European Commission published Regulatory Technical Standards (RTS) which provide more complete information on the content, methodology and presentation of existing disclosure requirements. The increasingly stringent RTS were deemed necessary to avoid risks of “greenwashing” and the misuse of the word “sustainability”
The full SFDR framework is still under review by the EU, and there are likely to be more changes in the future as concepts and interpretations are refined to improve usability.
All in all, SFDR remains a work in progress, and staying informed about the latest updates is paramount. Working alongside a trusted advisor who is well-versed in the evolving SFDR framework is essential. Their expertise will ensure compliance with the most recent requirements, providing guidance through the complexities of sustainable finance regulations.
In conclusion, a comprehensive approach to SFDR can offer FMPs a competitive advantage by effectively communicating ESG impacts and addressing sustainability risks, appealing to socially and environmentally-conscious investors. Non-compliance risks reputational damage in this competitive market.
Moreover, SFDR enhances decision-making by encompassing both financial and non-financial risks, encouraging a long-term perspective over short-term gains. Leveraging ESG data provides valuable insights for informed decision-making, leading to more stable financial returns.
Despite existing complications and challenges in SFDR implementation, SCG fully supports its obligations. We believe SFDR is the key to redirecting capital towards companies driving positive impact and facilitating Europe’s transition to a net-zero economy.
At Sustainable Capital Group, we understand the complexities of EU regulations in sustainable finance, and our sector experts are here to assist you. For personalised guidance, simply fill out our contact form, and we’ll be in touch with you shortly.