PRIMER: the EU’s Sustainable Finance Disclosure Regulation

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In this IFLR’s explainer, we look at the significance of the EU’s Sustainable Finance Disclosure Regulation (SFDR) and how it affects investors

The EU’s Sustainable Finance Disclosure Regulation (SFDR) is part of the bloc’s larger initiative to reorient capital towards more sustainable business. The regulation, which is set to redefine ESG disclosures, came into effect on March 10 2021.

What is the SFDR?

The SFDR requires financial market participants, including asset managers, private banks, venture capital funds, insurance companies, and credit institutions, to disclose on ESG issues.

One of the aims of the SFDR is to limit the risk of greenwashing while increasing transparency. The regulation requires fund groups to disclose the sustainability risk of their portfolios for the first time.

“This will make it easier for end investors to understand the true ESG and sustainability risks of their investments and make better informed decisions,” said Florence Fontan, head of company engagement at BNP Paribas Securities Services.

See also: SFDR poses challenges for EU investors

Additionally, the SFDR will require firms to disclose their sustainability risks and investments.  Sustainability risk pertains to the risk of a particular investment having a negative material impact.  A sustainable investment is one that contributes to improving an environmental or social objective.

What will the major change be for financial market participants?

Financial market participants will have to start to incorporate ESG considerations into all aspects of their business. “By providing for material disclosure obligations both on corporate-level and on product-level, it will certainly be a challenge for asset managers to implement those,” said Tanja Aschenbeck, partner at Osborne Clarke.

Asset managers will have to disclose how their investments contribute to the sustainable agenda as well as how they are compliant to the ‘do no significant harm’ principle laid out in the regulation.

“However, costs associated with compliance with the regulation will ultimately be passed on to investors. In addition, if different regimes develop in different geographies, there is a risk of further increased costs and confusion,” said John Ahern, partner at Covington & Burling.

For large financial market participants with more than 500 employees, June 30 2021 is the latest date in which they can issue a report. This report may come in the form of a published statement disclosing their sustainable investments on their website.

See also: Big changes expected for US green transition

“The EU SFDR applies to all asset managers – irrespective of whether they have a sustainability focus or not,” said Aschenbeck.

She continued: “Even if an asset management fund is not sustainability-focused, it is subject to several disclosure obligations on its website. Will funds which do not have a website yet be forced to have one?”

This is one of the challenges posed by the SFDR to investors.

Are there any problems or challenges?

Another challenge investors will likely face is the sheer volume of data that needs to be gathered.

Fontan at BNP Paribas Securities Services said: “The main issue for asset managers is that they will be required to access ESG data that are not made publicly available by investee companies. The data required of asset managers as part of SFDR is currently difficult to access, sometimes non-existent and generally very costly.”

Asset managers may struggle to meet their reporting obligations until SFDR addresses the ESG data challenge.

Fontan added: “This issue could be solved by the adoption of a legislative proposal to create a European single access point that will provide EU-wide access to all relevant information - including on sustainability - disclosed to the public by companies as put forward by the European Commission’s new capital markets union action plan.”

The broad scope and complexity of SFDR’s disclosure requirements is yet another challenge.

“SFDR’s scope is very wide and asset managers are understandably anxious to get it right and looking forward to clarification on what ESG data will be available and when,” said Fontan.

See also: Transition bonds could have more impact than green bonds

Furthermore, there is the added challenge of conflicting ESG disclosure and reporting regimes in different markets around the world. “It is important that there are multilateral discussions and exchanges among regulators aimed at harmonising requirements to the extent possible so that cross border activities are not unnecessarily complicated or burdensome,” said Ahern from Covington& Burling.

What are the different stages of the SFDR?

The main provisions of the SFDR came into force on March 10, 2021. However, the regulatory technical standard, which provides more details on the requirements with respect to the obligations imposed under the SFDR, is expected to enter into force on January 1 2022.

“The European supervisory authorities are due to report to the European Commission on best practices and voluntary reporting standards by September 10, 2022, and by December 30, 2022, the European Commission is due to evaluate the application of the SFDR,” explained Covington & Burling’s Ahern.

There will undoubtedly be some teething issues with regards to SFDR. “However, publicly committing to a sustainable investment strategy, while once discretionary, is now mandatory for fund managers and will be a big step towards removing the grey area that has plagued the sector over the last decade,” said Justin Partington, group head of funds at IQ-EQ.

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