- Category: European Union Carbon Market Glossary
The disclosure requirements embedded in the European sustainable finance disclosure regulation (commonly referred to as ‘SFDR’), constitute a key building block of the European sustainable finance framework.
4 December 2023
The ESAs propose adding new social indicators and streamlining the framework for the disclosure of principal adverse impacts of investment decisions on the environment and society. The ESAs also suggest new product disclosures regarding “greenhouse gas emissions reduction” targets.
Additionally, the ESAs propose further technical revisions to the SFDR Delegated Regulation:
15 September 2023
The European Commission launches 2 consultations (end date: 15 December 2023):
13 June 2023
17 February 2023
Commission Delegated Regulation (EU) 2023/363 of 31 October 2022 amending and correcting the regulatory technical standards laid down in Delegated Regulation (EU) 2022/1288 as regards the content and presentation of information in relation to disclosures in pre-contractual documents and periodic reports for financial products investing in environmentally sustainable economic activities published in the EU Official Journal
The SFDR stands for the 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. It started applying in March 2021. The rules of the SFDR were designed to enhance investor confidence and further support this market growth.
SFDR requires financial market participants and financial advisers to disclose at entity and product levels how they integrate sustainability risks and principal adverse impacts in their processes at both entity and product levels. It also introduces additional product disclosures for sustainable financial products making sustainability claims.
Moreover, the intention of the SFDR is to introduce consistency and clarity on how institutional investors, such as asset managers, insurance companies, pension funds, or investment advisors should integrate environmental, social and governance (ESG) factors in their investment decision-making process.
SFDR applies since:
10 March 2021
Detailed rules contained in the implementing measures of SFDR will apply from:
1 January 2023
This is accentuated in Recital 12 of the SFDR, which requires that in order to comply with their duties under those rules, financial market participants and financial advisers should integrate in their processes, including in their due diligence processes, and should assess on a continuous basis not only all relevant financial risks but also including all relevant sustainability risks that might have a relevant material negative impact on the financial return of an investment or advice.
Therefore, financial market participants and financial advisers should specify in their policies how they integrate those risks and publish those policies.
The Regulation requires financial market participants and financial advisers which provide investment advice or insurance advice with regard to insurance‐based investment products (IBIPs), regardless of the design of the financial product and the target market, to publish written policies on the integration of sustainability risks and ensure the transparency of such integration (Recital 13).
It is noteworthy, SFDR was intended to be a transparency framework, but in practice is used as a labelling system for financial products.
Exact requirements will be further specified through delegated acts, which will be adopted by the European Commission at a later stage. ESA’s Joint Consultation Paper of 23 April 2020 identified as a challenge that the negotiations were on-going on the draft Taxonomy Regulation while Article 2(17) SFDR defined “sustainable investments” without reference to the Taxonomy Regulation.
Recital 29 of the Commission Delegated Regulation of 6 April 2022 supplementing SFDR underlines the need to ensure comparability of the principal adverse impacts statement, the pre-contractual disclosures and the periodic disclosures and for this purpose sets out standard templates for the presentation of that information (the templates also contain summary explanations of key terms applied). The SFDR refers to (environmental and social) “characteristics” (Article 8), alongside “objectives” (Article 9).
Entry into force and implementation, transitory issues
SFDR applies from 10 March 2021 (Article 20). The exception are some of its provisions applying from 29 December 2019 and from 1 January 2022. The Taxonomy Regulation in Article 25 empowerd the ESAs, by amending the SFDR, to develop further RTS on “taxonomy-related product disclosures”. The deadlines for the taxonomy-related product disclosures RTS ranged from 1 June 2021 to 1 June 2022. Article 8, 9, 11 RTS on pre-contractual and periodic product disclosures for environmental taxonomy products were due to be delivered to the European Commission by 1 June 2021 for the “climate change mitigation” and “climate change adaptation” environmental objectives and by 1 June 2022 for the “sustainable use and protection of water and marine resources”, “transition to a circular economy”, “pollution prevention and control” and “protection and restoration of biodiversity and ecosystems” environmental objectives.
The transitory issues have been explained in the Joint ESA (European Supervisory Authorities) Supervisory Statement of 25 February 2021 on the application of the Sustainable Finance Disclosure Regulation (JC 2021 06) as follows:
- while financial market participants and financial advisers are required to apply most of the provisions on sustainability-related disclosures laid down in the SFDR from 10 March 2021, the application of the Regulatory Technical Standards (RTS) will be delayed to a later date;
- the European Commission’s Directorate-General for Financial Stability, Financial Services and Capital Markets Union in a letter sent to the ESAs on 20 October 2020 stated that “in terms of substance, the application of the Regulation is not conditional on the formal adoption and entry into force or application of the regulatory technical standards as it lays down at Level 1 general principles of sustainability-related disclosures”;
- in order to provide financial market participants and financial advisers with sufficient time to gather the information necessary and adjust their practices to apply the specific requirements of the RTS, and in order to provide for the alignment of the application of the RTS with the application of the amendments in the Taxonomy Regulation to the SFDR as well as the application of periodic reporting in the SFDR, the ESAs have proposed in their draft RTS to delay the application date of the RTS to 1 January 2022.
The said Supervisory Statement of 25 February 2021 ESAs also reads:
“For the sake of applying the provisions of the SFDR without the RTS during the interim period, national competent authorities are encouraged to refer financial market participants and financial advisers to the requirements set out in the draft RTS of the final report that has been submitted to the European Commission on 4 February 2021. The draft RTS can be used as a reference for the purposes of applying the provisions of Articles 2a, 4, 8, 9, and 10 of the SFDR in the interim period”.
It is to be noted that the aforementioned draft RTS submitted to the European Commission on 4 February 2021 has been replaced by the ESA’s Final report of 22 October 2021 on taxonomy-related product disclosure RTS with regard to the content and presentation of disclosures pursuant to Article 8(4), 9(6) and 11(5) of Regulation (EU) 2019/2088 (JC 2021 50), and the Updated Joint ESA Supervisory Statement of 24 March 2022 on the application of the Sustainable Finance Disclosure Regulation (JC 2022 12) adopted the same stance as regards the latter document.
On 6 April 2022 the Commission Delegated Regulation supplementing Regulation (EU) 2019/2088 of the European Parliament and of the Council with regard to regulatory technical standards specifying the details of the content and presentation of the information in relation to the principle of ‘do no significant harm’, specifying the content, methodologies and presentation of information in relation to sustainability indicators and adverse sustainability impacts, and the content and presentation of the information in relation to the promotion of environmental or social characteristics and sustainable investment objectives in pre-contractual documents, on websites and in periodic reports has been adopted by the European Commission.
European Commission's Explanatory Memorandum to this Regulation reads:
"On 3 February 2021, the ESAs submitted draft regulatory technical standards to the Commission, combining draft regulatory technical standards developed under Articles 2a, 4(6) and (7), 8(3), 9(5), 10(2) and 11(4) of the Sustainable Finance Disclosures Regulation. On 22 October 2021, the ESAs submitted draft regulatory technical standards to the Commission, combining draft regulatory technical standards developed under Articles 8(4), 9(6) and 11(5) of the Sustainable Finance Disclosures Regulation. In view of the interconnectedness of the 13 draft regulatory technical standards and to ensure that the requirements they introduced are fully consistent, the Commission has bundled the 13 standards in a single legal act. A single legal act also makes it easier to locate provisions on sustainability-related disclosures in the financial services sector. The Commission carried out legal review of the submitted draft regulatory technical standards and, whilst not changing any substantive requirements, adapted the provisions of the standards to ensure legality and legislative quality of this Regulation as well as consistency of the rules in this Regulation with the Sustainable Finance Disclosures Regulation. In order to avoid duplication of rules in enacting terms and annexes to this Regulation certain provisions in enacting terms were dropped".
The RTS after the adoption by the European Commission must be submitted to the European Parliament or the Council which may object to the draft RTS within a period of three months from the date of notification of the RTS adopted by the Commission. Therefore, the final RTS may be different to the draft RTS in the ESAs’ final report as well as to the Commission Delegated Regulation of 6 April 2022. Recital 40 of the said Regulation reads:
"It is necessary to enable financial market participants and financial advisers to adapt to the requirements laid down in this Delegated Regulation. Its date of application should therefore be deferred to 1 January 2023. It is, however, necessary to require financial market participants that have considered principal adverse impacts of investment decisions on sustainability factors as referred to in Article 4(1), point (a), of Regulation (EU) 2019/2088, or as required by Article 4(3) or (4) of that Regulation, by 31 December 2022, to publish the first time the information on those impacts on their websites in separate sections titled ‘Statement on principal adverse impacts of investment decisions on sustainability factors’ by 30 June 2023 for the period of 1 January 2022 until 31 December 2022",
Application timeline for products’ periodic reporting
Periodic reports referred to in Article 11(2) of the SFDR must comply with the requirements laid down in that Article from 1 January 2022. The SFDR applies other sustainability-related disclosure requirements after 10 March 2021. This means that financial market participants must draw up in 2022 respective periodic reports referred to in Article 11(2) in compliance with the SFDR, irrespective of reference periods.
For the requirements relating to those periodic reports, the draft RTS can also be used as a reference for the purposes of preparing for the application of Article 11 of the SFDR. The ESAs proposed that the requirements of Chapter V of the RTS would only apply to periodic reports published in or after 2022 in relation to reference periods starting from 1 January 2022, while the periodic reports published in 2022 in relation to reference periods starting before 1 January 2022 would apply the high level and principle based requirements in Article 11(1) of the SFDR. In particular, Articles 8(2a) and 9(4a) of the SFDR apply in respect of the environmental objectives referred to in points (a) and (b) of Article 9 of the Taxonomy Regulation from 1 January 2022 and in respect of the environmental objectives referred to in points (c) to (f) of Article 9 of the Taxonomy Regulation from 1 January 2023.
Application of the 500-employee threshold for principal adverse impact reporting at entity level to parent undertakings of a large group
Article 4(3) SFDR applies to financial market participants exceeding on their balance sheet dates the criterion of the average number of 500 employees during the financial year. Article 4(4) SFDR requires, from 30 June 2021, “financial market participants which are parent undertakings of a large group as referred to in Article 3(7) of Directive 2013/34/EU5 exceeding on the balance sheet date of the group, on a consolidated basis, the criterion of the average number of 500 employees during the financial year shall publish and maintain on their websites a statement on their due diligence policies with respect to the principal adverse impacts of investment decisions on sustainability factors”.
The application of the 500-employee threshold for principal adverse impact reporting raised some doubts, which have been voiced in the European Supervisory Authorities (ESAs) letter of 7 January 2021 to the European Commission (Priority issues relating to SFDR application, JC 2021 02).
The issues to be settled in this regard by the European Commission are:
- Must the calculation of the 500-employee threshold to the parent undertaking of a large group be applied to both EU and non-EU entities of the group without distinction as to the place of establishment of the group and/or subsidiary?
- Does the due diligence statement include impacts of the parent undertaking only or must it include the impacts of the group at a consolidated level?
The clarity in the above areas are absolutely vital for the proper application of the SFDR.
Integration of sustainability risks in pre-contractual disclosures
According to Article 3 SFDR:
1. financial market participants are required to publish on their websites information about their policies on the integration of sustainability risks in their investment decision-making process;
2. financial advisers are required to publish on their websites information about their policies on the integration of sustainability risks in their investment advice or insurance advice.
According to Article 6 of SFDR:
1. financial market participants are required to include descriptions of the following in pre-contractual disclosures:
(a) the manner in which sustainability risks are integrated into their investment decisions; and
(b) the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available;
2. financial advisers are required to include descriptions of the following in pre-contractual disclosures:
(a) the manner in which sustainability risks are integrated into their investment or insurance advice; and
(b) the result of the assessment of the likely impacts of sustainability risks on the returns of the financial products they advise on.
Where financial market participants or financial advisers deem sustainability risks not to be relevant, the descriptions referred to above must include a clear and concise explanation of the reasons therefor. However, it needs to be noted that the scope of application of these requirements is very broad, in particular, it is not restricted to products or funds labelled as an “ESG” or “green”. For a financial product with a diverse strategy, that is widely marketed, it will be difficult to definitely prejudge that sustainability risks are not relevant. The possible reasons for such an exclusion of sustainability risk can potentially be:
- the bespoke purpose of the product or fund,
- short shelf life of the product or fund,
- specific investment strategies, particularly accommodating investor’s needs.
Principal adverse impacts (PAI)
The said ESA’s Joint Consultation Paper of 23 April 2020 observes that “while ESG products are becoming more popular in Europe, justifying common harmonised product disclosure rules, the area of principal adverse impact reporting is relatively new”. According to Recital 8 of the SFDR “financial market participants and financial advisers should be required to disclose specific information regarding their approaches to the integration of sustainability risks and the consideration of adverse sustainability impacts”.
Recitals 18 and 20 of the SFDR read:
"Where financial market participants, taking due account of their size, the nature and scale of their activities and the types of financial products they make available, consider principal adverse impacts, whether material or likely to be material, of investment decisions on sustainability factors, they should integrate in their processes, including in their due diligence processes, the procedures for considering the principal adverse impacts alongside the relevant financial risks and relevant sustainability risks.
The information on such procedures might describe how financial market participants discharge their sustainability‐related stewardship responsibilities or other shareholder engagements.
Financial market participants should include on their websites information on those procedures and descriptions of the principal adverse impacts";
"Financial market participants which consider the principal adverse impacts of investment decisions on sustainability factors should disclose in the pre‐contractual information for each financial product, concisely in qualitative or quantitative terms, how such impacts are considered as well as a statement that information on the principal adverse impacts on sustainability factors is available in the ongoing reporting. Principal adverse impacts should be understood as those impacts of investment decisions and advice that result in negative effects on sustainability factors."
There are several disclosures concerning PAIs in the SFDR. As a general rule, the SFDR requires financial market participants who consider PAIs to disclose them at entity level on their website. It also includes a mandatory requirement for financial market participants to provide such disclosures when they have more than 500 employees (Article 4).
The Delegated Regulation of the SFDR includes a list of these PAI indicators. These entity level PAI indicators are divided into three tables in the Delegated Regulation. Indicators listed in table 1 are mandatory for all participants, and indicators in tables 2 and 3 are subject to a materiality assessment by the financial market participant (at least one indicator from table 2 and one from table 3 must be included in every PAI statement).
Second, the SFDR requires financial market participants who consider PAIs at entity level to indicate in the pre-contractual documentation whether their financial products consider PAIs (Article 7) and to report the impacts in the corresponding periodic disclosures (Article 11). When reporting these impacts, financial market participants may rely on the PAI indicators defined at entity level in the Delegated Regulation.
Finally, in accordance with the empowerment given in Article 2a of SFDR, the Delegated Regulation requires that the do no significant harm (DNSH) assessment of the sustainable investment definition is carried out by taking into account the PAI indicators defined at entity level in Annex I of the Delegated Regulation.
Application of Article 8 SFDR
Article 8 SFDR aims to enhance transparency on products “promoting environmental or social characteristics” in pre-contractual disclosures. It applies: “Where a financial product promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics” (so-called "light green funds").
ESAs’ letter of 7 January 2021 to the European Commission (Priority issues relating to SFDR application, JC 2021 02) identifies the following questions regarding the application of Article 8 of the SFDR and the meaning of “promotion” in the context of products promoting environmental or social characteristics:
- Can the name of a product, which may include words like “sustainable”, “sustainability”, or “ESG” be considered to qualify a product to be promoting an environmental or social characteristic or to be having sustainable investment as its objective?
- While a financial product to which Article 8 applies does not need to explicitly promote itself as targeting sustainable investments (within the meaning of Article 2(17) SFDR), would a reference to taking into account a sustainability factor or sustainability risk in the investment decision be sufficient for Article 8 to apply? If the answer is yes, how can financial market participants that disclose mandatory information according to Article 6(1) or Article 7(1) SFDR ensure that this is not automatically considered as “promoting environmental or social characteristics”.
- Must a product to which Article 8 applies invest a minimum share of its investments to attain its designated environmental or social characteristic in order to be considered to be promoting environmental or social characteristics?
- In the absence of active advertising of an environmental or social characteristic of the product, would an intrinsic characteristic of the product, such as a sectoral exclusion (e.g. tobacco) which is not advertised, also qualify as “promotion”?
- In addition, would complying with a national legal obligation, which applies to the financial market participant, such as a ban on investment in cluster munitions, also bring the product into the scope of Article 8?
Application of Article 9 SFDR
Article 9(1) and (2) SFDR apply “where a financial product has sustainable investment as its objective” - so-called "dark green funds").
In addition, Article 9(3) requires:
"Where a financial product has a reduction in carbon emissions as its objective, the information to be disclosed pursuant to Article 6(1) and (3) shall include the objective of low carbon emission exposure in view of achieving the long-term global warming objectives of the Paris Agreement.
By way of derogation from paragraph 2 of this Article, where no EU Climate Transition Benchmark or EU Paris-aligned Benchmark in accordance with Regulation (EU) 2016/1011 of the European Parliament and of the Council ( 1 ) is available, the information referred to in Article 6 shall include a detailed explanation of how the continued effort of attaining the objective of reducing carbon emissions is ensured in view of achieving the long-term global warming objectives of the Paris Agreement".
The above ESAs’ letter of 7 January 2021 identifies the following questions regarding the application of Article 9 of the SFDR:
- Must a product to which Article 9(1), (2) or (3) SFDR applies only invest in sustainable investments as defined in Article 2(17) SFDR? If not, is a minimum share of sustainable investments required (or would there be a maximum limit to the share of “other” investments)?
- Where an EU Climate Transition Benchmark (EU CTB) or EU Paris-aligned Benchmark (EU PAB) exists, is it necessary for a product to track an EU PAB or an EU CTB on a passive basis for Article 9(3) SFDR to apply to it?
- If the questions above are answered in the affirmative and if the minimum standards of an EU PAB or an EU CTB do not require the index components to be sustainable investments, can the product fall within the scope of Article 9(3) SFDR?
The cost of disclosures under the SFDR
The following two questions aim to assess the costs of the SFDR disclosure requirements distinguishing between one-off and recurring costs.
One-off costs are incurred only once to implement a new reporting requirement, e.g. getting familiarised with the legal act and the associated regulatory or implementing technical standards, setting-up data collection processes or adjusting IT-systems.
Recurring costs occur repeatedly every year once the new reporting is in place, e.g. costs of annual data collection and report preparation. In the specific case of precontractual disclosures for example, there are one-off costs to set up the process of publishing precontractual disclosures when a new product is launched, and recurring annual costs to repeat the process of publishing pre-contractual disclosures each time a new product is launched (depends on the number of products launched on average each year).
Interactions with the CSRD and the Benchmark Regulation
Financial market participants' and financial advisers’ ability to fulfil their ESG transparency requirements depends in part on other disclosure requirements under the EU framework. In particular, they will rely to a significant extent on the Corporate Sustainability Reporting Directive (CSRD). However, some entities are not reporting yet under those new disclosure requirements, or they may not be within the scope of the CSRD.
Both the SFDR and the Corporate Sustainability Reporting Directive (CSRD) introduce entity level disclosure requirements with a double-materiality approach.
Transparency requirements relate to the sustainability risks that can affect the value of investments (SFDR) or companies (CSRD) (‘outside-in’ effect) and the adverse impacts that such investments or companies have on the environment and society (‘inside-out’).
The CSRD sets out sustainability reporting requirements mainly for all large and all listed undertakings
with limited liability (except listed micro-enterprises), while the SFDR introduces sustainability disclosure requirements at entity level for financial market participants and financial advisers as regards the consideration of sustainability related factors in their investment decision-making process.
Moreover, in order for financial market participants and financial advisers to meet their product and entity level disclosure obligations under the SFDR, they will rely to a significant extent, on the information reported according to the CSRD and its European Sustainability Reporting Standards (ESRS).
Financial advisors (under MiFID 2) and distributors of insurance-based investment products (under IDD) have to conduct suitability assessments based on the sustainability preferences of customers. These assessments rely in part on sustainability-related information made available by market participants reporting under the SFDR.
The Benchmarks Regulation requires benchmark administrators to disclose on ESG related matters for all benchmarks (except interest rate and foreign exchange benchmarks). The SFDR makes reference to the CTB and PAB in connection with financial products that have the reduction of carbon emissions as their objective.
Application of SFDR product rules to MIFID portfolios and other tailored products
The SFDR applies to financial market participants and financial advisers, investment firms which provide portfolio management, including.
The above ESAs’ letter of 7 January 2021 emphasises the following ambiguities regarding the application of SFDR product rules to MIFID portfolios and other tailored products:
- For portfolios, or other types of tailored financial products managed in accordance with mandates given by clients on a discretionary client-by-client basis, do the disclosure requirements in SFDR apply at the level of the portfolio only or can they apply at the level of standardised portfolio solutions?
- If the disclosure requirements of SFDR apply at the portfolio level, how is it possible to maintain confidentiality obligations to the client in view of the disclosures required, especially the website disclosures required by Article 10 SFDR?