What is the Sustainable Finance Disclosure Regulation (SFDR)?

The good, the bad, and the ugly sides of ESG reporting dominated the headlines in 2022.

Companies and investors alike are looking for ways to quantify their environmental, social, and governance performance. ESG was once seen as a nice-to-have for a successful business. Now ESG reporting transparency is simply table stakes.

Claims of greenwashing and inconsistent ESG reporting dramatically increased throughout 2022. Various media sources are citing a lack of ESG performance data as a key issue for firms marketing themselves as sustainable without sufficient evidence to back their claims. Regulators and policymakers have begun to crack down on funds managers, proposing new rules to weed out unfounded ESG fund claims through the United States, European Union, and United Kingdom.

The largest clamp down is coming from the EU in 2023 with the Sustainable Finance Disclosure Regulation (SFDR). To simplify the complexity of the new regulation, Proof and SLR Consulting have compiled the most important information for impacted participants below.

This article is designed for investors — both within and outside the EU — who have heard about SFDR, but are still building their knowledge about the regulation and how it impacts them.

What is the new SFDR regulation?
The EU’s Sustainable Finance Disclosure Regulation (SFDR) is the first regulation to require private market investors who are marketing their products as sustainable to publicly disclose their ESG performance. Without complying, investors in the EU will be legally prohibited from marketing their products in this way, or will face significant penalties for doing so without the appropriate SFDR disclosures.

What is the rationale for the regulation?
The regulations are designed to increase market transparency, prevent greenwashing, and direct capital towards more sustainable businesses and financial products. For capital allocators, this regulation will make it easier to steer capital towards funds that are aligned with the allocator’s investment objectives. For the market, this will accelerate capital towards proven sustainable businesses and increase transparency of sustainability across all financial institutions and market participants.

Who is impacted?
All ‘Financial Market Participants’ (FMPs) legally domiciled in the EU who market any of their financial products as sustainable are required to report on Principal Adverse Impacts (PAIs) under SFDR. FMPs include alternative investment fund managers (AIFMs), Undertakings for the Collective Investment in Transferable Securities (UCITs) fund managers, management companies, portfolio managers and financial advisors, insurance and pension funds, and investment advisors. For FMPs not located in the EU, your current and prospective EU investors will need SFDR data from all their investments and will increasingly ask if your fund is SFDR Article 8 or 9 compliant. If you aren’t Article 8 or 9 compliant, this could hurt your fund’s ability to raise capital from EU investors and put your competitors at an advantage if you don’t have an Article 8 or 9 label attached to your fund.

What is involved?
Funds identifying as Article 8 or Article 9 will need to track Principal Adverse Impacts “PAIs” (i.e., a set of predefined ESG metrics) from January 2023 onwards. Article 6 funds will not need to track the PAIs, but will need to explicitly state that their fund does not consider ESG factors in its investment decisions. A fund will be classified as an Article 6, 8, or 9 fund depending on its sustainability objectives:

↳ Article 6 — Funds without a sustainability scope.
Requirements: “Financial market participants shall include descriptions of the following in pre-contractual disclosures: The manner in which sustainability risks are integrated into their investment decisions, and the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available. Where financial market participants deem sustainability risks not to be relevant, the descriptions referred to in the first subparagraph shall include a clear and concise explanation of the reasons therefore.”

↳ Article 8 — Funds which promote environmental or social characteristics.
Requirements: “Where a financial product promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices, the information to be disclosed pursuant to article 6 shall include the following: (i) Information on how those characteristics are met; (ii) If an index has been designated as a reference benchmark, information on whether and how this index is consistent with those characteristics.”

↳ Article 9 — Funds that have sustainable investment as their objective.
Requirements: “Where a financial product has sustainable investment as its objective and an index has been designated as a reference benchmark, the information to be disclosed pursuant to article 6 shall be accompanied by the following: (i) Information on how the designated index is aligned with that objective; (ii) An explanation as to why and how the designated index aligned with that objective differs from a broad market index.”

What are the key dates?
June 30, 2023 is the first due date to have all data collected, aggregate fund-level PAI metrics calculated, and disclosures posted on websites — which is a three-month process to complete.

How to get started?
✓ Educate your firm on SFDR and its implications for your firm. Familiarize yourself with the PAIs and what will be required to collect the data and calculate the fund-level results.
✓ Build a strategy to collect SFDR data from your portfolio. As a reminder, June 30, 2023, is first due date to your disclosures completed, which is approximately a three month process. March 31, 2023 is the latest recommended date to begin this process.
✓ Communicate with your investments about the upcoming data request, and what resources they will need to set aside for this effort.
✓ Develop a sales prospectus for your financial product that states your plans for Article 8 compliance and describes your sustainability strategy for the product.

Looking Ahead
The intent of this new regulation is to drive the capital markets towards investments that have a measurable positive impact on the planet and for its inhabitants. In doing so, we are moving away from a ‘check box exercise’ and into a world where we leverage ESG & impact performance data to improve investment select decision making and ongoing performance management. In 2-3 years, your fund’s ESG performance will be comparable to your peers, meaning it’s important to think ahead about how you will not only comply by disclosing, but also your plan for actively engaging with your investments to improve their performance over time. If we are successful, investors are better able to move capital towards sustainable investments, purpose-driven founders are better able to raise capital, and other countries will soon follow suit.

SLR & Proof are positioned to support capital allocators in their efforts to align to the new SFDR regulation, manage the ESG requirements of their portfolio companies, and prepare for the upcoming deadlines.

To learn more about Proof's SFDR solutions, request a call with Sales, send us a quick message through the chatbox [💬] in the bottom right of every page, or reach out through our Contact form anytime. Our team is always happy to offer more information and to help you determine if Proof is a good for for your organization.