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September 18, 2022updated 20 Sep 2022 11:28am

Explainer: What are the SFDR regulations?

The EU’s SFDR is designed to shift the flow of capital towards more sustainable activities. We provide the basics of how it works.

By Silvia Pellegrino

SFDR, EU, sustainable finance
A greener EU? Sustainable finance-linked regulations from the EU are causing headaches. (Photo by m-sur/Shutterstock)
  • The SFDR classifies funds as grey, light green or dark green, with stricter reporting requirements in place for the green funds.
  • Article 8 products accounted for 40.7% of eligible assets as of March this year.
  • It appears people are using SFDR as a means to interpret what ESG is, which is not exactly what the EU had in mind.

The EU Sustainable Finance Disclosure Regulation (SFDR) is a significant piece of new regulation that requires financial services providers and owners of financial products to analyse and disclose environmental, social and governance (ESG) considerations in a public way.

It was introduced to bring transparency to investment products with sustainability-related claims, improve the ability to compare products, and to help investors better understand the impact of their investment decisions. In short, the EU hopes it will channel investment capital towards more sustainable companies and activities.

This is part of the broader checklist by the EU in its bid to switch to sustainable growth and reach net-zero emissions by 2050 and is supported by the EU Taxonomy, a framework to classify environmentally sustainable economic activities.

The SFDR classifies funds as grey, light green, or dark green, with stricter reporting requirements for green funds. Investment managers, from the end of 2022, will have to begin reporting on the regulations put in place to ensure companies comply with global standards such as the UN Guiding Principles on Business and Human Rights.

Although SFDR was conceived as a disclosure-based regulation, observers have recently remarked that market participants are using the categories as a “quasi-standard or proxy” as a means to interpret what ESG, responsible and sustainable investing means. Interpretation and application of its provision has therefore been mixed at best.

To be more specific, it has been levelled that SFDR provisions do not make clear how to qualify an investment product as Article 6, 8 or 9 (outlined below), the boundaries between are therefore blurred leaving many to classify their own products.

“The interim conclusion is that the SFDR has increasingly been perceived and used as a product standard although it is ill-equipped to fulfil this function currently,” remarked Eurosif, an association promoting sustainable finance, in a June report analysing its impact. The association has compiled a checklist of recommendations to improve on SFDR, including the introduction of a new category of products focusing on sustainability risks and opportunities.

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To give a sense of the significance of SFDR and why it is important to ensure it is being applied appropriately, according to Morningstar data, as of 31 March 2022, 31.5% of funds available for sale in the EU were classified as either Article 8 (27.9%) or Article 9 (3.6%). This definition excludes money market funds, funds of funds and feeder funds.

In terms of assets, the two fund groups account for an even larger share of the EU pie at 45.6% of assets. Article 8 products account for a sizeable 40.7% of assets with Article 9 products accounting for a further 4.9%; the combined assets amount to €4.18trn.

For those coming in fresh to this, we have outlined the key definitions within the SFDR regulations, as defined by the EU.

What is SFDR level 1 and 2?

In April 2022, the European Commission published the proposed regulatory technical standards (RTS) for more information and guidance on the SFDR. There are two levels to the SFDR: level 1 and level 2.

SFDR level 1 “requires financial institutions within the EU to make principles-based disclosures on ESG-related activity”, according to IQ-EQ, an investor services company. This means that firms and companies have to report both on the sectors they are investing in and their portfolio companies.

These SFDR disclosures have some requirements too: they are made public on the institutions’ websites, accompanied by a sustainability risk policy.

Level 1 SFDR does not disclose the technical detail on what has to be disclosed, but is more general by mandating draft RTS to be more specific with the content of the disclosures.

SFDR level 2 includes more measures under the Disclosures Regulation. The European Supervisory Authorities (ESAs) – made up of the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority – released a consultation paper with further regulations about SFDR, which outlined the sustainability-related discourse obligations for asset managers.

These obligations focus on sustainability risks, sustainability factors, and technical disclosures for the products which have sustainability as an aim.

The RTS covers two main points: details of the asset manager’s policy for analysing the negative impacts of its investments on sustainability, and product-level disclosures for ESG-focused products.

Alongside various annexes disclosing indicators for establishing the adverse impact certain investments can have, the ESAs’ consultation paper also discloses the articles of SFDR that pertain to the main objectives of the initiatives.

The European Commission is proposing the RTS come into effect from 1 January 2023 – although the European Parliament and the Council have to formally agree on this, it seems, according to law firm Simmons & Simmons, highly likely that they will.

Articles 6, 7, 8 and 9 of the SFDR

As explained above, SFDR aims to create a more transparent field during investments. With asset managers having to disclose the different levels of sustainability integration, the SFDR is categorised into articles. The main ones are Articles 6, 7, 8 and 9.

Article 6 of the SFDR relates to funds which do not take into consideration any sustainability in the investment process and could include stocks which are not included by ESG funds (e.g. tobacco companies). These products will still be sold in the EU, but they need to be labelled as non-sustainable.

This Article – Integration of sustainability risks in investment decisions – has some pre-contractual disclosures:

  • If sustainability risks are integrated into the investment decision-making process, the asset manager has to disclose how they are integrated.
  • If sustainability risks are not integrated, the asset manager has to explain why.

Article 7 revolves around accessing the adverse impact investment decisions have on sustainability. There are additional pre-contractual disclosures on each investment portfolio, which state that the asset manager has to consider all the adverse impacts that the investment has on the sustainability factors. Article 7 will come into force on 30 December 2022.

From December 2022, the manager must be transparent about any negative impacts on sustainability and why. The question that must be asked is: “Does this financial product consider principal adverse impacts (PAI) on sustainability factors?”

Also known as environmental and social promoting, Article 8 covers financial products that are characterised by environmental and social factors, and whether their companies have good governance practices.

ESG investing is not the core factor of these products. Article 8 states that the disclosed information has to explain how these requirements are met.  

Article 8 funds are categorised as light green.

Article 9 funds are classified as dark green.

Under SFDR, an Article 9 fund is described as “a Fund that has sustainable investment as its objective or a reduction in carbon emissions as its objective”. There are requirements that must exist in order for the fund to be considered sustainable:

  1. The fund must incorporate good governance into the investment strategy.
  2. Article 9 relates to the fund portfolio, establishing whether or not the financial object causes any significant harm.
  3. Article 9 funds with a carbon reduction aim must refer to an EU Climate Transition Benchmark or an EU Paris-aligned Benchmark.

Who is affected by the SFDR regulations?

The SFDR generally affects two categories of financial firms:

  1. Financial advisers that give investment advice or insurance advice about insurance-based investment products within the EU.
  2. Participants of the financial market that produce and sell financial products and offer management services within the EU.

Some examples are banks, financial advisers and insurers.

Financial market members with fewer than 500 employees are not usually required to produce an adverse impact statement, however, they still need to explain their reasons.

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