SFDR Fundamentals, Challenges and Keys to Success

In the framework of the EU Action Plan for Financing Sustainable Growth, which also includes the EU Taxonomy, the NFRD, and thenow the proposed Corporate Sustainability Reporting Directive (CSRD), the SFDR establishes a level playing field for the measurement and disclosure of sustainability factors in financial products and mitigates the risk of greenwashing of financial instruments. Simply put, the SFDR makes it easier for investors to compare sustainability factors across multiple opportunities and make more informed sustainable investment decisions.

While this may sound simple, the SFDR, like any new regulation, is not without is complexities and challenges. This article provides a high level summary of the major deliverables, deadlines, challenges and an approach to achieve compliance with the SFDR.

Why Was the SFDR Regulation Implemented?

• Who is Impacted by the SFDR?
• Key Components of the SFDR
• Important Dates of the SFDR
• SFDR: Biggest Challenges
• Collecting Data
• Uncertainty in the Interpretation of SFDR Requirements
• Key Points to Define your SFDR Approach
• Build a Knowledge Foundation
• Strategy First
• Cascade to Management and Operations
• Execute, Continuously Improve and Communicate

Why Was the SFDR Regulation Implemented?

As the world begins an imperative transformation towards more ‘Sustainable’ economic models, Europe has quickly established itself as one of the most proactive regions, taking direct action to set and achieve tangible sustainability objectives. One of the most important forces with the strongest influence on this transformation is the finance and investment sector.

In this context, the EU has implemented the Sustainable Finance Disclosure Regulation (SFDR) with three main objectives:

1. Influence the flow and acceleration of capital towards more sustainable businesses
2. Increase transparency of sustainability across all financial institutions and market participants.
3. Incorporate material ESG risk factors into main stream risk management

Who is Impacted by the SFDR?

Before diving into the details of the regulation, the first step is to dispel any misconceptions about who is, and who is not, impacted. One of the biggest mis-understandings in the financial services industry is that this regulation only applies to companies that offer sustainable or ESG related financial products, services or advice. This is not true.

While a significant portion of the regulation applies specifically to ‘ESG products’, the regulation applies to all ‘Financial Market Participants’ (FMPs) involved in the EU asset management industry. FMPs include AIFMs, UCITs fund managers, management companies, portfolio managers and financial advisors, as well as insurance and pension funds and investment advisors.

It is also important to understand that while this regulation applies to all FMPs domiciled in the EU, it also applies to non-EU FMPs distributing funds into the EU, as well as to all underlying assets in the portfolio of EU distributed funds, even if these assets are not based in the EU. Finally, while only large firms of more that 500 employees are obligated to comply, smaller firms must provide reasons if they chose not to comply.

Key Components of the SFDR

The requirements of the regulation are defined both at both company level and product level. Disclosures are made through three primary channels, including website, pre-contractual documents and periodic reports.

It is also important to understand that all marketing material for all funds must comply with SFDR and Taxonomy requirements. The following tables set out the high level disclosure requirements. For further detail, you should refer to the SFDR level 1 text and the Final Report on draft Technical Regulatory Standards published on 2/2/2021.

Important Dates of the SFDR

SFDR: Biggest Challenges

Collecting Data

Without doubt, accessing company level ESG data is the biggest hurdle for FMPs. While most large companies are required to align their sustainability data with the EU Taxonomy under the NFRD, it will take time for a critical mass of ESG data to be collected by the large data providers. But it will take even longer to gather the data for SMEs, medium to large regional companies and private companies as they have not been subject to the NFRD and therefore have not produced this data.

This puts the responsibility on the investors and asset owners to engage with their investees and on banks to engage with their customers in order to obtain qualitative and quantitative ESG data, align it with the EU Taxonomy and apply it under the SFDR.

It is no longer as simple as buying ESG scores created by analytics, proxies and estimates from third party providers. Now you need actual data from the source. Would a company be allowed to report its annual profit based on an estimate or average of its 5 closest competitors? No, because regulators and investors need to see actual, audited profits. The same is now true for carbon emissions and other ESG factors.

Uncertainty in the Interpretation of SFDR Requirements

There is also concern among FMPs and other market participants regarding the high level of uncertainty in the interpretation of SFDR requirements.

The EU is on the fast track for sustainability. Level 1 requirements have been put into practice on March 10th, 2021. However, the draft Level 2 Regulatory Technical Standards (RTS) were released later than expected and have not yet been confirmed by the European Commission. Yet it is expected that the RTS be applied from the 1st of January, 2022.

This leaves a gap where Level 1 general principles must be applied ‘in terms of substance’* without confirmation of the detailed requirements defined in the draft RTS. The general consensus among FMPs is that it is not required to meet the requirements defined in the current draft RTS in order to achieve ‘compliance in principle’ with the SFDR Level 1 requirements. However, the Joint ESA Supervisory Statement released on February 22, 2021 encourages the National Competent Authorities to refer FMPs to the requirements defined in the draft RTS when preparing for the January 1, 2022 deadline when the final RTS is expected to be applied.

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 on the application of the SFDR

Key Points to Define your SFDR Approach

The best way to achieve SFDR compliance is to think of it as a byproduct that results from carefully considering and incorporating the most substantially relevant sustainability factors into all aspects of the investment management and operational best practices your company already has in place.

With this approach SFDR, and sustainability in general, will become an opportunity specific to your organisation, rather than a challenge with a huge cost that bears little fruit. Some key points to think of that will help establish this approach.

Build a Knowledge Foundation

External experts are a source for acceleration, but establishing a foundation of ESG knowledge in your internal team will be more valuable in the long run. Your in-house experts will better understand the impact of sustainability on you firm from a business perspective and be able to identify both risks and opportunities specific to your business.

Strategy First

Start at the top by identifying which ESG factors are most relevant to your activities and how they can be integrated into policies, risk management, product development and opportunity qualification as well as stewardship.

Cascade to Management and Operations 

Figure out and plan how your company will incorporate the strategy and policy components into tangible management activities and operational processes. It will now become clear how SFDR requirements can naturally be met.

Execute, Continuously Improve and Communicate

Put the plan into action, identify and prioritise improvements, disclose results and further plans to all stakeholders.

I can not emphasise enough how important it is to establish a mind-set that sustainability and SFDR compliance is all about integration. It is not necessarily about creating a new strategy, process or product. It is about integrating sustainability into the existing business structure, the same way you would incorporate other ‘best practices’ into your company’s framework as new technology and management practices gain credibility.

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