At first glance, the European Union's (EU) new Sustainable Finance Disclosure Regulation (SFDR) appears relatively complicated. Financial market participants (FMPs) and financial advisors may be confused about what SFDR is, when it takes effect, what they will need to prepare to comply with it, and what kind of resources will be available to help organizations comply with it.
This article breaks down some of these tough questions into their components and attempts to make the SFDR a little easier to understand.
What Is SFDR?
At its core, SFDR requires investment companies to report on the sustainability of the companies in which they are invested. The framework is a new EU regulation that affects all FMPs and financial advisors who operate their businesses in the EU, with new guidelines and requirements about what sustainability disclosures investment organizations will need to make about the companies in their portfolios.
However, the term 'sustainability' in this context includes multiple factors, including 'environmental, social and employee matters, as well as matters relating to human rights, anti-corruption and anti-bribery.' That means that sustainability does not only refer to environmental concerns. Even if your investments don't have a high environmental impact, that doesn't necessarily mean you won't have to make disclosures under the new SFDR regulations.
SFDR is the direct result of an EU commission that worked between 2016 and 2018 to build a roadmap for a future law such as the SFDR. The EU's High-Level Expert Group created guidelines for a law that would have two main objectives: 'Integrate sustainability considerations into the financial system, and [s]teer the flow of capital towards sustainable investments.' In other words, it designed a system that would encourage companies to prioritize sustainability as a core value.
What Are Principal Adverse Impacts (PAIs)?
Central to understanding these upcoming regulations is the concept of Principal Adverse Impacts (PAIs).
A PAI is an investment decision or piece of advice that may negatively affect the sustainability of an investment, such as its impact on climate and the environment, respect for human rights, social matters or other factors. PAIs are a core part of the new SFDR regulation. Now is the time for organizations to gather information and think critically about what PAI indicators might be present in their portfolios. These indicators will inform your disclosures under SFDR and help to determine whether an investment product meets specific requirements.
When Will the SFDR Become Active and Who Does It Affect?
The first part of the SFDR became law on March 10, 2021. Currently, organizations are in a compliance grace period where FMPs and financial advisors can consider the coming implications of phase 2 of the SFDR, tentatively set to take effect in July 2022. Right now, impacted financial organizations of 500 employees or more are required to start tracking PAI indicators and consider their implications for their portfolios. The European Commission has said that all organizations that will eventually be affected by the SFDR should 'comply with the SFDR's high-level and principle-based requirements' from March 10, 2021, onwards.
Although the full text and implementation methodology of the changes that will come into effect in July 2022 are not yet available, it can reasonably be expected that disclosure of PAIs will begin at that point for all organizations implemented in the scope of the SFDR. Regulatory Technical Standards for how disclosures will need to be made and further instruction on what indicates a PAI has not been decided yet and is expected to be clarified.
What Information Will Asset Managers Need to Be Prepared to Deliver?
Asset managers at organizations under the scope of SFDR will need to prepare disclosures of any PAIs that they have identified related to their investment portfolios. These disclosures will most often occur in either pre-contractual disclosures (such as prospectus documents) or periodical documents that they already produce (such as an annual report).
To comply and create these reports, asset managers will have to collect a significant amount of environmental, social and corporate governance (ESG) data on how their organization has been run in the past. This data will most likely form the most critical evidence in the disclosures they will have to make.
Considering that SFDR encompasses the entirety of ESG and more, rather than just environmental issues, this data will need to come from a wide variety of sources to ensure compliance. For instance, poor governance can be considered a PAI indicator, though the 'G' in ESG is an area that few organizations consider when tracking their portfolio impact. That will need to change.
What Types of Processes Will Help Financial Companies Address This Requirement?
There are several tools available to help organizations comply with the upcoming regulations of SFDR. While most of them currently seem to be structured around comparing existing ESG databases to individual organization's ESG track record, greater functionality will undoubtedly develop further as more regulations are unveiled.
The fact is, organizations will need access to a diverse range of ESG data to comply with SFDR. Often, this will require cross-departmental coordination and reporting to remain in compliance.
Still, despite the delays, impacted companies need to start thinking now about how they will comply with SFDR when it finally arrives and the systems that will need to be in place to gather the necessary data. What information will your firm need to be reporting? Where will it be stored? And how different is it from what you are collecting now? As with other regulations, preparation is key to compliance; the time is now to put the necessary systems in place to prepare for the coming full rollout of SFDR.
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