The SFDR: a brief overview

The SFDR is an integral part of the European Union’s 2018 Sustainable Finance Action Plan, a major policy shift aiming to promote sustainable investment across the 27 member states. It is imperative to understand what is required by the SFDR — the regulation imposes mandatory disclosure requirements for all financial institutions and market participants based in the EU.

While the Level 1 SFDR disclosure requirements entered into force back in March 2021, the Level 2 SFDR requirements (also known as the Regulatory Technical Standards (RTS)) are due to come into effect at the start of 2023.

The SFDR has three overarching objectives:

• To increase transparency and reduce greenwashing through standardised reporting
• To direct more capital towards sustainable businesses and opportunities
• To incorporate material ESG considerations into mainstream risk management

Through these objectives, the EU aims to build a level playing field for the measurement and disclosure of sustainability factors in financial products, thereby mitigating the risk of greenwashing. The vision and hope is that investors will be able to easily compare standardised sustainability factors across different business opportunities, in order to make more informed sustainable investment choices.

The SFDR works in tandem with the EU Taxonomy, a classification system that establishes a list of environmentally sustainable economic activities. It also goes hand-in-hand with the Corporate Sustainability Reporting Directive (CSRD); the SFDR puts pressure on financial actors, and the CSRD puts pressure on companies. The CSRD requires all large companies to publish regular reports on their environmental and social impact activities.

Who does the SFDR apply to?

All Financial Market Participants (FMPs) with EU shareholders and those marketing financial products in the EU, including:

• Asset managers
• Pension funds
• Insurers

This regulation will not only apply to EU-headquartered firms. Parent companies, including many in the US, could also be in scope if they have set up a legal entity in the EU or if they have EU-based subsidiaries.

Although the SFDR was not maintained in UK law following Brexit, a UK-focused regulation named SDR is planned, which is expected to work similarly to the EU SFDR.

A high level look at what firms must disclose

The SFDR disclosure obligations are divided into three key categories:

1. The principal adverse impacts (PAIs) of investment decisions on sustainability factors

Firms (all FMPs with 500 employees or over) must disclose the potentially negative consequences (PAIs*) an investment decision may have on sustainability factors and how they are mitigating the impacts.

*PAIs refer to a set of 14 mandatory data points (both environmental and social aspects) which aim to show financial market participants how certain investments pose sustainability risks. As well as these 14 indicators, at least one extra environmental indicator and one extra social indicator must be considered.

2. Consideration of sustainability risk in investment processes

Firms must disclose where an ESG risk could materially impact investment and align their remuneration policies with sustainability risk management

3. Provision of sustainability information with respect to financial products

Firms must disclose where their financial products stand and there are different disclosure obligations for different classifications. The SFDR distinguishes between three types of product classification:

Article 6 → Products where ESG considerations are not integrated into the investment decision-making process. Fund managers must explain where integration is not relevant when products do not meet the criteria for Article 8 or 9.

Article 8 → Products that promote environmental and/or social characteristics and portfolio companies should have good governance processes. Implication that ESG investing is not core to these products. Also known as “light green” products.

Article 9 → Products that have sustainable investment as their main objective. Also known as “dark green” products.

Olivier Carré, Financial Services Leader at PwC Luxembourg, predicts that by 2025, half of Europe’s mutual funds will adhere to SFDR's Article 8 and Article 9.

The SFDR has two levels of disclosure

Entity level: disclosure obligations for financial institutions regarding their policies on integrating sustainability risks into decision-making.

Product level: reporting obligations concerning financial products and their associated sustainability risks.

Disclosures are made through three primary channels: website, pre-contractual documents and periodic reports.

Entity level disclosure:

The following table sets out a timeline for the high level disclosure requirements for financial entities, outlining the type of disclosure required, the relating SFDR article and when the mandatory requirement is applicable. Most entity level disclosure is already enforced, apart from the incoming disclosure requirements on PAIs of investment decisions based on the period 01/01/2022 - 31/12/2022.

Product level disclosure

The following table sets out a timeline for the high level disclosure requirements for financial products, outlining the funds impacted by the regulation, the type of disclosure required, the related SFDR article and when it is applicable. Most product level disclosure is yet to be enforced, including the consideration of PAIs in financial products and disclosure requirements for Article 8 and 9 funds.

Key dates:

10 March 2021: SFDR Level 1: relatively high-level disclosures from FMPs, on their sustainable investment strategy, risk management, and categorisation of products in terms of sustainability (Articles 6, 8 or 9).

1 January 2023: SFDR Level 2 (also known as the SFDR Regulatory Technical Standards (RTS)): more detailed disclosure required including of PAIs both at entity level and product level and disclosures related to ESG-focused products (Articles 8 and 9). Application date was originally 1 January 2022, however it has been pushed back to 1 January 2023.

For further detail, refer to the SFDR Level 1 text and the Final Report on draft Technical Regulatory Standards (RTS).

Although the RTS were published back in April 2022, the European Supervisory Authorities (ESAs) submitted eight questions to the European Commission (EC) in September. These questions revolve around the way ESG funds are labelled and the type of information they have to disclose. They are yet to be answered, despite the fact that Level 2 disclosures are due to enter into force in less than three months. Therefore, there may still be last minute changes to the regulation, which is creating uncertainty amongst ESG fund managers. As soon as these new questions are answered by the EC, 9fin will provide a clear outline of any updates and concretely highlight what this will mean for fund managers.

A closer look at article 8 and 9 funds:

Classifying funds continues to be one of the most difficult tasks in complying with the SFDR; 9fin often gets asked questions in relation to the classification of financial products into Article 8 and 9. Difficulties arise due to the fact that the SFDR was not designed as a labelling system. Its vague concepts and the resulting differences in interpretations pose a major challenge for asset managers.

The following section outlines the differences between classifications and also highlights the difficulties with Article 8, which is increasingly becoming a “catch-all category”; it is home to a wide variety of asset classes with vastly different approaches to ESG.

Article 8 funds: the promotion of environmental and/or social characteristics

While this statement may seem simple, there is difficulty in defining Article 8 funds. The term “promotion” is very much up for interpretation. In 2021, the European Commission explained that “promotion” of sustainability characteristics can be described through claims, information, reports, disclosures, or even impressions that portfolio assets consider the stipulated environmental/social characteristics (access the full list of possible ways to describe the promotion of sustainability characteristics).

Disclosure requirements for Article 8 necessitate the definition of sustainability indicators in order to detail how the relevant characteristics are measured. It is recommended that PAIs are used as sustainability indicators. Firstly, because they are easily comparable and can be tracked throughout the lifetime of the portfolio, and secondly, because they are already required in other SFDR disclosures.

One suggested Article 8 format relates to an ESG-based exclusion policy. For example, a fund manager could decide to exclude mining companies from their funds. However, it is difficult to determine how PAIs could track progress for this “characteristic”. Furthermore, according to Morningstar, an investment research firm, some funds have simply formalised ESG exclusions in response to the SFDR, without changing a single characteristic of their investment process or strategy.

Unfortunately, as a result of its vague description, Article 8 is increasingly being seen as an all-encompassing category, including several different asset classes all with different approaches to ESG.

If Article 8 fund managers do not clearly integrate sustainability characteristics in investment decisions, this gives rise to the risk of a crackdown from the authorities. US and German regulators are currently investigating DWS following a claim from its former head of global sustainability, Desiree Fixler, who highlighted that DWS overstated how much it used sustainable investment criteria to manage its assets. This case highlights the importance of providing clear evidence showing how ESG factors are integrated into the investment process to avoid facing similar scrutiny.

Article 8 plus funds: the promotion of environmental and/or social characteristics with a minimum commitment to making sustainable investments

In response to the lack of clarity surrounding Article 8, a new form of classification has emerged, with more stringent requirements; Article 8 plus.

Article 8 plus funds have been developed by the financial sector, rather than through regulation. These funds differ from Article 8 funds, in the way that a proportion of the fund must be classed as “sustainable investments”, as per the SFDR definition. There are three requirements for this sort of investment:

• Contribution to a social or environmental aim
• Compliance with the “do no significant harm” principle from the EU Taxonomy (disclosure of PAIs is required)
• Adherence to “good governance”

Article 8 plus fund managers are required to embed classification processes into pre-contractual and periodic disclosures, for example, through defining the alignment of activities with the EU Taxonomy. This will make it clear whether or not portfolio assets are classified as sustainable investments under the SFDR — there is a clear overlap between the EU Taxonomy classification system and the SFDR sustainable investment classification.

It is clear that some Article 8-labelled funds may not take into account sufficient sustainable characteristics and as a result, these funds risk being accused of greenwashing. Portfolio Adviser (a news platform aimed at fund managers, wealth managers and private bankers/advisers) argues that this category is going to seem like a lower threshold in a year’s time than it does today. As a result, there are clear benefits to ensuring that funds meet the Article 8 plus classification. Doing so provides more clarity for investors on the sustainability characteristics of investments.

Article 9 funds: the objective of the fund is sustainable investment

Article 9 funds go one step further than Article 8 plus funds and require all assets to be a “sustainable investment”. The disclosures for Article 9 funds are the same as for Article 8 plus funds, except for the fact that investments must exclusively be sustainable.

The ESG team at 9fin produces detailed, qualitative analysis on all new high yield bond and leveraged loan issuers in the form of ESG QuickTakes. These QuickTakes outline the material ESG considerations for an issuer and its sector in a clear and succinct manner. In addition, the team delves into a company’s specific approach to ESG, in order to guide and inform fund managers’ Article 8/9 classification process.

A closer look at Principal Adverse Indicators:

Another challenging part of ensuring SFDR compliance is related to the PAI reporting requirements, both at entity level and product level.

The updated RTS, published on 6 April 2022, provide a prescribed template for the required PAI disclosure in Annex I. FMPs that consider PAI on sustainability factors (all FMPs with 500 employees or more) will have to provide information on various ESG-related matters, including environmental and social indicators. A total of 14 key indicators (nine indicators related to the environment, and five covering social factors) are considered mandatory, in order to appropriately assess adverse sustainability impacts across a variety of ESG factors.

As well as the 14 indicators outlined above, at least one extra environmental indicator and one extra social indicator must be considered. The PAI statement aims to show investors and potential investors how investment decisions impact a previously defined set of mandatory sustainability indicators, as well as voluntary ones.

Without doubt, accessing company level ESG data related to these PAIs is the biggest hurdle. FMPs can no longer simply buy ESG scores and rely on them. Now you need actual data from the source, which is particularly difficult when it comes to private companies.

As discussed in our ESG within LevFin insights piece, private company ESG reporting is especially sparse. Of 9fin’s dataset of 11 key PAI-aligned metrics, private companies reported on an average of just 4.16. (9fin clients can read the report. If you are not a client but would like to request a copy, please complete your details here.)

However, this is set to change, as a result of the Corporate Sustainability Reporting Directive (CSRD), which is set to come into force from January 2024. Companies will have to adhere to more detailed mandatory reporting requirements, and data must also be machine-readable. All listed entities will be in scope as well as large private entities that meet at least two of the following three criteria:

• More than 250 employees
• More than €40m turnover
• More than €20m on the balance sheet

9fin has a data solution to facilitate data collection in relation to PAIs. Our dedicated team of experienced ESG analysts do the hard yards and collect PAI-aligned data points directly from publicly available documents and from companies themselves. We deliver the information through a dynamic interface, helping FMPs to easily review data.

We currently offer a dataset consisting of 14 PAI-aligned data points across 500 of the most-followed LevFin companies. We are in the process of ramping up our coverage and will soon have a total of 25 data points across over 740 European private companies, covering all of the mandatory PAI data points.

9fin's ESG team will be running a complimentary webinar on 24 November for everyone interested in how to approach ARticle 8 and 9 reporting under SFDR. You can sign up to attend or watch the replay.