What is the Sustainable Finance Disclosure Regulation (SFDR)?

The Sustainable Finance Disclosure Regulation (SFDR) is a European regulation intended to improve financial sector transparency for sustainable investment products. It also helps to prevent greenwashing and to increase transparency around sustainability claims made by financial sector participants.

The SFDR is a fundamental pillar of the EU Sustainable Finance Agenda and was introduced by the European Commission as a key part of its 2018 Sustainable Finance Action Plan. The Taxonomy Regulation and the Low Carbon Benchmarks Regulation also play important roles within that.

The Sustainable Finance Disclosure Regulation (SFDR) imposes sustainability disclosure requirements on financial actors in the EU covering a broad range of environmental, social and governance (ESG) metrics at both entity- and product-level.

What is the background to the SFDR?

The Sustainable Finance Disclosure Regulation (SFDR) is part of a suite of European regulation aimed at building a sustainable economy. The European Green Deal envisions a European economy that is climate neutral by 2050, in line with the Paris Agreement, and is positive for biodiversity. The SFDR – along with other EU sustainable finance initiatives – plays a key role in achieving that.

The SFDR, together with the Taxonomy Regulation and the Low Carbon Benchmarks Regulation, belongs to a package of legislative measures arising from the European Commission’s Action Plan on Sustainable Finance.

The focus for the SFDR is to require greater disclosures on sustainability from financial market participants. By enabling investors and asset managers to better understand the impact that their investments have on society and the environment, the expectation is that they will be able to shift capital away from activities with a detrimental impact and towards areas with a positive impact.

The SFDR was introduced in 2019 and came into effect in March 2021.

Who does the SFDR apply to? 

The SFDR applies to EU-based financial market participants with over 500 employees. This includes banks, investment firms, asset managers, fund managers, pension funds, insurance companies, institutional investors, venture capital funds, alternative investment funds and credit institutions that offer portfolio management. Financial advisors providing investment advice or insurance advice regarding insurance-based investment products (IBIPs) are also included. The SFDR is also applicable to investment managers and financial advisers based in the EU, even if they are based elsewhere.

What are the SFDR requirements?

If your company falls under the remit of the SFDR, as described above, then you’ll need to meet certain disclosure requirements. These requirements cover a broad range of environmental, social and governance (ESG) metrics at both entity- and product-level.

You’ll need to report on sustainability issues in a standardised manner, which will require collecting information and data from your clients and portfolio companies, as relevant.

There are two levels of disclosures under the SFDR, as described below:

Entity-level disclosures (Level 1)

As a financial market participant, the entity-level sustainability disclosures must, also known as Level 1 disclosures, require you to disclose your entity-level policies on sustainability. These requirements apply from 10th March 2021. To comply, you’ll need to provide the following information on your website:

Sustainability risk policy:

How are sustainability risks factored into your investment decisions?

Principal adverse impact:

How do your investments affect a range of sustainability factors, such as social matters and climate-related indicators? You’ll need to report on 14 different sustainability factors to comply, six of which address greenhouse gas emissions.

Sustainability risk remuneration policy:

Are risks factored into your company remuneration policy, and if so, how?

If you do not consider the sustainability impact of your investment decisions, then you’ll need to state this clearly on your website, together with a clear reason for why you choose not to do so.

As part of principal adverse impact, the SFDR requires you as a financial actor to report on the volumes of investee companies. This includes Scope 1 and 2 emissions, and since January 1st, 2023, it also includes Scope 3 emissions, which broadly cover a company’s value chain. Read more about Scope 1-3 emissions here.

You’ll also need to disclose any actions you take to address these principal adverse impacts, as well as a summary of company engagement policies.

From 1st January 2022, reporting on principal adverse impact is compulsory for companies covered by SFDR.

Product-level disclosures (Level 2)

Reporting on product-level disclosures, or Level 2 disclosures, is required from 1st January 2022. This entails adopting a further series of disclosures for each of the financial products that you produce or promote.

Depending on the financial product in question, there are different categories to consider:

Mainstream:

Where your company does consider principal adverse impact, you should explain how your financial products account for these principal adverse impacts. This applies to all of your products, whether or not they are intended to meet sustainability goals.

Promoting environmental or social characteristics:

For products that promote environmental or social characteristics (known as Article 8 products), you should provide additional information on how these attributes are met. You need to disclose the degree of EU Taxonomy alignment for the underlying activities of such products.

Having sustainable investment objectives:

For products with a sustainable investment objective (known as Article 9 products), you should explain how the objective is achieved and provide additional disclosure on alignment with EU Taxonomy Regulation. You should clearly explain which sustainability indicators are used to provide investment advice.

From 30th June, 2023, companies will need to disclose detailed indicators for principal adverse impacts for the period from July 2022 to December 2022.

Product classification under the SFDR

There are three types of product classification under SFDR – Articles 6, 8 and 9.

Article 6: These products do not always integrate sustainability and ESG considerations into the investment decision-making process. They are typically known as 'mainstream' financial products but they should consider sustainability risks. These products do not meet the criteria of Articles 8 or 9.

Note that Article 6 imposes on all financial firms the obligation to disclose the way in which sustainability risks are integrated into investment decision making.

Article 8: These financial products promote environmental and/or social characteristics, and the companies in which the investments are made have good governance practices. However, ESG investing is not core to these products.

Article 9: These financial products have sustainable investment as their core objective.

Note that Article 9 establishes whether or not a given financial product causes any significant harm.

How can financial organizations prepare for the SFDR?

If you are a financial market participant with over 500 employees located in the EU, then you will need to have complied with the SFDR since March 10th, 2021, with reporting of principal adverse impacts since January 1st, 2022. The SFDR regulatory technical standard has been in place since January 1st, 2023. These standards were developed by European Supervisory Authorities and are intended to improve the disclosures that investors receive.

We recommend following these steps for effective SFDR compliance:

1)      Define the ESG data you need from across your investments and portfolios to satisfy SFDR. This includes environmental data, such as carbon footprint and natural resources use; social data, such as labour issues and human rights; and governance data, such as corruption policies. There are a total of 64 indicators of principal adverse impacts under SFDR, so it is best to gather relevant data to these.

2)      Collect relevant ESG data for SFDR compliance from your investments. You should aim to collect unbiased company data – meaning reliable sourcing from companies directly, and cross-referencing data with unbiased sources such as company reviews and financial news.

3)      Screen your portfolio using these data sets. Use the ESG database you have created, screen your current portfolio for PAI indicators and set up a system to screen future acquisitions and investments for sustainability characteristics. Doing so can help you locate investment areas that could violate sustainability best practice, while also identifying positive areas for sustainability impact.

4)      Establish a reporting process once you have a robust screening process in place to alert you to SFDR risks and principal adverse sustainability impacts (PAIs) as they arise in your portfolio. To comply with SFDR, make a disclosure about the current state of your investments on your website. The reporting process could develop further as we approach the full application of SFDR.

What is the relationship between the SFDR and the EU Taxonomy?

The CSRD and the EU Taxonomy both play a crucial role in advancing sustainable finance and promoting sustainable growth and environmental objectives within the EU. The Taxonomy Regulation, enacted in 2020 as part of the EU Green Deal, establishes a framework for defining and disclosing environmentally sustainable economic activities. It focuses on six specified environmental objectives: climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems. These objectives are further refined through the development of regulatory technical standards and specific environmental criteria.

The CSRD aims to enhance corporate sustainability reporting by expanding the reporting requirements for EU companies and promoting the integration of sustainability risks. It seeks to align reporting with the sustainable objectives outlined in the EU Taxonomy, including the regulatory technical standards and specific environmental criteria. By incorporating the Taxonomy's objectives into the CSRD, the reporting framework will provide a more standardized and transparent approach to assessing and disclosing the environmental impact of companies. This alignment will facilitate the identification of sustainable economic activities, enabling investors and stakeholders to make informed decisions and direct capital towards environmentally friendly investments, thereby fostering sustainable growth within the EU as part of the broader EU Green Deal agenda.

How is the SFDR different from the CSRD?

The Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD) are two initiatives introduced by the European Union to promote sustainable investments. Both regulations require companies to report on their ESG performance, but there are some important differences between them. The SFDR applies specifically to financial firms, including asset managers, portfolio management services, and financial advisers, and aims to ensure environmentally sustainable investments by requiring enhanced disclosure obligations on sustainability risks and their integration into the investment process. On the other hand, the CSRD applies to a wider range of companies and requires more comprehensive ESG information disclosure. While the SFDR only requires limited third-party verification of disclosed information, the CSRD demands more extensive reasonable assurance. Both regulations aim to support investors in making informed decisions, but the SFDR is more focused on or insurance advice, while the CSRD emphasizes the importance of ESG information disclosure and accountability for all companies.

SFDR Glossary

Principle Adverse Impacts (PAIs)

Principle Adverse Impacts refer to the significant negative effects that an organization's activities, products, or services can have on ESG factors. Note that under the SFDR, financial actors are expected to consider PAIs in their investment or insurance advice.

Pre-contractual disclosures

Pre-contractual disclosures refer to the mandatory information that financial market participants must provide to investors before entering into an investment contract, offering transparency regarding sustainability-related risks and impacts.

Carbon emissions

Carbon emissions refer to the release of carbon dioxide (CO2) and other greenhouse gases into the atmosphere as a result of a company's operations, including activities such as energy consumption, manufacturing processes, and supply chain activities.

Sustainability factors

Sustainability factors encompass environmental, social, and governance (ESG) considerations, including respect for human rights, anti-corruption efforts, and other relevant ethical practices that can influence the financial performance and impact of investments or companies.

Sustainability risks

Sustainability risks refer to potential adverse impacts on financial performance that can arise from ESG factors such as climate change, resource scarcity, human rights violations, and other sustainability-related challenges, which may affect investments or companies. The SFDR mandates the integration of sustainability risks by financial actors into their investment processes.

EU Sustainable Finance

EU Sustainable Finance refers to the framework and initiatives established by the European Parliament to integrate sustainability considerations into the financial system, promoting environmentally and socially responsible investments and fostering the transition to a sustainable economy.

Sustainable Investment

The SFDR defines a 'sustainable investment' as an investment in an economic activity contributing to an ESG objective.