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Demystifying SFDR for financial firms and advisors

Demystifying SFDR for financial firms and advisors

As demand for sustainable financial products grows, investors are increasingly looking for data on how investments actually promote sustainability—and on how climate risks may impact their value. The EU’s mandatory Sustainable Finance Disclosure Regulation (SFDR) programme directs financial firms and advisors on how to offer this transparency.

The latest SFDR technical standards, released 6 April 2022, demand far more data than the first wave of requirements—including detailed emissions data from portfolio companies, many of which are still measuring their carbon footprints for the first time.

While these new rules take effect 1 January 2023 (applicable to 30 June 2023 filings), most filers need to begin collecting this additional data today. This guide covers what SFDR asks for—and how and when to report it. Watershed helps leading companies measure, report, and act on their emissions, and our in-house climate advisors support financial institutions like Baillie Gifford with their climate compliance obligations. If we can help with any of this, please reach out.

Covered organisations

SFDR covers all EU investment management firms and advisors, including asset managers, banks, and insurers—along with all non-EU firms that target the EU market through the Alternative Investment Fund Managers (AIFM) Directive.

The specific rules, however, vary based on three broad groupings:

  1. Large financial market participants (FMPs)—e.g. banks, asset managers, investment firms, insurance companies, venture capital firms, pensions funds, etc.
  2. Smaller FMPs with fewer than 500 employees (counted at a group level, including headcount from any non-EU entities).
  3. Financial advisors—whether individuals, entities, or intermediaries—who guide EU consumers on investment, insurance, and pension products.

We’ll get into how the rules vary by group as we discuss the rules in turn.

SFDR’s relationship with the EU’s “Green Taxonomy”

SFDR is a twin project with the EU’s new Green Taxonomy: an in-progress rulebook that determines which economic and business activities officially count as green.

Under SFDR, when a covered organisation labels or markets a financial product as sustainable, they must disclose the degree to which the underlying investments meet this taxonomy’s minimum qualifications—ie. how green they really are.

Combined with the EU’s soon-coming corporate disclosure programme (CSRD), companies will face strong pressures to align their activities with this taxonomy—and sustainability-focused funds will need to report on the collective progress of their portfolio companies.

A great first step for fund managers is to commission a footprint measurement to identify where their portfolio companies’ carbon hotspots are.

What SFDR asks for

In the long run, SFDR is about creating the sustainability equivalent of nutrition labels for financial products—which will outline two things for investors:

  1. Sustainability risks, or how a changing climate will affect the underlying investments
  2. Principal Adverse Impacts (PAI), or how the investments will impact the world / climate

The EU is pushing towards this by gradually increasing the stringency of their minimum disclosure requirements—which must now be made at two “levels”:

  1. At an entity level (applies to FMPs*, but not financial advisors)
  2. At an individual product level (applies to both)

*While all FMPs must provide product-level disclosures, those with 500 or fewer employees can opt out of entity-level disclosures if they explain their reasoning in writing.

Entity-level disclosures

Covered FMPs need to regularly disclose four things:

  1. How they factor sustainability risks when making investment decisions—eg. when it happens in the selection process, who’s responsible for deciding, and which specific climate-risk considerations or benchmarks might disqualify an investment.
  2. If and how their remuneration policies reflect the above approach.
  3. How they factor a specific list of 14 Principal Adverse Impacts (PAI)—covering both the environment and broader social issues.
  4. How they approach due diligence for the above, including which recognised codes and standards they’re referencing in their self-evaluations

Of the core 14 Principal Adverse Impacts that each FMP must cover, six are climate-related (precise formulas here):

  1. Scope 1-3 GHG emissions—ie. their own emissions plus a share of total emissions from each portfolio company (proportional to the FMP’s investment in them).
  2. Their carbon footprint—ie. their total Scope 1-3 GHG emissions divided by the current value of all investments.
  3. The aggregate GHG intensity of portfolio company and other asset emissions—i.e. the emissions of each company relativised to a financial metric like revenue.
  4. The share of investments in fossil fuel companies.
  5. The share of energy produced or consumed by the portfolio companies that came from renewable vs. non renewable sources.
  6. Energy consumption (per million euros of portfolio company revenue) for each high-impact climate sector.

The new rules also require the disclosure of at least one additional non-core PAI indicator from each of the environmental and social categories. The easiest and most impactful climate-related option is “how many of your portfolio companies don’t have carbon emissions reductions initiatives yet?”—which spurs lagging companies to take their first step towards real action.

Product-level disclosures

The rules ask that all financial products be clearly bucketed into one of three categories:

  • Article 6 products don’t have sustainability as a core objective, nor is sustainability (as defined by the Green Taxonomy) a screening consideration during investment selection
  • Article 8 (“light green”) products also don’t have sustainability as a core objective, but some investments are screened for sustainable characteristics* and marketed accordingly
  • Article 9 (“dark green”) products have sustainability as a core objective, and all component investments are marketed as sustainable*

*Once the Green Taxonomy is complete, “sustainable” can also mean taxonomy-aligned. For now, products must just disclose how aligned they are with the taxonomy’s finished sections.

As we’ll cover in the next section, each product’s disclosure obligations correspond to its strongest ESG marketing claims. Article 9 products claim the most impact, and thus have the highest bar to clear. Article 6 products aren’t considered green, and require no disclosures.

How and where to file

SFDR disclosures fall in two categories:

  1. Pre-contractual disclosures are to be provided to potential investors, and must include both entity and product-level sections. They’re meant to be forward-looking, focusing on sustainability objectives and expected performance.
  2. Periodic disclosures are for product-level disclosures only, and serve as report cards on how each product is doing relative to its goals.

Both types of disclosures must be summarised and uploaded to a prominent place on the filer’s website. These filings must be dated, and must include the next anticipated publication date.

Pre-contractualPeriodic
Entity Level DisclosureYN
Article 8 Product DisclosureYY
Article 9 Product DisclosureYY

Disclosure templates

Entity level (pre-contractual only)

1. How do you factor sustainability risks when making investment decisions?
2. Do your remuneration policies reflect the above approach? If so, how?
3. How do you factor the 14 core Principal Adverse Impacts (PAI)?
4. How do you factor two additional PAI (one environmental, one social)?
5. How do you approach due diligence for the above?

Note that entity-level disclosures must address all 14 core PAI, while product-level disclosures are free to leave out the carbon-related PAI. But many investors want to see at least Scope 1-3 emissions data on a product-by-product basis, and we strongly encourage including it.

Product level (pre-contractual)

Answer the left or right column based on product classification:

Article 8Article 9
1. Which generic environmental and/or social characteristics does this product promote?1. Which specific sustainable investment objective does this product promote?
2. Which reference benchmark(s) (if any) will determine whether this product aligns with its characteristic or objective?2. Which reference benchmark(s) (if any) will determine whether this product aligns with its characteristic or objective?
3. How does this product consider PAI? 3. How does this product consider PAI?
4. What’s this product/s investment strategy?4. What’s this product/s investment strategy?
5. What percentage of this product is reserved for investments that align with at least one Green Taxonomy objective?5. What percentage of this product is reserved for investments that align with at least one Green Taxonomy objective?
6. Where can I find more product-specific information online? 6. Where can I find more product-specific information online?

Product level (periodic)
Here Article 8 and 9 disclosures cover the same questions:

Since your last report…
1. How did this product perform compared to its reference benchmark?
2. How did this product perform on its PAI considerations vs. the last five years?
3. Which actions were taken to improve?
4. What were this product’s top 15 investments (by total value)?
5. What proportion of investments aligned with at least one Green Taxonomy objective?

Getting started

SFDR filings are based on calendar years, where each year’s data must be shared by 30 June of the following year—eg. 2022 data by 30 June 2023. All PAI-related metrics must be calculated at the end of each calendar quarter and then averaged for each annual report.

While the ruleset covered here goes into effect 1 January 2023, filers are strongly encouraged to structure their 2022 filings (due 30 June 2023) with its rules in mind. The programme’s next update is expected to be finalised before January 2023, and to be applicable to filings due later that year. We’ll update this guide with what you need to know.

If we can help with compliance reporting or painless carbon measurements for portfolio companies, please get in touch.

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