Five key questions about the EU’s new Sustainable Finance Disclosure Regulation

One of the difficulties faced by responsible investors has been a lack of common rules, data and language to define strategies and outcomes. The Sustainable Finance Disclosure Regulation (SFDR) is the European Union’s (EU) effort to solve at least part of that problem.

What is SFDR?

The SFDR rules – which come into effect this year – give asset managers like AXA IM a template for reporting how environmental, social and governance (ESG) factors are handled at both firm level and product level. That should give clients a simpler way to compare how asset managers are approaching major sustainability issues like climate change.

Asset Managers will provide greater transparency on the degree of sustainability of financial products so that they can be compared. This includes:

  • Consideration of sustainability risks, including the risk of depreciation in the value of underlying assets due to environmental or social events
  • Consideration of principal adverse impacts (PAI) on sustainability factors; these are the negative effects on environmental, social and employee matters as well as respect for human rights, anti-corruption and anti-bribery resulting from an investment decision
  • Sustainable investments in economic activities that contribute to environmental or social objectives. They include investments in EU-taxonomy-eligible economic activities

What products are affected?

The SFDR rules affect all products managed by EU entities. Their impact is greater for those strategies which seek to apply ESG criteria as part of the portfolio decision-making process.

There are three distinct categories, known by the name of the part of the SFDR regulation that applies in each case:

  • Article 6 products are those which only assess and address sustainability risks
  • Article 8 products are deemed to be those that promote environmental and social characteristics, taking ESG criteria into account as part of the investment process, 
  • Article 9 products have a sustainable objective and therefore target specific sustainability outcomes – either environmental or social – alongside targets for financial returns. They aim to reduce, as far as possible, any negative effects in respect of environmental, social and employee matters, as well as embedding respect for human rights, anti-corruption and anti-bribery into investment decision making

Thanks to SFDR, asset managers will now be able to state what percentage of their assets under management are classified as Article 6, Article 8 or Article 9.

What kind of information will be published?

All products will need some form of disclosure under the new rules. Even strategies that do not claim any ESG integration will have to describe to clients how sustainability risks are incorporated into decision making, and how those risks might affect financial outcomes (Article 6 products).

For products considered to fall under Article 8 or Article 9, there are more detailed requirements. Asset managers must publish:

  • How the investment strategy takes into account the ESG characteristics or the sustainable objective, including with regard to planned asset allocation
  • Details of the ESG objective/objectives and a breakdown of the different categories of investment
  • Details of how negative impacts are quantified and addressed and how holdings that might cause harm to the sustainability objectives are screened out
  • A list of applicable sustainability indicators
  • Information on how the use of derivatives is consistent with the ESG aims of the product

Are there any other changes?

Another SFDR disclosure requirement involves larger asset management firms publishing on their websites the potential negative environmental and social impacts of all their holdings, as well as details of engagement with corporate management.

Again, the new rules set consistent and common templates for all affected firms to follow. In total there are 18 mandatory items, which will require significant disclosures from investee companies.

Why has this happened now?

The growth of the responsible investment industry has accelerated in recent years and the amount of measurable and verifiable data has increased alongside it. That means that it is now possible to quantify and compare ESG outcomes far more effectively than it was before. The advent of the SFDR rules reflects this encouraging development, but it also reflects the rise of sustainability as a priority at government level. SFDR is part of a wider European Union effort to reorient capital allocation towards more sustainable business models. More generally, this comes as part of a global trend which includes commitments such as those entered into as part of the Paris Agreement on climate change.

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