What is SFDR?
The Sustainable Finance Disclosure Regulation (SFDR) is a European regulation introduced to improve transparency in the market for sustainable investment products, prevent greenwashing, and increase transparency around sustainability claims made by financial market participants.
Are you subject to the new SFDR requirements implemented by the European Commission? Even though the SFDR is primarily for European-based businesses, your US company may still need to follow some of the provisions.
As an organization deeply passionate about helping companies achieve greater zerowaste-to-landfill goals, Keter stays abreast of rapidly evolving environmental regulations to ensure our clients are prepared.
In this article, we will outline everything you need to know about the SFDR and how your business can leverage the added transparency from the required disclosures.
Additional topics we will cover include:
- The Basics of the Sustainable Financial Disclosure Regulation
- The Goals of the SFDR
- Who Must Follow the SFDR
- Understanding Articles 6, 8, and 9
- Understanding the Different Disclosure Levels
- Differentiating Between Environmental and Social Indicators
- The Importance of the SFDR
- The Implementation Requirements of the SFDR
- The Relation of the SFDR to ESG-Focused Companies in the United States
- Maximizing SFDR Compliance and Market Visibility
- How Keter Environmental Services Can Help
The Basics of the Sustainable Financial Disclosure Regulation
The Sustainable Financial Disclosure Regulation, known as SFDR, places a mandatory Environmental, Social, and Governance (ESG) disclosure burden on asset managers and other businesses participating in financial markets, such as banks, hedge funds, mutual funds, and others. The SFDR was signed into effect on March 10, 2021, by the European Commission; however, the regulation has been bouncing around the EU’s High-Level Expert Group (HLEG) since 2016.
The HLEG sought to accomplish two goals:
- Work sustainability considerations into the financial framework.
- Facilitate the flow of additional capital toward sustainable investments
The first step in reaching the HLEG’s goals was to pass a flagship plan, known as the Sustainable Finance Action Plan, which included the SFDR as one of the main
components.
The Goals of the SFDR
The primary goal of the SFDR is to expand what sustainability information financial advisors and market participants must disclose to avoid greenwashing. Greenwashing is a term used to describe unsubstantiated claims aimed to deceive consumers about environmentally friendly aspects of a business’s operations. This marketing ploy has significantly increased in the past few years as consumers move toward sustainable alternatives.
The required disclosures under the SFDR level the playing field, allowing investors and consumers to make more informed decisions that align with their sustainability objectives. The driving force behind the prospective success of the SFDR is the concept of Principal Adverse Impacts (PAIs).
At the most basic level, PAIs evaluate the negative effects financial advice can have on sustainability factors. The SFDR defines sustainability factors in relation to PAIs as environmental, social, human rights, anti-corruption, anti-bribery, or employee matters. The SFDR now requires investors to report the PAIs found in their portfolios.
Since the SFDR is a relatively new regulation, there are bound to be changes and tweaks to the ESG disclosures required of businesses and market participants.
Who Must Follow SFDR
The SFDR applies to all financial market participants and financial advisors that have EU shareholders or are explicitly marketing to EU shareholders. This means that a US-based business might be required to comply with the SFDR.
The European Commission has further clarified that the following industries are considered financial market participants:
- Insurance companies that have insurance-based investment products
- Investment firms or credit institutions that engage in portfolio management
- An institution that holds occupational retirement provisions
- Manufacturers or pan-European providers of pension products
- Managers of qualifying venture capital funds, alternative funds, social entrepreneurship funds, and ucits
Basically, any business that has a direct connection to the financial market is required to comply with SFDR. In addition, shareholder is a broad term. For example, pension products won’t necessarily have shareholders, but they do retain participants that are relying on management to make smart sustainability decisions.
It is important to note that although a company may not be considered a financial market participant, it still may be required to provide granular data regarding its sustainability initiatives to those entities that may have a vested interest and are subject to the SFDR.
Understanding Articles 6, 8, & 9
There are three main articles found in the SFDR framework: Articles 6, 8, and 9. Article 6 is the starting point, with 8 and 9 increasing in disclosure complexity. The fundamentals of the SFDR and disclosure requirements are based on how strong the company ties to ESG practices. A company that doesn’t focus on sustainability through marketing techniques won’t have as high of a disclosure burden compared to a company that drives investments through sustainability initiatives.
Article 6
Article 6 of the SFDR focuses on transparency of the integration of sustainability risks. According to the regulation, financial market participants should include descriptions of the following two areas of pre-contractual disclosures:
- How sustainability risks are integrated into investment decisions
- Results of the assessment and the impact of sustainability risks on the return of their financial products
When fund managers find relevant sustainability risks, they must:
- Declare that sustainability risks have been integrated into investment decisions
- Create a defined process to assess and identify major risks
- Generate a standardized disclosure policy that mitigates significant risks
- Outline how risk detecting and mitigation will be achieved
- Track the results of risk implementation measures
Article 6 doesn’t limit these disclosure requirements to only ESG or Green classified businesses. Instead, Article 6 applies to all market participants. If managers and
executives determine that sustainability risks aren’t relevant to operations, they must clearly state their rationale in accordance with the article.
Article 8
Article 8 is designed for businesses that promote environmental and social characteristics and capitalize on maintaining good governance practices. When a business promotes its financial products through marketing ploys focused on environmental or social characteristics, it must disclose the following under Article 8:
- Describe how environmental or social governance practices are met
- List detailed information on how the business is maintaining reference benchmark characteristics, if they have been designed as a reference benchmark
- Pinpoint where calculation information is referenced
Article 8 targets funds that don’t have ESG as one of their core investing products.
Article 9
Article 9 prioritizes the transparency of businesses with sustainable investment as one of their core objectives. Contrary to Article 8, Article 9 focuses on businesses
that should be making a positive impact on society or the environment instead of just having strong governance practices. Article 9 takes Article 8 a step further, requiring managers to disclose the following:
- Information on how the business is aligned with the reference benchmark
- A detailed explanation of how the reference benchmark business differentiates itself from the broad market index
Article 9 is designed for businesses strongly tied to ESG objectives and sustainability.
Understanding the Different Disclosure Levels
The SFDR breaks down disclosures on two different fronts: at the entity level and at the product level.
Entity-Level Disclosures
Entity-level disclosures focus on the policies financial market participants use throughout the decision-making process on sustainability risks. How is the impact on the environment determined? Are social and environmental concerns addressed before moving forward with a new product segment or revenue stream?
Entity-level disclosures operate at the legal entity level. Financial advisors and market participants must publish a statement of intent that identifies which Article they align with.
In addition, the following four website disclosures are required at the entity level:
- How the company plans to identify and prioritize PAI
- A statement on the impact of PAI and mitigating actions taken
- A summary of the engagement policies surrounding the prevention and management of conflicts of interest
- A clear reference to business conduct codes and the policies the company follows for due diligence and reporting
For some financial advisors and market participants, the disclosures can significantly exceed the required four narrative website disclosures. In fact, the draft Level 2 Regulatory Technical Standard outlines another potential 64 quantitative ESG metrics, of which 14 are mandatory. This will likely dramatically increase the workload for many financial advisors and market participants.
Product-Level Disclosures
Product-level disclosures outline three main areas when a financial market participant must comply with Articles 6, 8, or 9, which include:
Pre-Contractual Disclosures – These disclosures are similar to entity-level disclosures that outline how the market participant integrates sustainability and the adverse impacts on investors. However, pre-contractual disclosures do include more complex areas for Articles 8 and 9.
Periodic Reporting – Throughout the periodic reports that public companies are required to remit, there must be precontractual disclosures, a determination of how to reference benchmark status was met or maintained, and paragraphs relating to green taxonomy disclosures.
Website Product Disclosures – These disclosures only apply to financial market participants that must follow Articles 8 and 9. Due diligence of underlying assets, limitations, data sources, and determination and measurement of sustainability characteristics must be disclosed on the financial market participant’s website.
Differentiating Between Environmental and Social Indicators
It’s essential to understand how the SFDR defines both social and environmental indicators.
Social Indicators
Social indicators include a variety of cultural, national, and geographic considerations, like:
- Number of investee companies that have been charged with violations of the OECD guidelines or UNGC principles
- Average pay gap between genders
- Number of investee companies that are involved in controversial operations, like weapons or drugs Number of investee companies that don’t have detailed policies in place to stay in compliance with OECD guidelines and UNGC principles
Environmental Indicators
Environmental indicators are equally as important, which the SFDR includes:
- Amount of GHG emissions and intensity
- Carbon footprint
- Impact of non-renewable energy
- Total energy consumption
- Number of investee companies near biodiversity-sensitive areas and the impact of the investee company
- Comparison of emissions to water generated by investee companies
- Amount of hazardous waste generated by investee companies
- Number of investee companies in the fossil fuel industry
The Importance of the SFDR
The importance of the SFDR expands beyond just transparency throughout marketing campaigns. In fact, the implementation of disclosures under the SFDR looks to improve the impact that businesses are having on the environment.
Transparent Investing
The passage of the SFDR aims to level the playing field for investors through transparency into sustainability measures by financial market participants and advisors. Market participants are now forced to evaluate their impact on social and environmental concerns and clearly state those findings to their investors.
For example, businesses will now need to base their strategic decisions on quantitative and qualitative information instead of making decisions based on their personal agendas or biases. Are there systems in place that measure the impact of a decision on ESG? If so, how does it work? If not, how will the company implement the system to maintain compliance with the SFDR?
Ethical Marketing Campaigns
One of the main target areas of the SFDR is greenwashing and the over-exaggeration of green credentials. The SFDR will allow companies to focus on the risks found in the investment process while addressing the concerns of third parties, like investors and consumers. The goal of all these movements is to better the world for all consumers while boosting transparency in the company’s operations so investors and consumers can make informed decisions.
By implementing mandatory ESG disclosures, companies have no choice but to analyze the statements that are made in marketing campaigns, financial statements, and product websites. Consumers and investors need clarity into the actual impact of financial market players on the environment. To avoid making false claims and being assessed penalties by the European Commission, financial market players are more likely to rethink operations to actually achieve the ESG results that they boast.
The Beginning of New Regulations
The SFDR is just the beginning of the regulations that businesses can expect going into the next few years. Shifts in consumer demand toward environmental-friendly movements have tightened regulations that major market players are experiencing.
Future ESG-related legislative action is expected by the European Commission’s Sustainable Finance Action Plan and other global government agencies. Global warming and other environmental concerns have been at the forefront of discussions in the European Union and other global legislative bodies.
The Implementation Requirements of SFDR
The implementation of SFDR occurs in phases. Both Level 1 and Level 2 disclosures are in full effect. Level 1 disclosures focus on principal adverse sustainability impacts and the methods that a financial advisor or market participant will use to measure those impacts. Level 2 measures are known as the Regulatory Technical Standards and will outline details on the presentation of disclosures, indicators for PAIs, and more. Here is the prospective timetable laid out by the European Commission:
June 30, 2021 – All firms with over 500 employees will need to disclose the specifics of their due diligence processes related to PAIs and sustainability.
January 1, 2022 – The application of the EU Taxonomy Climate objectives is set to begin. Financial businesses will need to disclose their alignment with this objective; however, no templates will be available for the application process yet. Additionally, disclosures on Taxonomy-eligibility will be required.
December 30, 2022 – Firms are required to disclose the processes used to evaluate PAIs. Businesses that don’t evaluate PAIs must outline how they reached that conclusion.
January 1, 2023 – Financial market participants and advisors that promote investment in the business through environmental and social characteristic marketing need to adopt periodic and precontractual reporting that aligns with the EU Taxonomy’s main four objectives: sustainable use and protection of water, transition to a circular economy, pollution control and prevention, and protection of biodiversity ecosystems. Articles 8 and 9 will not go into effect with the remaining four objectives of the EU Taxonomy Climate regulation.
June 30, 2023 – Firms that effect with the remaining four engage in PAI research must disclose key indicators from January 1, 2022, through December 30, 2022. Entity-level disclosures are now required.
January 1, 2024 – Product-level disclosures are now required. Articles 8 and 9 businesses need to disclose their relationship to the Taxonomy Climate objectives.
As more companies begin to adopt the required disclosures of the SFDR, there will more likely be additional milestones that businesses will need to abide by. Furthermore, as more countries begin to see tangible change and improvements through the use of the SFDR in the EU, we can expect new regulations to appear globally. This makes it important to stay informed on the latest regulations that your business is subject to.
The Relation of the SFDR to ESG-Focused Companies in the United States
Although the SFDR primarily applies to EU financial advisors and market participants, your US-based business isn’t in the clear just yet. With technology significantly reducing barriers to entering global markets, it’s not uncommon for your business to expand operations to overseas markets. Whether you are operating a physical location overseas, bringing on an EU shareholder, or advertising to EU consumers, the SFDR has the potential to impact you.
Moreover, the SFDR has a direct impact on ESG-focused businesses. The demand for ESG investing remains one of the most relevant investment strategies going into the next few years. Climate disaster risks, the recent pandemic, and social changes have all brought ESG unpreparedness to light. This has led to all businesses taking the initiative to increase their commitment to sustainability.
US companies with an ESG focus must reevaluate their current policies and procedures to maintain market demand and remain relevant. In fact, recent studies show that nearly 80% of US consumers now consider the sustainability of a product or company before making purchasing decisions. If your business cannot effectively market to this group of consumers, you may face ongoing issues.
Additionally, new and growing businesses might be looking to attract outside investors. Limiting your investment pool to the United States can lead to the inability to obtain the necessary capital. However, by presenting global opportunities for investors, you are more likely to secure the needed funds. When your business has EU investors, you can be subject to the requirements of the SFDR. This makes it imperative to have compliance with these regulations before you open the door to global investors.
Maximizing SFDR Compliance & Market Visibility
The good news is that there are ways you can position your business for SFDR compliance, even if you aren’t required to follow the regulations yet. The goal of the SFDR is to promote transparency throughout sustainability measures. Consumers and investors that see these additional disclosures outside of what your business is required to show may be more likely to choose your company over a competitor. Consider implementing the following strategies to maximize market visibility and promote ESG clarity throughout your business.
Understanding the Regulations Your Business Must Follow
First, you need to understand the regulations your business must follow. Are you subject to the SFDR? If so, adopting the disclosures isn’t an added perk for investors and consumers; it’s a requirement. On the other hand, if you aren’t yet required to comply with the SFDR, what portions of the disclosures would benefit your consumers and investors?
Your company shouldn’t provide only the required information to investors. Instead, you should evaluate the information and data your consumers and investors want to base their lending decisions on.
Tracking Environmental & Social Footprints
After you understand the areas of clarity your investors and consumers can benefit from, you need to have the right resources tracking qualitative and quantitative information. Recycling and waste are two of the major concerns that the SFDR looks to address.
One of the resources that companies are utilizing is recycling and waste-managed services organizations that can help them more efficiently operate their waste programs and alleviate the day-to-day challenges that often occur. Another resource would be recycling and waste management tracking software. Using software gives your business access to real-time and verifiable data to achieve the level of clarity needed for the SFDR disclosures.
Creating Effective & Compliant Marketing Campaigns
ESG-focused companies also need to pay close attention to the marketing and advertising they are promoting. Companies that are subject to the SFDR cannot engage in any greenwashing. Their advertisements geared towards sustainability should be backed up by data-driven information.
To do this, it’s important to have the proper resources to gather information on waste and recycling. This helps your business make substantiated claims that investors and consumers can base their decisions on.
How Keter Environmental Services Can Help
SFDR is just one of many regulations enacted to ensure companies are indeed doing what they have been reporting. These requirements are happening now, in real-time, and while they currently apply to EU financial market participants, they will make their way to the United States. In fact, your organization may be asked to report certain recycling and waste key performance indicators to certain EU-based organizations that maintain a financial interest in your company. Will you be ready? Can you deliver that granular data in a timely manner?
At Keter Environmental Services, we provide companies with data-driven recycling and waste-managed services to help your organization reimagine its complex waste streams, achieve new efficiencies, and reach sustainability goals. Verifiable data is at the heart of our operations, giving our clients the transparency they desire and need in their recycling and waste reporting.
We take a unique approach to the sustainability inefficiencies your company faces, crafting personalized solutions based on your needs. Not only can our team help you obtain the data needed to comply with the SFDR, but we can do so through efficient operations of your waste program.
