SFDR: The Obligations and Challenges of Sustainable Finance
Climate change is causing issues around the world. As governments squabble with each other, the window to take resolute action grows shorter every year.
In such a gloomy world, the European Union (EU) is a bright spot with its pioneering initiatives to fight climate change and improve economic sustainability. The EU Sustainable Finance Disclosure Regulation (SFDR) is a cornerstone of these efforts.
In this article, get to know the SFDR, its objectives, its obligations, and how you can help your company comply effectively.
What Is the SFDR?
The EU has set several sustainability and climate action goals to conform with the Paris Agreement, the United Nations Sustainable Development Goals, and the European Green Deal.
A sustainable EU financial industry is essential to these goals because it powers the bulk of the economic activities that have direct or indirect influences on these goals.
As part of the 2018 sustainable finance action plan, the Sustainable Finance Disclosure Regulation sets guidelines for financial market participants and financial advisors on transparency about their financial products' sustainability risks, adverse sustainability impacts, and sustainability characteristics.
The SFDR works in lockstep with other sustainability regulations like the EU Taxonomy regulation and the Corporate Sustainability Reporting Directive (CSRD) to achieve the European Commission's sustainability goals. The SFDR's high-level objectives are explained next.
Objectives of the SFDR
The SFDR aims to:
- Promote sustainability in financial products: The SFDR seeks to promote more sustainability in banking, investments, and other financial products. This is in line with the do no significant harm principle of ensuring that any economic objective doesn't adversely affect any sustainability concern.
- Bolster sustainable investment objectives: A sustainable investment is investing in an economic activity that improves an environmental, social, and governance (ESG) objective. Environmental objectives include increased use of renewable energy sources, lower greenhouse gas emissions, less harmful impacts on biodiversity, and similar. Social objectives improve human rights or help vulnerable communities improve their socio-economic conditions. Governance objectives ensure that investee companies follow good labor and governance practices.
- Improve transparency on sustainability factors: Sustainability factors include environmental concerns, climate change, carbon emissions, social matters, labor concerns, human rights, and anti‐corruption matters.
- Disclose sustainability risks to stakeholders: A sustainability risk is an ESG-related event that can adversely impact the value of an investment.
- Establish reporting standards: One of the SFDR's goals is to publish regulatory technical standards for the content, methodology, and presentation of sustainability disclosures. Such standards improve the transparency, consistency, comprehension, and comparability of reports across companies over time.
- Reduce greenwashing risks: The SFDR's transparency rules aim to prevent greenwashing by companies.
Let's see which companies are supposed to follow the SFDR.
Who's Impacted by the SFDR?
The SFDR applies to:
- Financial market participants (FMPs) that are providers of financial products or financial services
- Financial advisors that offer investment advice or insurance recommendations
FMPs are a broad category of companies. A few examples are:
- Investment firms that offer investment products
- Asset managers and fund managers that oversee investment funds
- Portfolio management service providers
- Insurance undertakings
- Undertakings for Collective Investment in Transferable Securities (UCITS) funds
- Pension and retirement funds
Financial advisor firms with fewer than three members are exempt.
What Are Your Disclosure Obligations Under the SFDR?
The detailed disclosure requirements set out in the official text of the SFDR are explained below.
Report Sustainability Risks
If you're an FMP or financial advisor, publish the following information about the sustainability risks of your financial product or advice:
- Explain risk integration on your website: Disclose on your website how you integrate sustainability risks into your investment decision-making process or advice.
- Describe risk integration in pre-contract disclosures: In the pre-contractual disclosures (such as prospectuses) for your financial products or advisory services, describe how you have integrated sustainability risks in your investment decisions or advice.
- Disclose possible impacts on financial returns: In your pre-contractual information, you must also include the possible material impacts of such risks on the investment returns of the products you market or recommend.
Disclose Adverse Sustainability Impacts
The principal adverse impacts (PAIs) are the negative outcomes of investment decisions or advice on any sustainability concern, like the environment, social or employee matters, human rights, or anti-corruption.
As an FMP or financial advisor, you must publish information about these impacts through online channels, entity-level disclosures, and product-level disclosures. Include the following details according to the size, nature, and scale of your activities:
- Identification of the PAIs: Explain how you identify your PAIs and their indicators at an entity level and product level. If there are many impacts, justify how you prioritize them.
- Impacts and actions: Include descriptions of the impacts along with the preventive or corrective actions you've taken or planned.
- Shareholder engagement: If you're an institutional investor or asset manager, publish annual reports explaining your engagement with stakeholders on sustainability impacts. Ensure that your reports conform to the EU shareholder rights regulation by describing how you monitor your investee companies on sustainability factors, conduct dialogues with them, exercise your voting rights, and manage potential conflicts of interest.
- Due diligence policies for the impacts: Explain your prior due diligence policies before making any investments. Ensure that they conform to the Organisation for Economic Co-operation and Development's Due Diligence Guidance for Responsible Business Conduct and the United Nations’ Principles for Responsible Investment.
- Alignment with the Paris Agreement: Include an evaluation of your due diligence policies against the objectives of the Paris Agreement.
- Justifications for exclusions: If you haven't published related information for your company or your product, explain why that's so and when you plan to publish it.
PAI disclosures, indicators, and emission metrics must conform to the reporting templates and tables under Annex I of the regulatory technical standards (RTS).
Ensure Transparency About Sustainable Financial Products
If you promote a financial product as a sustainable investment based on its environmental or social characteristics, you must disclose the following information in your pre-contractual disclosures, in periodic reports, and on your website:
- Fulfillment of the characteristics: How does your product satisfy those sustainable characteristics?
- Fulfillment of sustainability objectives: If the product is promoted as a sustainable investment with certain sustainability objectives, explain your investment strategy to achieve them.
- Suitability of a reference index: If you use a standardized index — like the STOXX Index or the S&P ESG Index — as a reference benchmark for your product, explain how that index satisfies those characteristics. Also include references to the methodology used by the index and how it differs from a broad market index.
These disclosures must conform to the templates under Annex II, Annex III, Annex IV, and Annex V of the RTS.
Disclose Remuneration of Staff
Some FMPs or advisors may incentivize the sale of risky financial products by downplaying their sustainability risks and paying remuneration that's proportional to such sales.
To prevent this, they must show, on their websites, how their staff remuneration policies are consistent with sustainability risks and are decided based on risk-adjusted performance assessments.
5 Strategies to Navigate the SFDR Obligations
The SFDR's obligations are quite challenging for financial companies. We explore some of the challenges and strategies that can ease your compliance.
1. Identify Sustainability Risks and Impacts
Assessing the sustainability risks and adverse impacts of your financial products is a major challenge because they depend on other entities. An asset manager's risk depends on those of its investee companies. It's exponentially harder for a fund of funds. An insurance advisor's impacts are decided by those of the insurance products they promote.
To pull it off, you need to apply systematic enterprise risk management, qualitative risk assessments, and quantitative risk analyses. Moreover, you must do this for each of your financial products and each entity it covers.
2. Control Your Sustainability Data Collection Challenges
The first step for any kind of risk assessment is raw data. You need sustainability data from your value chain. But the multi-level dependency that's a characteristic of the financial sector makes even the basic step of data collection a major challenge. And you need to repeat this regularly for the SFDR's periodic reports.
A good strategy involves centralized data collection, orchestration, collaboration, and automated data validation workflows.
3. Maintain Data Freshness and Consistency
The SFDR requires you to keep the reported information up to date on your website, in your pre-contractual disclosures, and in your periodic reports. You are also expected to explain all amendments clearly on your website.
Additionally, you must ensure that your marketing communications are consistent with the disclosed information.
For such consistency, you'll need a centralized, authoritative, system of record (SOR) that acts as the single source of truth for all the disclosed sustainability information.
4. Process Emission Data Analytics
Another challenge is slicing all the emission data metrics — like Scope 1, Scope 2, and Scope 3 emission data — across entity and product levels. In addition, climate metrics are still an evolving field, and your systems must keep up with new developments.
You'll need powerful data analytics engines with domain-specific metric formulas for such work.
5. Conform to Regulatory Technical Standards
The SFDR requires disclosures to adhere to strict reporting standards that determine its content, methodology, and presentation. You'll need a smart reporting platform that has the domain knowledge to pull the required data from the SOR and aggregate them according to the standard's specifications.
These challenges necessitate the use of powerful compliance platforms like Certa.
SFDR: The Obligations and Challenges of Sustainable Finance
Climate change is causing issues around the world. As governments squabble with each other, the window to take resolute action grows shorter every year.
In such a gloomy world, the European Union (EU) is a bright spot with its pioneering initiatives to fight climate change and improve economic sustainability. The EU Sustainable Finance Disclosure Regulation (SFDR) is a cornerstone of these efforts.
In this article, get to know the SFDR, its objectives, its obligations, and how you can help your company comply effectively.
What Is the SFDR?
The EU has set several sustainability and climate action goals to conform with the Paris Agreement, the United Nations Sustainable Development Goals, and the European Green Deal.
A sustainable EU financial industry is essential to these goals because it powers the bulk of the economic activities that have direct or indirect influences on these goals.
As part of the 2018 sustainable finance action plan, the Sustainable Finance Disclosure Regulation sets guidelines for financial market participants and financial advisors on transparency about their financial products' sustainability risks, adverse sustainability impacts, and sustainability characteristics.
The SFDR works in lockstep with other sustainability regulations like the EU Taxonomy regulation and the Corporate Sustainability Reporting Directive (CSRD) to achieve the European Commission's sustainability goals. The SFDR's high-level objectives are explained next.
Objectives of the SFDR
The SFDR aims to:
- Promote sustainability in financial products: The SFDR seeks to promote more sustainability in banking, investments, and other financial products. This is in line with the do no significant harm principle of ensuring that any economic objective doesn't adversely affect any sustainability concern.
- Bolster sustainable investment objectives: A sustainable investment is investing in an economic activity that improves an environmental, social, and governance (ESG) objective. Environmental objectives include increased use of renewable energy sources, lower greenhouse gas emissions, less harmful impacts on biodiversity, and similar. Social objectives improve human rights or help vulnerable communities improve their socio-economic conditions. Governance objectives ensure that investee companies follow good labor and governance practices.
- Improve transparency on sustainability factors: Sustainability factors include environmental concerns, climate change, carbon emissions, social matters, labor concerns, human rights, and anti‐corruption matters.
- Disclose sustainability risks to stakeholders: A sustainability risk is an ESG-related event that can adversely impact the value of an investment.
- Establish reporting standards: One of the SFDR's goals is to publish regulatory technical standards for the content, methodology, and presentation of sustainability disclosures. Such standards improve the transparency, consistency, comprehension, and comparability of reports across companies over time.
- Reduce greenwashing risks: The SFDR's transparency rules aim to prevent greenwashing by companies.
Let's see which companies are supposed to follow the SFDR.
Who's Impacted by the SFDR?
The SFDR applies to:
- Financial market participants (FMPs) that are providers of financial products or financial services
- Financial advisors that offer investment advice or insurance recommendations
FMPs are a broad category of companies. A few examples are:
- Investment firms that offer investment products
- Asset managers and fund managers that oversee investment funds
- Portfolio management service providers
- Insurance undertakings
- Undertakings for Collective Investment in Transferable Securities (UCITS) funds
- Pension and retirement funds
Financial advisor firms with fewer than three members are exempt.
What Are Your Disclosure Obligations Under the SFDR?
The detailed disclosure requirements set out in the official text of the SFDR are explained below.
Report Sustainability Risks
If you're an FMP or financial advisor, publish the following information about the sustainability risks of your financial product or advice:
- Explain risk integration on your website: Disclose on your website how you integrate sustainability risks into your investment decision-making process or advice.
- Describe risk integration in pre-contract disclosures: In the pre-contractual disclosures (such as prospectuses) for your financial products or advisory services, describe how you have integrated sustainability risks in your investment decisions or advice.
- Disclose possible impacts on financial returns: In your pre-contractual information, you must also include the possible material impacts of such risks on the investment returns of the products you market or recommend.
Disclose Adverse Sustainability Impacts
The principal adverse impacts (PAIs) are the negative outcomes of investment decisions or advice on any sustainability concern, like the environment, social or employee matters, human rights, or anti-corruption.
As an FMP or financial advisor, you must publish information about these impacts through online channels, entity-level disclosures, and product-level disclosures. Include the following details according to the size, nature, and scale of your activities:
- Identification of the PAIs: Explain how you identify your PAIs and their indicators at an entity level and product level. If there are many impacts, justify how you prioritize them.
- Impacts and actions: Include descriptions of the impacts along with the preventive or corrective actions you've taken or planned.
- Shareholder engagement: If you're an institutional investor or asset manager, publish annual reports explaining your engagement with stakeholders on sustainability impacts. Ensure that your reports conform to the EU shareholder rights regulation by describing how you monitor your investee companies on sustainability factors, conduct dialogues with them, exercise your voting rights, and manage potential conflicts of interest.
- Due diligence policies for the impacts: Explain your prior due diligence policies before making any investments. Ensure that they conform to the Organisation for Economic Co-operation and Development's Due Diligence Guidance for Responsible Business Conduct and the United Nations’ Principles for Responsible Investment.
- Alignment with the Paris Agreement: Include an evaluation of your due diligence policies against the objectives of the Paris Agreement.
- Justifications for exclusions: If you haven't published related information for your company or your product, explain why that's so and when you plan to publish it.
PAI disclosures, indicators, and emission metrics must conform to the reporting templates and tables under Annex I of the regulatory technical standards (RTS).
Ensure Transparency About Sustainable Financial Products
If you promote a financial product as a sustainable investment based on its environmental or social characteristics, you must disclose the following information in your pre-contractual disclosures, in periodic reports, and on your website:
- Fulfillment of the characteristics: How does your product satisfy those sustainable characteristics?
- Fulfillment of sustainability objectives: If the product is promoted as a sustainable investment with certain sustainability objectives, explain your investment strategy to achieve them.
- Suitability of a reference index: If you use a standardized index — like the STOXX Index or the S&P ESG Index — as a reference benchmark for your product, explain how that index satisfies those characteristics. Also include references to the methodology used by the index and how it differs from a broad market index.
These disclosures must conform to the templates under Annex II, Annex III, Annex IV, and Annex V of the RTS.
Disclose Remuneration of Staff
Some FMPs or advisors may incentivize the sale of risky financial products by downplaying their sustainability risks and paying remuneration that's proportional to such sales.
To prevent this, they must show, on their websites, how their staff remuneration policies are consistent with sustainability risks and are decided based on risk-adjusted performance assessments.
5 Strategies to Navigate the SFDR Obligations
The SFDR's obligations are quite challenging for financial companies. We explore some of the challenges and strategies that can ease your compliance.
1. Identify Sustainability Risks and Impacts
Assessing the sustainability risks and adverse impacts of your financial products is a major challenge because they depend on other entities. An asset manager's risk depends on those of its investee companies. It's exponentially harder for a fund of funds. An insurance advisor's impacts are decided by those of the insurance products they promote.
To pull it off, you need to apply systematic enterprise risk management, qualitative risk assessments, and quantitative risk analyses. Moreover, you must do this for each of your financial products and each entity it covers.
2. Control Your Sustainability Data Collection Challenges
The first step for any kind of risk assessment is raw data. You need sustainability data from your value chain. But the multi-level dependency that's a characteristic of the financial sector makes even the basic step of data collection a major challenge. And you need to repeat this regularly for the SFDR's periodic reports.
A good strategy involves centralized data collection, orchestration, collaboration, and automated data validation workflows.
3. Maintain Data Freshness and Consistency
The SFDR requires you to keep the reported information up to date on your website, in your pre-contractual disclosures, and in your periodic reports. You are also expected to explain all amendments clearly on your website.
Additionally, you must ensure that your marketing communications are consistent with the disclosed information.
For such consistency, you'll need a centralized, authoritative, system of record (SOR) that acts as the single source of truth for all the disclosed sustainability information.
4. Process Emission Data Analytics
Another challenge is slicing all the emission data metrics — like Scope 1, Scope 2, and Scope 3 emission data — across entity and product levels. In addition, climate metrics are still an evolving field, and your systems must keep up with new developments.
You'll need powerful data analytics engines with domain-specific metric formulas for such work.
5. Conform to Regulatory Technical Standards
The SFDR requires disclosures to adhere to strict reporting standards that determine its content, methodology, and presentation. You'll need a smart reporting platform that has the domain knowledge to pull the required data from the SOR and aggregate them according to the standard's specifications.
These challenges necessitate the use of powerful compliance platforms like Certa.
How Does Certa Support Your SFDR Obligations?
So far, you saw the obligations and challenges that SFDR brings. To satisfy them, you need a purpose-built compliance platform like Certa that offers compelling features like:
- A centralized system of record: Certa's SOR provides centralized storage for all your sustainability data across time. Use it as a single source of truth to keep your operational, compliance, and marketing functions consistent at all times.
- Process orchestration: Certa's automated process orchestration brings end-to-end efficiency, repeatability, alerting, and collaboration to your multi-level data collection and reporting workflows. Automate everything from emailing contacts across investee companies with the right reporting templates to extracting and storing the data.
- Data analytics: Certa's predefined templates and data analytics enable you to determine complex metrics, like Scope 1, Scope 2, and Scope 3 greenhouse gas emissions, at product and entity levels.
- A risk management system: Certa includes a full-fledged risk management platform that you can customize with flexible risk scoring to include the investment-specific risk factors you want.
- Standards-compliant reporting: Certa has built-in support for a variety of sustainability reporting standards like the SFDR's RTS, the Global Reporting Initiative (GRI), CSRD's European Sustainability Reporting Standards, and more.
Talk to our sustainability expert to see how Certa can help your SFDR compliance program.
