Environmental, Social, and Governance (ESG) factors have become competitive differentiators for both businesses and investors, especially in recent years. However, tracking how corporations are following through on their ESG commitments has been a challenge for investors and financial advisors. In order to ensure ESG compliance and regulations, the EU implemented the Sustainable Finance Disclosure Regulation (SFDR). This article will cover how the EU SFDR impacts investors and financial advisors.
Data is increasing at an exponential rate from social media posts, blogs, web content, online brochures, and other channels. Although digital innovation has made it easier for corporations to interact with their audience and investors, one of the challenges it has led to for investors and consumers is in identifying whether corporations are actually staying true to their corporate statements and ESG disclosures.
Investors are curious to know which corporations are acting in sustainable ways and how their initiatives are lining up to make the world a better place. Up until recently, ESG regulations were non existent, creating a barrier between financial participants and corporations.
Understanding the SFDR
The shift to impact investing or sustainable investing and the lack of regulations around ESGs has made it easier for companies to give a false impression of their products and services and provide misleading information about the ethics of their services or products. To prevent this greenwashing, the European Union’s Sustainable Finance Disclosure Regulation (SFDR) framework went into effect in March, 2021.
The European Commission initiated the SFDR in light of the EU Green Deal and its action plan towards furthering sustainable finance. The SFDR aims to create a stable, sustainable, and transparent financial system that promotes sustainability in capital flows and fosters transparency and long-term strategies into finance and economics. As a result of the SFDR, ESG disclosure obligations are mandatory and financial market participants and financial advisers are required to transparently report on their ESG initiatives on both product and entity levels.
To hold corporations accountable, the EU passed the Taxonomy Regulation which is a key piece of legislation from the SFDR. The EU taxonomy is a green classification system that defines the EU’s sustainability objectives into specific criteria for investment purposes. The EU Taxonomy Regulation requires mandatory disclosure of Taxonomy-aligned activities through the taxonomy classification tool. The classification tool recognizes green or “environmentally sustainable,” economic activities that impact any of the EU sustainability objectives.
Together, the SFDR and the Taxonomy Regulation ensures that corporations are actually following through on their ESG commitments. Disclosure on Taxonomy- aligned activities enable investors and financial advisors to compare companies and investment portfolios. Additionally, ensuring regulations and compliance enables ESGs to be a regular part of investment and financial capital market workflows.
Both the SFDR and the Taxonomy Regulation apply to a broad audience spanning the entire asset management industry and other financial participants that conduct business in or with the EU. Furthermore, the Taxonomy Regulation applies directly to Member States, who are prohibited from introducing their own rules that could compromise the integrity of the Taxonomy.
The SFDR applies broadly to all asset managers and financial advisors who conduct business in Europe. Non European asset managers and financial advisors and their subsidiaries who conduct business in Europe or sell products to the EU must also follow the SFDR. Lastly, non-EU firms that assist EU funds or assets are also required to disclose ESG information.
All asset managers and financial advisors that the SFDR applies to are required to publish information on their sustainability/ESG processes on their websites, in promotional materials, in periodic reports, and in any pre-contractual documentation. Financial products must be divided into three categories (dark green, light green, and non-sustainable) depending on their ESG impact. Lastly, they must report on any considerations of negative sustainability impacts if asked, to ensure that it follows the “do no significant harm” principle of the SFDR.
What the SFDR Means for ESG Investing
ESG (Environmental, Social, Governance) investing is one of the fastest-growing investment strategies around the world. Global challenges from climate change, social unrest, and a global pandemic has shed light on the importance of corporate social responsibility and sustainability. As a result, investors, financial institutions, corporations, and consumers around the world have increased their commitment to ESGs.
According to Morningstar, assets in EU sustainable funds hit 1.1 trillion Euros by December 2020, marking a 55 percent rise compared to the previous year. Additionally, in the U.S., flows into sustainable funds were almost double the pace in 2019. Fortune states that the demand in ESG in the U.S. also rose by a third in 2020 compared to the year before.
The SFDR regulations may help standardize ESG terminology and reporting requirements around the world. Under the SFDR and Taxonomy Regulations, investment firms are required to disclose:
- The environmental sustainability of an investment and the accuracy of any ESG claims made;
- The risks investments present to ESG factors;
- The risks ESG factors present to investments.
The SFDR rules are broken down into mandatory and “comply or explain” rules and are separated between entity and product-level rules.
As investors inquire more regularly about how corporations are combatting climate change, how employees and service providers are being treated, their commitment to sustainability initiatives, and other ESG activities, the SFDR improves the chances for investors to identify the right companies acting in line with their values. Investors will also have more control over investments and a better understanding of the impact their investments have. The SFDRs not only provide greater transparency to investors, but to consumers and clients as well, ultimately transforming the financial industries and the way corporations do business.
Goals for the SFDR
The goals of the SFDR are to ensure that European investors have accurate and transparent reporting to make investment decisions that are in line with their own social impact goals. SFDR hopes to eliminate greenwashing or false or misleading ESG information from companies’ marketing or advertising practices on their products and services.
To achieve this, the SFDR requires that all sustainable and non-sustainable funds disclose ESG practices to potential investors. This encourages firms to improve the sustainability of their business operations in order to comply with the mandatory disclosure requirements and remain competitive in an increasingly ESG-focused market. With greater corporate transparency, investors will be able to make better informed investment decisions and there will be more of a measurable impact on the growth of a sustainable economy.
Impact of the SFDR on U.S. Financial Markets
Although U.S. companies are not directly impacted by these regulations, it is a game changer for sustainable investing. The SFDR is also raising the bar for future sustainable investing regulations and it is changing the future of ESG investing by holding corporations and financial institutions and advisors accountable to being more transparent and honest about the sustainability of their products, services, and business operations.
With pressure from the presidential administration, demand from consumers, increasing demand from investors, and demand from non-governmental and international organizations like the UN, sustainability and ESG regulations will soon become a priority in the United States.
Impact of the SFDR on Investors
The SFDR applies to all portfolio and fund managers, financial advisors, and pension providers who participate in EU financial markets in any capacity.
- Asset managers must disclose their ESG policies at both the firm and product level. They must also be transparent about what they consider are negative effects that an investment decision or advice might have on sustainability factors (also known as Principle Adverse Impacts (PAIs).
- Larger firms will be required to report on how they consider PAIs.
- Financial advisors must explain to their clients how they determine the sustainability factors on investment returns.
Although the SFDR is the first of its kind in the ESG investing world and only applies to financial markets that conduct business with or in the EU, it sets the bar for sustainable investing across the world.
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