March 2021
The introduction of the EU Sustainable Finance Disclosure Regulation (SFDR) represents a major milestone in the financial services industry, requiring a range of ‘financial market participants’1 to be more transparent about how they integrate ESG risks into their investment decisions and about the ESG credentials of their products. Large swathes of the UK industry are caught by this EU initiative, largely by virtue of managing EU products or marketing products to EU clients. And for those not strictly in scope, we are seeing many clients take the strategic decision to align themselves with SFDR in response to market pressures.
With the first implementation deadline of 10 March 2021 having passed, firms should be under no illusions that the task is complete. They must now urgently turn their attention to the long list of remaining Level 1 and Level 2 obligations, which is where the hard work begins on becoming SFDR compliant. In this Reflections article, we consider the main outstanding areas that firms will need to focus on, some of the challenges they are likely to encounter in doing so, and how they can organise themselves to navigate this next phase of their SFDR journey.
1 Financial market participants under Article 2 of SFDR catches a wide range of firms, including AIFMs, UCITS managers and investment firms/credit institutions providing portfolio management as defined in MiFID II, and insurance undertakings which make available insurance-based investment products.
A flagship concept in SFDR is reporting the principal adverse impacts (PAIs) of your investment decisions2. Under Level 1, firms must publish, by 30 June 2021, a website statement setting out how PAIs are considered. Smaller firms that benefit from the proportionality threshold needed to do this by 10 March 2021 where they ‘opted in’, or explain why they have not considered PAIs (and any plans for doing so in the future). There are then product-level PAIs to complement the entity-level policy, which need to be reflected in pre-contractual product disclosures by 30 December 2022.
We have seen some firms get on the front foot by already publishing their PAI statement in line with the Level 1 obligation, especially given its principles-based nature, which allows for a more qualitative articulation of how impacts are considered. However, the ESAs have put forward a far more prescriptive PAI reporting framework in the draft RTS, presenting a much more challenging exercise for the industry. Firms will need to report against at least the 14 mandatory sustainability indicators prescribed in the RTS, which creates a significant data challenge given the shortages and/or inconsistencies in obtaining data on metrics like water emissions and the hazardous waste ratio across all portfolio companies.
The first report for reference periods spanning 1 January 2022 to 31 December 2022 would need to be published by 30 June 2023, so firms have some time to get this right. However, given the current gaps in publicly-available data on these types of metrics, firms are having to re-imagine their ESG data strategy, including using time consuming bespoke data requests for investee companies. It is also unlikely that existing ESG reporting frameworks capture each of the prescribed PAIs, so firms will also need to understand the extent to any gaps and establish a plan for closing those.
2 This is mandatory for firms with more than 500 employees or which classify as 'qualified parent undertakings' and applies on a 'comply or explain' basis for remaining firms.
SFDR introduces new ESG product categories, which are having far-reaching impacts across all aspects of the industry’s work on ESG. Ahead of 10 March 2021, firms needed to assess whether their existing products should be re-classified as ‘Article 8 or 9 products’3, and update their pre-contractual materials and produce new website disclosures to set out how the products do what they say on the tin. Whilst the Level 1 rules don’t contain much detail on how this should be done, the draft RTS contains a granular template which many firms have turned to in order to meet the Level 1 obligation.
There has been significant uncertainty over what constitutes an Article 8 product in particular. This means that, absent further clarifications from the regulators, firms will need to make careful judgements themselves. It will be important to get this right to avoid the risk of greenwashing, which is clearly an area the regulators will be paying close attention to when supervising how firms are categorising their products.
Next comes the ex-post reporting on the extent to which any Article 8 or 9 funds have performed their respective ESG functions. The draft RTS requires reporting to include information such as the top investments of these products, indexes used, and performance against a designated benchmark. While this will need to be included in periodic reports issued during 2022, firms will need to be collecting the appropriate data to underpin the reporting now, given that the reference period will be 2021. There is also the link with the Taxonomy Regulation to think through, which will see firms having to report on the extent to which their Article 8 and 9 products are taxonomy-aligned.
3 i.e. products promoting environmental/social characteristics and with sustainable investment objectives, respectively.
Given the volume of work left to complete to align with both Level 1 and 2 obligations, SFDR will remain a key focus for the financial services sector over the rest of 2021 and beyond. Here are some of the core areas firms should be thinking about as part of their efforts:
So despite the fact that the initial 10 March deadline has now passed, firms are only really at the beginning of their SFDR journey - those that haven’t already done so should kick off their work for this crucial second phase of implementation. Our view is that, given the impacts SFDR is having on ESG product classifications and branding, it would be wise to view this as a commercial opportunity to develop new SFDR-aligned products in response to growing investor demand, as much as a compliance exercise. After all, what’s clear is that this significant piece of regulation is shifting the dial on practices in this area and is bringing ESG into the mainstream, so firms that don’t engage with this commercially risk falling behind competition.