What do the Game-changing EU Sustainable Finance Regulations Mean for the Wider ESG Industry?

The European Green Deal is our new growth strategy – for a growth that gives back more than it takes away. It shows how to transform our way of living and working, of producing and consuming”. These were the sentiments expressed by European Commission President, Ursula von der Leyen, when she introduced the European Green Deal1 in late 2019, a roadmap for the regional bloc to transition to a more sustainable economy.

The Green Deal is by far the most ambitious policy initiative to:

  1. achieve net-zero carbon emissions by 2050,
  2. incentivise private sector investments with sustainability mandates, and
  3. achieve sector-wide targets and goals, such as halting biodiversity losses and reducing waste generation.

Private sector investments have been identified as being instrumental to financing the Green Deal and the transition to a more sustainable economy. To meet the climate and energy targets that the bloc has committed to under the Paris Agreement2, the European Commission estimates that additional annual investments of €260 billion will be required.

In order to incentivise capital financing towards technologies and initiatives that meet sustainability objectives, the Commission has made two key legislative proposals, namely the Taxonomy Regulation3 and Sustainable Finance Disclosure Regulation (SFDR). The SFDR and its implications for the financial industry will be the focus of this article.

Is this the defining moment for sustainable finance?

The SFDR has been announced at a critical juncture, with investors increasingly seeking investments aligned with their social and environmental objectives, and demand for sustainable investments set to increase to 95% of global assets by 2030 (see Figure 1). One of the drivers of demand growth is an expected wealth transfer of $68 trillion 4 to the more socially conscious millennial generation over the coming years, who have been found to be twice as likely as other generations to invest in companies or funds that target social or environmental outcomes 5. Over the course of the Covid-19 pandemic, the industry saw record inflows into funds with ESG mandates, with sustainable fund assets hitting a record $1.7 trillion in 2020 6, bolstered by the expectation that funds with ESG considerations will perform better than those without. The pandemic has accelerated the trend of stakeholder capitalism and is challenging shareholder primacy.

Figure 1: Assets under management with ESG mandate. Source: Deutsche Bank estimates, Global Sustainable Investment Alliance (GSIA)7

The SFDR will standardise sustainability reporting and improve transparency for investors

The SFDR consists of sustainability disclosure requirements for financial market participants and financial advisors. The key goal is to prevent greenwashing and enable end-investors to make more informed decisions on where to direct their capital. Key provisions of the SFDR have taken effect as of 10 March 2021 and reporting will commence in 2022.

The disclosures are primarily centered around the following topics, on both an entity and product level:

  • Sustainability risks
    • Assessment of the impact of ESG risks on the financial return of products on an ongoing basis
  • Principle adverse impacts (PAI)
    • Assessment of financial products’ negative impacts on sustainability factors
  • ESG approach positioning
    • Transparency on ESG approach adopted
    • This applies to Article 8  & 9 products, in terms of reporting on the extent to which the environmental and social objectives are met, and how they are met
    • This overlaps with the EU Taxonomy regulations, with disclosures required on alignment with the Taxonomy objectives and activities
These disclosures are required to be disseminated via various channels, namely websites, pre-contractual documents and periodic reports, on a comply or explain basis, as summarised in the table below:
Product Type of Disclosure Medium of Disclosure Type of Entity
All investment products Sustainability risks Websites & pre-contractual documents All financial entities (comply or explain basis)
All investment products PAI Websites, pre-contractual documents and periodic reporting Mandatory for holding companies and entities with 500 employees or more
Comply or explain basis for entities with fewer than 500 employees
Article 8 & 9 products ESG approach & Taxonomy alignment Websites, pre-contractual documents and periodic reporting All financial entities (comply or explain basis)

Table 1: Summary of SFDR disclosure requirements

The Regulatory Technical Standards (RTS), developed by the three European Supervisory Authorities, contains details on the information, methodology and presentation formats for the required disclosures. In particular, the PAI will need to be reported according to a pre-defined catalogue of 50 indicators, of which 32 are mandatory (16 environmental and 16 social indicators) and 18 voluntary (11 environmental and 7 social). Reporting on the ESG approach and Taxonomy alignment will also need to be done using a mandatory template set out by the RTS.

What are the wider consequences of the SFDR for the financial industry?

The SFDR will have far-reaching normative implications for financial market participants and financial advisors, as firms will need to make strategic decisions on their sustainability approaches. With the regulations mandating unambiguous disclosures on the ESG-orientation of firms, as well as consideration of sustainability risks and adverse impact throughout the investment process, firms will have to make decisions on the adoption of firm-wide sustainability measurement practices, communication of products’ sustainability impacts, and more. Although the disclosures are implemented on a comply or explain basis, there would be steep reputational and competitive disadvantages for failing to incorporate sustainability considerations in investment practices. This is due to the increasing importance and expectations of sustainability to stakeholders across the industry, with 77% of institutional investors expected to stop purchasing non-ESG products in the next 24 months11. It is clear that sustainability will be mainstreamed in the industry over the coming years.

While the SFDR has been developed for the European Economic Area, the regulation will impact financial entities worldwide. Firstly, the SFDR will apply to non-EU based asset managers who register their funds for marketing in the EU under Article 42 of the AIFMD, as well as managers who provide portfolio management services to EU firms who are subject to the SFDR. Additionally, the regulatory environment in other countries is rapidly changing in parallel with the SFDR (notably Australia, China, Hong Kong, Japan and Singapore13), in terms of the promotion of green finance, and requirements for the incorporation of sustainability risks and disclosures at entity and product levels. The Network for Greening the Financial System (NGFS) is also working towards creating globally consistent green taxonomies.

The SFDR will not merely be a compliance checkbox; instead, it will necessitate sustainability to be embedded into decision making. This, in turn, will require ESG measurement frameworks and reporting capabilities to be in place within firms, as sustainability risks and impact will need to be clearly communicated to end-investors, and sweeping claims of ‘ESG integration’ will no longer pass muster. Since the announcement of the Sustainable Finance Action Plan in 2018, the regulators have demonstrated that they expect the SFDR to be adopted rapidly across the industry. This has been seen in the quick development of the legislation and associated technical standards announced in 2020, and a tight implementation timeline over the next three years, with several reporting milestones. The time for talking about sustainability has passed and the time for taking action has arrived.

From the perspective of ESG or impact-focused investors, the SFDR will allow for more clarity and comparability on the sustainability objectives and performance of investments. With universal reporting requirements and standards, investors will now be able to readily assess the sustainability claims and credentials of ESG-oriented investment products. This, in turn, will ensure that capital is flowing towards investments that are credibly creating impact or meeting key environmental or social objectives.

As an impact investment firm, the principles of the SFDR are firmly aligned with our mission at GreenArc, and we welcome these much needed standards to signal the end of green-washing. We are committed to delivering transparent and credible sustainability and impact reporting on investments, and invite you to get in touch to explore how we can help you adhere to the new regulatory reporting requirements.

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