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In this last part of our ESG article series, we focus on the European Union’s response to the problems raised in the previous episodes of the series, the SFDR Regulation.
In our previous posts, we addressed various problematic cases that emerged with the growing popularity of ESG-based and other sustainability-related investments. We have shown sustainability issues that are cause for concern, such as how easy it is to use „green” words to make businesses more favourable, or how difficult it is to navigate the ESG-based investment products market as a consumer. All this is possible because there are no mandatory principles, methodologies, information obligations to follow, in short, there are no regulations. The topic is becoming increasingly relevant, thus, it is no surprise that we are witnessing an increasingly strong regulatory momentum in Europe, and steps are being taken in a similar direction in the US as well.
The SFDR, short for Sustainable Finance Disclosure Regulation, was published in 2019, as an important element of the Union’s Sustainable Finance Action Plan. The SFDR is related to a number of other regulations, such as Taxonomy or MiFID, but it itself imposes significant rules.
The basic goal of SFDR is to make disclosures about green, sustainable investment and savings products available on the market, reliable for investors in a more informative and clearer way, thus contributing not only to awareness but also to increasing product offerings. The keywords are transparency, comparability and the reduction of „greenwashing”. Although the focus is on environmental issues, the regulation also governs rules for social issues, such as inequalities (gender, race, religion, etc.), social cohesion and human capital.
Companies that offer an investment product must disclose via various channels how the company’s operation and its investment products are in line with environmental and social objectives and what related risks are involved. Companies that do not offer a sustainable investment product or a product that achieves some degrees of ESG integration, should also communicate this.
The regulation is very complex, affecting financial actors in many different ways. It contains regulations at the organizational (investment policy, remuneration policy) and product (information obligation) levels. It occasionally differentiates companies according to their size (500 +/- employees) and differentiates between the products concerned, examining their sustainability goals. The standards include ongoing, periodic and, at the individual level, one-time disclosure obligations.
The regulation aims to harmonise responsible investments and increase the comparability of financial market participants and their products through the governance of 3 factors:
|Regulated factor and its description|| ||High-level compliance|
|Sustainability risk: An occurrence or existence of an environmental, social or management event or circumstance which may have an actual or potential substantial adverse effect on the value of the investment.||Risks should be integrated into investment, advisory and remuneration policies and published on the website and in pre-contractual disclosures. The effect of the risks on returns must be stated before the contract is signed.|
If the above-mentioned is not applicable, its explanation should be published.
|Sustainability factor: Environmental, social, labor and human rights questions or issues regarding the fight against corruption and bribery.||For ESG products, the reason for ESG classification, the methodology of calculating the score, the type of benchmark or index used, the way it is related and its methodology of calculation must be disclosed in the pre-contractual documents, on the website, and in periodic reports.|
|Adverse impact: The principal adverse impacts on sustainability factors caused by the investments or advice of financial market participants.||How the adverse impacts on sustainability are taken into account and figures associated must be published on the website on entity level and in pre-contractual disclosure on product level.|
The various disclosure requirements created must, in principle, be complied with by financial market participants (including financial advisers) from 10 March 2021, with the exception of those provisions which require further detailed regulation. The expected specifications are included in the so-called RTS, which are under development. (We can call it the first level of compliance.)
Regulatory Technical Standards (RTS) (will) contain a number of detailed regulations for SFDR, which the European Supervisory Authorities (ESAs) have been asked to develop. For the time being, the entry into force of the related provisions of the SFDR is uncertain until the adoption and official publication of these RTS. On 4 February 2021, the European Supervisory Authorities published their Final Report on the draft of the RTS, at the same time proposing an entry into force date of 1 January 2022. The European Commission is now reviewing the draft of the proposed measures and, after further negotiations, will adopt or reject them, which will have a major impact on the date of entry proposed by the ESAs. (Second level of compliance.)
In the absence of the RTS, a number of key issues remain unanswered, such as the lack of formal adoption of the specific requirements. At the same time, the European Commission issued a resolution on the subject in October 2020, which makes it clear that financial institutions must comply with the provisions that are not dependent on the adoption of the RTS from 10 March 2021, and where further detailed specifications are expected, they need to comply with its high level and principle-based requirements.
Due to its regulatory form, the SFDR is directly applicable to all EU countries, but individual Member States may introduce clarifying, harmonising and complementary regulations which the responsible supervisory bodies can use to provide guidance to local actors on how to implement the regulation.
The next steps expected in the near future are already visible: New RTS are constantly being scheduled for the next 2 years, so the market will have to constantly adapt to them as well. Although not all details are known yet, financial players already have to meet the requirements at the first level. However, we do not yet know much about the practical implementation of the regulation. There are still many unclear points regarding why and how questions, as this regulation is among the first to try to regulate the market for ESG-based and sustainable investments. It is a challenge to cover all aspects in sufficient detail, not to mention the cases that will only come to light during the final entry into force. In other words, it is no question that many regulations will still be enacted on the subject. The SFDR, therefore is “just” another (albeit important) step on the long road towards making finance sustainable.
It is no coincidence that we have written a three-part article series on this topic as opposed to just a single post because we at Dorsum are also actively addressing SFDR compliance issues to support our Clients in relation to the regulation.