The Sustainable Finance Disclosures Regulation is a key initiative emerging from the European Union’s 2018 action plan on sustainable finance. Active ownership will be a crucial instrument for investors to deliver the real economy impacts we need to see.
SFDR applies to financial products made available in the EU and the financial market participants who provide them, with additional requirements for financial advisers. FMPs were required to comply with most of the high-level requirements by 10 March 2021.
SFDR disclosure requirements include how sustainability risks are integrated into investment decisions and the likely impacts of such risks on the product’s financial returns. They look at whether and how adverse impacts of investment decisions are considered with disclosure of designated social and environmental impact metrics. And there are additional pre-contractual disclosures and periodic reporting for products with specific social or environmental characteristics or a sustainable investment objective (often referred to as ‘Article 8’ or ‘Article 9’ products respectively).
The impact of SFDR will vary from firm to firm, but this undoubtedly represents a significant ramping up of disclosure across the board. Firms that already extensively integrate sustainability considerations, such as the international business of Federated Hermes, are focusing on adapting disclosures to the new templates.
However, for some firms this regulation will drive significant operational changes beyond the disclosure process, with new processes required to integrate sustainability risks and understand their potential impact on financial products.
The regulation is intended to increase transparency through disclosure to end-investors, reducing perceived ‘greenwashing’ and enabling end-investors to make more informed choices. The industry has generally been supportive of the aims of the regulation, and many firms have recognised this as an opportunity to show clients in more detail how sustainability considerations are integrated into investment processes.
FMPs will face challenges in obtaining the necessary data from investments for their disclosures, particularly from non-EU companies who will not be subject to the proposed Corporate Sustainability Reporting Directive.
However, it seems the EU hopes to improve this throughout the investment chain by mandating such disclosures from FMPs who will need to engage with their investees for the necessary data.
It remains to be seen how the disclosures will impact the decisions of end-investors. Increased transparency will strengthen end-investors’ ability to hold their asset managers to account and create greater alignment between marketing materials and product documentation. The industry will be monitoring capital flows closely to understand whether the disclosures – and in particular the categorisations of products – impact clients’ capital allocation decisions.
As we move beyond the initial application of SFDR, it is important that the EU retains a sufficiently broad view of how investors can play their part in tackling issues like climate change and inequality. Only effective stewardship of assets, combined with the appropriate government policy and regulation, can deliver the change we need to see – whether that is meeting the United Nations Sustainable Development Goals or emissions targets set by the EU.
While SFDR acknowledges engagement as a means to mitigate the negative environmental and social impacts of investments, we believe a much greater emphasis on active ownership is needed. If society is to address such issues, whole companies and sectors need to pivot rapidly. The strongest tool investors have to drive this change is using ownership rights to engage.
SFDR is an important piece of the sustainable finance puzzle. And once the dust settles, it will be up to governments, investors and companies to identify other levers of change – including stewardship – to help us reach these goals. The rest of the world is looking on to see what lessons can be learnt from the EU’s ambitious strides in sustainable finance.