In this, the second installation of the series by Jana Everett (MBA ‘22) in partnership with Eka Ventures, we give an overview of the EU’s Sustainable Finance Disclosure Regulation (SFDR) and related legislation. Along with the piece on systems thinking, this review sets the stage for a guide for impact investors to developing a theory of change and establishing impact KPIs for their investments.
The EU has set the pace for sustainable finance regulation around the world, with its progressive Sustainable Finance Disclosure Regulation (SFDR) passed in 2019 and follow-on legislation in 2020, 2021, and 2022. Unlike guidance from the Taskforce on Climate-related Financial Disclosures (TCFD), on which UK mandatory disclosures are based, the SFDR encompasses environmental and social impact disclosures.
The EU has passed four critical pieces of legislation:
● Regulation 2019/2088 (“the SFDR”);
● Regulation 2020/852 (“the Taxonomy”);
● Regulation 2021/2139 (Taxonomy technical screening criteria, ”the TSC”); and
● Regulatory Technical Standards (“the RTS”).
The SFDR establishes transparency requirements at the entity and the product level. It provides three tiers of sustainability for financial market participants (FMPs) and financial advisors (FAs). Each of these tiers has different transparency requirements, laid out in Articles 6, 8, and 9 (more on this below).
The Taxonomy sets out six environmental objectives to which entities and products claiming alignment to Articles 8 or 9 must contribute substantially. (Future legislation is expected to establish additional, socially-oriented objectives and taxonomies.) The TSC issued in 2019 provides criteria for substantial contribution to the first two objectives of climate change mitigation and adaptation, with criteria for the remaining four objectives expected this year.
The RTS specifies the required content and presentation of disclosures relating to:
● the principle of do no significant harm (DNSH) according to principle adverse sustainability impact (PAI) indicators
● contribution (or lack thereof) to a sustainable investment objective and further DNSH compliance requirements
Unlike the Taxonomy, the RTS already provides socially-oriented indicators in addition to environmental and governance ones.
Transparency: Articles 6, 8, and 9
The aims of the SFDR and subsequent legislation are to improve sustainability-related disclosures, make disclosures more comparable for end investors’ use, and reduce greenwashing and adverse sustainability impacts in financial services. The legislation broadly categorizes financial market participants (FMPs) and financial advisors (FAs) according to three tiers of sustainability consideration in their product offerings.
Article 6 of the SFDR refers to products that do not take into account environmental or social sustainability factors. Per Article 4, FMPs and FAs offering these products are required to explain on their websites why sustainability factors are not considered.
Article 8 refers to financial products which promote environmental or social characteristics, while Article 9 products have sustainable investment as their objective. Article 8 entities may screen for ESG ratings in their products, for example, and if a product has a sustainability benchmark, the entity must disclose whether it is consistent with the product’s stated sustainability characteristics. Article 9 products contribute substantially to one of the SFDR’s sustainable investment objectives, and must choose a benchmark index aligning with the fund objective. For example, they may feature investment in carbon capture technologies, contributing to the climate change mitigation objective set out by the Taxonomy.
Objectives & Enabling Activities
The Taxonomy sets six environmental sustainability objectives:
1. Climate change mitigation
2. Climate change adaptation
3. Sustainable use and protection of water and marine resources
4. Transition to a circular economy
5. Pollution prevention and control
6. Protection and restoration of biodiversity and ecosystems
The EU is expected to release further objectives specific to social impact in due course.
To qualify as environmentally sustainable in alignment with Article 9, a product must contribute substantially to one or more of these six objectives. Each objective will have criteria for what constitutes a substantial contribution, organized by sector and activity, although to date only criteria for the first two objectives of climate change mitigation and adaptation have been published (the TSC).
Economic activities that directly enable activities making a substantial contribution to one of these objectives can also qualify as environmentally sustainable. For example, investment in research into potential new carbon capture solutions may enable activities that contribute substantially to climate change mitigation. Enabling activities must not lead to lock-in of assets which undermine the environmental objectives. Research into carbon capture technologies done on behalf of oil and gas companies may be tricky, because it may contribute to long-term continued use of carbon-intensive energy sources. Enabling activities must also have a substantial positive environmental impact on the basis of life cycle considerations.
Do No Significant Harm & Principal Adverse Impact
No Harm in Contribution to an Objective
In addition to contributing substantially to an environmental objective, Article 9-aligned products and entities must prove they do no significant harm to any of the objectives.
The TSC provides criteria, by sector, of what would constitute significant harm to each environmental objective in pursuit of another. For example, residential care activities may contribute substantially to climate change adaptation, but for this sector the TSC requires a waste management plan to be in place to avoid significant harm to the objective of pollution prevention and control.
Most FMPs and FAs must publish PAI statements (using this template) as part of their measurement of significant harm. The requirement applies to all FMPs with more than 500 employees and any FMPs or FAs claiming alignment to Articles 8 or 9. There is a PAI opt-out option for smaller FMPs and for FAs of any size. There are 14 mandatory PAI indicators covering greenhouse gas emissions, biodiversity, water, waste, and social and employee matters. The RTS lays out additional, voluntary indicators for reporting.
A Look Ahead
Most of the disclosure requirements enacted by the SFDR are already enforceable, although PAI statements become mandatory only from 2023. The EU is on pace producing additional legislation at least annually, and with key elements like social objectives and criteria for the remaining environmental objectives outstanding, there is much more to come.