The Sustainable Finance Disclosure Regulation (SFDR) is a European regulation designed to promote sustainable investment and increase transparency in the financial sector. Financial Market Participants (FMPs) must disclose how they take sustainability into account in their investment decisions and report on the ESG strategies and impacts of their financial products.
The EU Taxonomy works as a classification tool. It defines when an economic activity can be regarded as sustainable. The EU Taxonomy lists activities and the criteria that need to be fulfilled for the activity to be considered (environmentally) sustainable. The EU Taxonomy sets out three overarching conditions that an economic activity must meet in order to be considered sustainable:
The SFDR, like the CSRD, cross-references with the EU Taxonomy and the criteria listed in the EU Taxonomy are used by FMPs to calculate the share of taxonomy-aligned investments in the portfolio. In effect, these two regulations are one package serving the same goal - to create transparency about the sustainability of investment portfolios. Ultimately, the intention is to steer more investments towards sustainable portfolios.
The Corporate Sustainability Reporting Directive (CSRD) has been in force since January 2023 and applies to all economic sectors, going beyond the financial sector. It requires all large companies to report extensively on their sustainability profile and performance. The directive is linked to the EU Taxonomy and requires companies to disclose their share of activities aligned to the Taxonomy (similar to SFDR). The Corporate Sustainability Due Diligence Directive (CSDDD) will complement the CSRD and will require large companies to identify, assess, mitigate and remediate adverse human rights and environmental impacts in the supply chain. The CSDDD currently remains at proposal stage. It is expected that both directives will complement the SFDR and the EU Taxonomy (and vice versa), so that increased transparency on sustainability performance is established in both the real and financial economy.
Although the regulatory landscape for ESG is evolving, there are still many uncertainties regarding the specific requirements. On SFDR and Taxonomy alone, the European Commission (EC) and the European Supervisory Authorities (ESAs) have published multiple Q&As since the regulations came into force to provide much-needed guidance for FMPs. Despite this, the application of SFDR concepts such as ‘sustainable investment’, the existing categorisation of financial products (Art 6, 8 and 9), or the taxonomy criteria (e.g. on climate change adaptation) remains challenging. This is also the case for overarching concepts, such as 'do no significant harm' (DNSH), which does not seem to be fully in line with the SFDR and the EU Taxonomy. This is further complicated by the fact that the current first ‘version’ of the SFDR is currently under review by the European Commission, with possible changes ranging from minor adjustments to a complete overhaul of the SFDR and its fundamental workings. As for the EU Taxonomy, it remains incomplete, with more criteria for environmental contributions to be added in the future and a taxonomy for social objectives yet to be defined. How well the CSRD will complement the two regulations through provision of company disclosure on sustainability remains to be seen upon its first application in 2024.
In the midst of all this, the EU is currently attempting a balancing act between (1) publishing legislation in time (to speed up the transition) and with sufficient level of ambition (to realise the EU Green Deal) and (2) making laws that complement each other and include realistic and feasible requirements for FMPs, and that therefore work well in practice (and not only in theory).
The current ESG environment also presents challenges for FMPs. Ensuring compliance with sustainable finance legislation is a must, but already proving difficult given the stated uncertainty and a lack of guidance. The fact that only very limited ESG data is available at the portfolio and investment level (and when it is available, it is difficult to compare) makes it even harder to comply with existing disclosure requirements. Moreover, many FMPs manage different types of financial products, making it challenging to implement a one-size-fits-all ESG approach. This leads some FMPs to adopt a rather conservative and cautious ‘let’s wait and see’ approach towards their ESG ambitions, sticking to the minimum disclosure requirements until the regulatory landscape matures.
However, the truth is that, all regulation aside, the pressure on investors to play an active role in the sustainability transition is rising. Whilst in the past ESG was widely seen (and approached) as a ‘tick-the-box exercise’, this is now changing. Stakeholders increasingly expect investors to embrace the paradigm shift, ‘really’ deal with ESG, commit serious resources to the topic and take meaningful action, backed with quality data to support their performance. While many FMPs have taken the first steps by developing a proprietary ESG approach (often with an aversion to existing legislation, claiming that it takes awareness and resources away from a better, more normative approach), many of these investors will, in the future, have to level up their efforts and revise / improve their strategies and methodologies. Other FMPs have not implemented any activities yet and will be required to commit considerable time and energy to the topic of ESG in order to maintain their ‘licence to operate’.
Investors need to think strategically about ESG, demonstrating real commitment and meaningful progress, whilst maintaining regulatory compliance and avoiding greenwashing at all costs. Working with our clients and talking to peers and partners, we have observed useful practices that help market participants achieve this balancing act. We have summarised some of these below:
We hope that these practices will help your organisation to determine or improve your ESG approach. If you have any questions or would like to learn more, please do not hesitate to contact us.
Blog 1 | Building Trust through Compliance: A Closer Look at PAI Statements under SFDR
In recent years, regulations for sustainability reporting have become more stringent and the pressure to comply with these standards has intensified. The Sustainable Finance Disclosure Regulation (SFDR) imposes mandatory reporting on a range of ESG topics.
Blog 2 | Sustainability claims and consequences: a changing landscape
In this second blog, we turn our attention to the pervasive issue of greenwashing, exploring the risks it poses and the strategies to combat it. Furthermore, we provide insights into the changing landscape of responsible investment and strategies for sustainable growth.