The previous blog post on the Sustainable Finance Disclosure Regulation (SFDR) reviewed what the regulation means for financial institutions at an introductory level. Specifically, it explained the type of disclosure required, when it will be required, and who is affected. The SFDR requires financial market participants within the EU, financial advisors based in the EU, and non-EU financial market participants to disclose product ESG data. At the beginning of 2023, SFDR Level 2 took effect, requiring the use of Regulatory Technical Standards (RTS) for more specific and technical disclosures.
The type of product-level information to disclose is determined by the fund categorization set by the Financial Market Participant (FMP). A fund can be classified in three ways: Article 6, a “grey” fund, covers products that traditionally do not integrate sustainability into the investment process. Article 8, a “light green” fund, includes products that promote environmental or social characteristics and follow good governance practices. Article 9, a “dark green” fund, includes any product that has a clear sustainable investment objective. In this post, we will explain the disclosure requirements for each fund categorization and how to meet product-level disclosure requirements.
What is Product-level Disclosure and Why Does it Matter?
It is important to distinguish between a financial product and a financial fund, as each is subject to unique disclosure requirements. Under the SFDR, a financial product refers to a product or service offered by a financial market participant. This can include investment funds, pension products, insurance-based investment products (IBIPs), or portfolio management services. A fund refers to an investment fund, which can encompass mutual funds, exchange-traded funds (ETFs), and real estate investment trusts (REITs), among others.
How to Report Product-Level Information Under SFDR:
The SFDR has outlined three minimum disclosure requirements that Financial Market Participants (FMPs) must adhere to, regardless of whether the fund is categorized under Articles 6, 8, or 9. The three types of disclosure requirements include pre-contractual disclosure, periodic reports, and website disclosure. All products, regardless of fund categorization, must disclose certain material information that meets the disclosure requirements of Article 6, at minimum. Articles 8 and 9 require additional disclosure as the product progresses through its stated ESG journey. The outcome of these disclosure requirements intends to provide investors with clear, comparable information on the sustainability impacts of their investments.
The Pre-contractual disclosure requirement of the SFDR is intended to increase transparency of sustainable investments and investment objectives ahead of the formalization of a legal relationship. FMPs are expected to provide information on the promotion of environmental or social characteristics as well as any sustainable investment objectives the financial product may have. Pre-contractual disclosure requires FMPs to identify sustainability risks and explain their materiality and how they could impact the investment returns of the financial product. This requirement is narrative-based and is often written with the assistance of ESG experts to accurately describe the sustainability risks considered.
Second, pre-contractual disclosure requires FMPs to describe how sustainability risks are integrated into investment decisions. If they are not integrated, FMPs are expected to explain why and include methodologies, data sources, and tools used to assess and manage risks.
Third, FMPs are required to disclose the results of an assessment of the likely impacts of sustainability risks on the returns of the financial product, including both potential negative impacts and positive impacts. The risks disclosed should align with the risks outlined in the previous disclosure requirements.
Finally, FMPs must provide a statement on whether Principal Adverse Impacts (PAIs) were considered during investment decisions. Principal Adverse Impacts are a pre-defined list of ESG indicators intended to unify ESG disclosure under specific and consistent metrics, and cover a host of ESG topics - ranging from carbon emissions to human rights and labor management.
The Periodic Reporting requirement is intended to provide information about the sustainability impact and performance of FMP’s financial products. While not required for Article 6 funds, periodic reporting is required for Article 8 and 9 funds.
If a financial product promotes environmental or social characteristics (Article 8) or has a sustainable investment as its objective (Article 9) the periodic report must provide an assessment of whether those characteristics or objectives are met. Additionally, FMPs must disclose the percentage of economic activities that qualify as environmentally or socially sustainable under the EU Taxonomy, which is a classification system that defines environmentally sustainable economic activities. The EU Taxonomy categorizes business activities under 6 environmental objectives including, climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems.
For Article 9 funds, if a benchmark index is used as a reference, the periodic report should include a comparison between the overall impact of the financial product and the impact of the designated index. FMPs are also expected to include a broad market index for comparison of sustainability-related impacts.
Website disclosure requires FMPs to provide specific information about their sustainability practices and policies on the financial product’s relevant website. This includes publishing information about sustainability risk policy and how sustainability risks are integrated into the investment decision-making process.
Website disclosure must also include a statement on due diligence policies with respect to PAIs on sustainability factors. If no due diligence policies were in effect, the statement must include a clear reason for why there were no policies.
Article 8 funds require additional disclosure that includes a detailed description of the environmental or social characteristics the fund is aligned with. Similarly, Article 9 funds should include a description of the alignment to a sustainable investment objective within the EU Taxonomy.
Product-level disclosure requires financial market participants to meet three types of disclosure including pre-contractual disclosure, periodic reports, and website disclosure. Each of the three disclosure types have different requirements and vary in rigor depending on the fund classification. Annex I of the SFDR has detailed templates for a PAI statement. Annex II through Annex V contains templates for pre-contractual and periodic reporting for Articles 6, 8, and 9. SFDR disclosure requirements simplify and create uniformity across FMPs to enable investors to see the sustainability impacts and performance of financial products.