The Regulation (EU) 2019/2088 on sustainability-related disclosures in the financial services sector (SFDR) was adopted on 10 March. It has implied a substantial change in the sustainable investment framework, and has been the subject of much financial sector discussion over last year. The Sustainable Finance Disclosure Regulation is part of a larger EU proposal to redirect capital towards more sustainable businesses, and represents a complete transformation of the provision of financial products, both in the internal policies of financial operators and in the classification system for sustainable financial products.
Although almost 90% of investors would like to invest in sustainable products, most are not used to do it, according to a survey by Analistas Financieros Internacionales (Afi), Allianz Global Investors and finReg360. The new SFDR regulation aims to change this. Through the implementation of this regulation, investors will be better informed to take decisions on sustainable finance issues. They will also have more and better information when deciding on their investments and will be able to compare products offered by different institutions according more homogeneous criteria.
What is the SFDR regulation?
The SFDR requires all asset managers to include sustainability risks in their investment decisions. It also requires funds to be clearly categorised according to their sustainability performance. Institutions must specify their objectives, policies and methodologies (relating to sustainable principles) in prospectus, websites and annual reports. In addition, the regulation differentiates the disclosure requirements between those of institutions and those of financial products.
A key part of the new regulation is the classification of funds. Until now, each fund manager could use its own classification criteria. The Sustainable Finance Disclosure Regulation makes it mandatory to classify all investment products under management into the following three categories:
- Products that have sustainable investment as its objective (Article 9).
- Products that promote environmental or social characteristics (Article 8).
- Non-sustainable products (Article 6).
This classification aims to improve transparency and information in order to let end-investors understand how sustainability influences their investment decision-making processes.
The implementation of this regulation is a step forward in terms of transparency, and it has been a major challenge for the financial sector:
SFDR Implementation gap
The regulatory framework on sustainability reporting is between two levels. It means that all the package of standards on the SFDR regulation do not comes into force at the same time.
The first part, adopted since 10 March, requires Financial Market Participants to specify on their websites and in their product prospectus whether or not they intend to consider sustainability when managing assets. However, it does not go into how the information is detailed. At the second phase, the ways of communicating this information will be homogenised by applying technical criteria for the regulation implementation. Initially, it was envisaged that the second phase could be approved by the time the Regulation is applied (phase 1), but this has not been the case and the final standard is expected to enter into force at the beginning of 2022.
This gap in the application of the regulation in two phases will mean having to face an adaptation process – modifying the funds initially monitored and adjusting them to the requirements of phase 2 – with the uncertainty and costs that this entails for the financial sector.
Lack of taxonomy
Sustainable investment definition is a problem, since it can be interpreted in different ways. The EU taxonomy is a new regulation that aims to create a harmonised concept of what really is “sustainable”, by providing a common language and uniform criteria to identify which activities can be considered sustainable for the environment. But this taxonomy is still under development.
At the first phase, the SFDR regulation does not go into assessing what is or is not sustainable, but simply requires entities to define themselves in this regard. This, together with the lack of a defined taxonomy, leads to the risk of greenwashing.
Although the ideal situation would have been to have a fully developed taxonomy at the time of entry into force of the regulation, the fact that this was not the case does not limit the opportunity to move towards a homogenization of the standards and of the information provided to customers. When the taxonomy comes into effect, this work will be specified and improved. Meanwhile, progress towards this change should not be stalled
Cross-cutting nature of ESG criteria
One of the main challenges faced by financial institutions in complying with the regulation is the cross-cutting nature of sustainability within the organisation and the need to involve the entire institution in sustainable investment: senior management, the business area, the risk function, internal audit, compliance, etc. Furthermore, this new regulation affects the entire production chain of the financial industry, from marketing to management as well as to the design of financial products. Over last year, financial institutions have had to carry out an extensive process of classifying their funds, drafting new prospectuses, updating reports, and redesigning websites, among others, with the consequent investment in resources and time that this has entailed for the institutions. Although we understand the complexity and work involved for financial institutions in adapting their internal processes to this new regulation, we believe that their efforts will be rewarded, as the regulation is encouraging the financial sector to broaden its horizons, redirecting its offer towards sustainable products that meet growing customer demand.
Impact beyond the financial sector
The SFDR regulation, while directly affecting financial market participants, indirectly has an impact on other businesses as well. Companies, through the data they provide in sustainability reports and Non-Financial Information Statements (NFS), will have to report on the contribution of their business to sustainability. Investors will rely on this reported information to calculate the sustainable contribution of companies and advisors will assess which products fit with their sustainability policy. So everything is interconnected and the SFDR regulation cannot be isolated as simply affecting the financial sector.
In fact, the European Regulation on Non-Financial Information, transposed in Spain with Law 11/2018 of 28 December, is currently under review within the European Union, so that there is a correlation of information on sustainability in the reports issued by companies, with the regulations promoted by the EU within its Sustainable Finance Plan and with the Taxonomy.
The implementation of the SFDR regulation is an evolving process but it is a fundamental step towards finding appropriate ways to communicate sustainability and reduce uncertainty for companies, managers and end customers. With the entry into force of this new regulation, the financial sector, somewhat stigmatised in recent times, has a great opportunity to contribute to sustainable development and to convince society that its role in this race is very relevant and necessary.