The Implications of Sustainable Finance Disclosure Regulation (SFDR)

Share on facebook
Share on twitter
Share on linkedin

Investors have become increasingly sensitive to the effects of greenwashing. Tariq Fancy, former chief investment officer for sustainable investing at BlackRock, recently wrote that the “multi-trillion dollar area of socially conscious investing is being presented as something it’s not” and that Wall Street is “greenwashing the economic system”. Fancy isn’t the first high-profile individual to draw attention to the greenwashing problem in the financial world, and he certainly won’t be the last. However, some policymakers around the world are already taking action in the form of SFDR.

On 10th March 2021, Sustainable Finance Disclosure Regulation (SFDR) came into effect. The legislation captures financial market participants operating within the European Union, and it sets specific rules for how financial institutions and participants declare sustainability-related information. SFDR hopes to avoid the greenwashing of financial products and advice in the EU. Similarly, it hopes to encourage financial market participants to consider sustainability matters. 

But how did this legislation come about in the first place?

High-level expert group on sustainable finance (HLEG) and SFDR

In December 2016, the European Commission established a high-level expert group on sustainable finance (HLEG). The group comprises 20 senior experts from the finance sector, civil society, academia, and observers from both European and international institutions. These 20 individuals advised the European Commission on a range of issues:

  1. The group advised how to “steer the flow of public and private capital toward sustainable investments”.
  2. They “identified the steps that financial institutions and supervisors should take to protect the stability of the financial system from risks related to the environment”.
  3. The group hoped to “deploy these policies on a pan-European scale”.


Principal Adverse Impacts (PAIs)

SFDR contains requirements relating to the principal adverse impact statement (PAIs). PAIs are intended to show current or prospective investors how investment decisions have/may have an adverse impact on sustainability factors relating to environmental, social, human rights, anti-corruption and anti-bribery matters. We found that PAIs have witnessed an increase in search demand by 59% over the last 12 months and has doubled in demand over the last 48 months, highlighting the growing awareness regarding how investment decisions could have an impact on sustainability factors.

PAIs operate on a comply or explain basis. Financial market participants must publish and maintain their website where they consider principal adverse impacts on investment decisions on sustainability factors. A statement must accompany it on the due diligence policies relating to these impacts, taking into account the size, nature and scale of their organisational activities. 

Suppose financial market participants do not consider the adverse impacts of investment decisions on sustainability factors. In that case, they must publish and maintain their website the precise reasons why it does not do so. This statement must include whether and when they intend to consider such adverse impacts on investments. 

What did HLEG recommend?

In their final report, published in 2018, HLEG made several ‘priority action’ recommendations:

  • Establishing an EU sustainability taxonomy, 
  • Starting with climate mitigation, to define areas where investments are needed most;
  • Clarifying investor duties to extend the time horizons of investment and bring greater focus on environmental, social and governance (ESG) factors into investment decisions; 
  • Upgrading disclosures to make sustainability opportunities and risks transparent;
  • Enabling retail investors to invest in sustainable finance opportunities; 
  • Developing official European sustainability standards for some financial assets, starting with green bonds; 
  • Establishing ‘Sustainable Infrastructure Europe’ to deploy development capacity in EU member states for infrastructure necessary for a more sustainable economy; 
  • Integrating sustainability firmly in the governance of financial institutions as well as in financial supervision.


Confronting short-termism

The HLEG also made other recommendations to the European Commission. The report draws attention to short-termism in financial markets. Consequently, it suggests that the EU should confront the problem to reduce the impact on long-term corporate investment and development. Short-term performance pressures may result in an excessive focus on quarterly earnings. Unfortunately, this means less attention is placed on strategy and long-term value creation. Positive long-term goals that do not create immediate revenue are put on the back burner, including sustainability initiatives. 

The United Nations Global Compact

Similarly, The United Nations Global Compact is actively encouraging investment markets to think more sustainably. The organisation encourages companies to ‘act long term in a short-term world’ by following ‘cope, shift, change’ strategies. To do this, companies must cope with short-termism in their investor base by developing and implementing sustainability strategies that provide clear financial benefits short term. 

Companies must also shift to a long-term orientated investor base by demonstrating how their business strategy, including sustainability initiatives, will create long-term value for investors. For example, organisations should consider reporting on metrics that contribute to the long-term success of the business. The United Nations Global Compact is also asking businesses to encourage policymakers to enact measures that enable companies to prioritise long-term sustainable activities.

The progress of SFDR

We found that over the last 12 months, search demand for SFDR has surged aggressively by 1,816%, highlighting the growing awareness of SFDR as its implementation of both phase one (and later on phase two) is rolled out. As of 30th June 2021, large firms with over 500 employees must disclose their due diligence policies for PAIs on sustainability factors. On 1st January 2022, level two will commence. At this time, periodic reporting on environmental and social characteristics and sustainable objectives will begin. By December 2022, organisations that consider PAIs must disclose how their products and services consider these impacts, and others are obliged to explain why they do not. By January 2023, products and services that promote environmental or social characteristics and products with sustainable investment as their primary objective must have periodic and pre-contractual reporting in place in alignment with the EU Taxonomy’s objectives.

The EU Taxonomy’s four remaining objectives are as follows:

  • The sustainable use and protection of water and marine resources;
  • The transition to a circular economy;
  • Pollution prevention and control;
  • The protection and restoration of biodiversity and ecosystems.


What does the future hold for ESG disclosure?

Global financial markets recognise the need for more transparency in ESG disclosure. For example, earlier this year, the U.S. Securities and Exchange Commission announced the creation of a Climate and ESG Task Force. The task force “will develop initiatives to proactively identify ESG-related misconduct”. Clearly, investor concerns about greenwashing have been heard. In the EU, the new SFDR rules on ESG disclosure will allow investors to interpret new sustainability information and reassure them that organisations are not participating in greenwashing. The legislation should help to make the finance industry more transparent in its objectives and encourage long-term sustainable objectives.

The role of data

It appears that data, artificial intelligence and Natural Language Processing will play an increasingly pivotal role as time goes on. Advanced technology can enable financial market participants to come under more scrutiny regarding ESG and offer investors transparency. However, gathering ESG-related metrics are less straightforward than traditional financial metrics.

We found that searches related to the Task-Force on Climate-related Financial Disclosures (TFCD) have increased by 87% over the last 12 months, as measures are focused on improving and increasing the reporting of climate-related financial information. Similarly, AI ESG searches have experienced an uplift of 181% in the last 12 months. This suggests that individuals are aware of the ability to leverage AI in ESG and unlock knowledge without constraints. If ESG investing is here to stay, specialised technology and a clear regulatory framework must be put in place sooner rather than later.*

At onefourzero, our services involve in-depth due diligence reports to data-driven analysis and strategies. To find out more about our services, or to contact us for more information, click here.

*MarketLine (2021), ‘ESG Investing: Just a passing trend unless regulatory bodies get it right the first time’