SFDR: a sea change for sustainable investment transparency

He outlines the implementation timeline of the rules, the requirements, remaining uncertainties in interpretation and the key considerations for Level 2 disclosures.

The asset management landscape changed significantly after 10 March 2021. There is a shift away from being able to mention ‘ESG’ or ‘sustainable’ in the name of a financial product. From this date, under the SFDR, all financial products had to be classified as Article 6 (non-ESG), Article 8 (those which promote an environmental or social characteristic either alone or in combination with other characteristics) or Article 9 (those which have sustainable investments as their investment objective as defined in Article 2 (17) of the SFDR.

These legislative requirements are intended to provide increased transparency around Environmental, Social and Governance (ESG) characteristics and the integration of sustainability risks at a product and entity level via pre-contractual documentation disclosures, website disclosures, and periodic reporting. In turn, they are providing investors with the necessary ESG factors to consider within the investment decision-making process, which helps them make informed decisions that align with their investing goals.

On 14 November 2022, the Central Bank of Ireland (CBI) published an information note ‘Sustainable finance and the asset management sector: Disclosures, investment processes & risk management’ intended to provide information on the main disclosure issues and outline risks identified by the CBI in terms of potential greenwashing or areas where there has been a lack of transparency or clarity. A significant challenge observed related to the lack of granularity and high-level nature of the disclosure obligations under the SFDR level 1 and Taxonomy Regulation. This issue is addressed with the introduction of SFDR level 2 disclosure requirements, as these are more prescriptive in nature.

Level 2 disclosure requirements

The SFDR delegated measures (level 2) set out additional disclosure obligations with an effective date on 1 January 2023 in respect of:

• Fund managers’ website disclosure of the principal adverse impacts (PAIs) of investment decisions on sustainability factors under SFDR Article 4 (the entity-level PAI disclosure rule).
• Fund disclosure of environmental or social (E/S) characteristics under SFDR Articles 8, 10 and 11 (product-level disclosure rules).
• Fund disclosure of sustainable investment objectives under SFDR Articles 9, 10 and 11 (product-level disclosure rules).

To meet the SFDR requirement, companies must disclose their PAI from greenhouse gas emissions to waste, biodiversity and human rights. This is becoming the minimum standard, and companies who fail to do so will be visible. The better the information that fund managers have access to, the more likely they will confidently include companies within their Article 8 or 9 funds.

Article 8 products promote social and/or environmental characteristics and may invest in sustainable investments but do not have sustainable investing as a core objective. In contrast, Article 9 products have a sustainable investment objective. Further detail on determining the scope of Articles 8 and 9 can be seen below.

Level 2 compliance timeline

Key dates to note for level 2 compliance are set out below, with entity-level PAI disclosure required to be published on the fund manager’s website by 30 June 2023 being an upcoming focus for fund managers.

1 December 2022 - Central Bank deadline for filing level 2 pre-contractual disclosures for Article 8 & 9 funds, using mandated templates

1 January 2023 - level 2 deadline for publication of website disclosures for Article 8 & 9 funds, per Level 2 rules

Post 1 January 2023 - level 2 financial report disclosures must be included in reports for Article 8 & 9 funds published after 1 January 2023, using mandated templates

30 June 2023 - level 2 deadline for publication of entity-level PAIs, referencing 2022 calculations, using the mandated template

Determining the scope for Articles 8 and 9

Article 8 applies to a financial product that ‘promotes, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices’.

The initial expectation from investors is for funds to migrate towards SFDR

Article 8 funds. This will occur through a combination of new fund set-ups and the significant transition of existing funds that have already adopted ESG criteria in their investment policies but are now formally aligning with Article 8 status.

Sustainable investment under SFDR means an investment:

• In an activity that contributes to an environmental or social objective.
• That does not significantly harm any social or environmental objective (the DNSH test).
• That follows good governance practices (in the case of investee companies).

Article 9 applies to a financial product that ‘has sustainable investment as its objective’ with ‘sustainable investment’ defined under Article 2 (17) of the SFDR. Furthermore, the SFDR recognises of Ireland’s funds sector (while most funds three different variations of Article 9 SFDR products and tailors the disclosure requirements based on whether:

i) an index has been designated as a reference benchmark;

ii) no such index has been designated; and

iii) whether the financial product has a reduction in carbon emissions as its objective.

What are the key considerations of level 2 disclosure?

The main controversy regarding these level 2 requirements is where asset managers must disclose on a highly challenging set of ‘Principal Adverse Impacts’ (PAI). These PAI comprise a list of sustainability factors (e.g. greenhouse gas emissions, waste, biodiversity, human rights) that firms need to consider in their investment policies and decisions. They consist of mandatory and voluntary indicators, related to environmental and social topics. Managers are also expected to provide a statement on due diligence of sustainability risks and integration of sustainability factors in the remuneration policies.

ESG funds are widely expected to outnumber conventional funds by 2025, which will likely result in asset managers facing pressure from their current and future investors to offer Article 8 or 9 financial products instead of Article 6 products.

Michael Tuohy Partner, Audit & Assurance

Article 8 ‘The Guardrails’ - The CBI notes that the definition of an Article 8 compliant product under the SFDR does not contain minimum investment thresholds or any prescribed composition of investments. The CBI states that supervisory engagement will focus on funds with a low proportion of their portfolio promoting environmental and/ or social characteristics. It may also examine funds which have changed their SFDR classification and consider further the rationale provided at the time of the change.

Investment funds classified as either Article 8 or Article 9 products under the SFDR remain a small but significant part of Ireland’s funds sector (while most funds have classified themselves as Article 6 products). However, the proportion of Article 8 and Article 9 products is expected to grow over time, given investor demand for investment products which are considered sustainable. ESG funds are widely expected to outnumber conventional funds by 2025, which will likely result in asset managers facing pressure from their current and future investors to offer Article 8 or 9 financial products instead of Article 6 products.

As European regulations have continued to evolve, it is evident that meeting these new requirements should be seen as more than just a compliance exercise. The decisions which need to be made should have been made in conjunction with an asset manager’s overall strategic direction.

Michael Tuohy, Partner and Financial Services Audit Leader at Mazars.