ESG as a game changer

Sustainability is gaining momentum internationally, and so are the efforts towards a green and sustainable transition. As part of its ambitious plan to steer more financial flows towards sustainable projects, the European Commission has identified numerous sets of measures to mainstream sustainability within the financial industry and to incorporate environmental, social and governance (ESG) factors and risks across the financial sector. The initiative forms part of the broader efforts to connect finance with the specific needs of the European and global economy for the benefit of the planet and our society. 

A cornerstone of these ambitions is the EU Sustainable Finance Disclosure Regulation (SFDR), which applies directly to financial institutions that are domiciled within the EU (third country institutions need to assess on a case-by-case whether they are affected). With transparency being an essential feature of sustainable investing and a perpetual concern of regulators, the SFDR aims to provide disclosure on sustainability within the financial markets in a standardized way, thus preventing greenwashing and ensuring comparability.

The new rules not only introduce increased transparency for ESG portfolios but also have implications for certain non-ESG products and services. They also affect various corporate and organizational topics, regardless of whether and to what degree the financial institution offers ESG products or services.

Overview of the new regime

The SFDR constitutes an ambitious framework prescribing the content to be disclosed by financial institutions in connection with investment decisions they make and investment or insurance advice they provide, especially with respect to the environmental and social impacts thereof. For this purpose, the SFDR differentiates between so-called Financial Market Participants, those entities that make investment decisions for their clients, and Financial Advisors, such entities that provide their clients with investment or insurance advice. Within this publication, both are jointly referred to as financial institutions. Moreover, the SFDR defines the type, scope and form of disclosure of sustainability-related information, by introducing new requirements for financial institutions at entity and service/product-level. While entity-level disclosures address the integration of sustainability risks in the investment, advisory and remuneration policies as well as the consideration of so-called principal adverse impacts, service/product-level disclosures comprise sustainability-related information in pre-contractual documents, website disclosures and in periodic reports. The scope of the SFDR is quite broad and covers portfolios of discretionary mandates as well as UCITS funds or insurance-based investment products, to name a few, which are collectively referred to as financial products.

Principal adverse impact

A particularly new concept is the SFDR obligation to provide more transparency on the so-called principal adverse impacts (PAIs) of investment decisions (and investment/insurance advice) on sustainability factors. PAIs are described as impacts that result, or might result, in negative effects on sustainability factors, such as social and employee matters, respect for human rights, anti-corruption or anti-bribery matters. Most notably, this new obligation comes with a comply or explain option for financial institutions that do not exceed a pre-defined number of employees. Institutions falling below this threshold may choose not to make PAI disclosures if they clearly outline the reasons therefor on their website. Large institutions or parent undertakings of a large group that are domiciled in the EU and that surpass the threshold, however, must disclose on their websites how they consider PAIs in their investment decisions or investment/insurance advice. While initially this year institutions will have some leeway in implementing these website disclosures, a catalogue of mandatory and voluntary adverse sustainability indicators will apply from 2022 on. This means that institutions will then need to measure and report the PAI involvement in their portfolios against a pre-defined rule-set.

Sustainability risk and remuneration

The SFDR further imposes disclosures on how sustainability risks are integrated into the investment decision-making process and into the investment advice or insurance advice. Moreover, affected financial institutions will need to provide transparency on how they consider sustainability risks into their remuneration policies. Both disclosures need to be published on their websites.

Sustainable products

At the product level, the SFDR obligations differentiate between three different categories of financial products, in order to determine the depth of the applicable requirements:

1. mainstream or non-ESG products;
2. products promoting environmental or social characteristics, and;
3. products with a sustainable investment objective.

Depending on the classification of a product, the SFDR provides specific disclosure requirements in pre-contractual documents, on the website and in periodic reports. Inter alia, the SFDR calls therein for information on how the environmental or social characteristics are met, or how the sustainable investment objectives are to be attained.

Further developments

The SFDR is just one initiative from the broader regulatory EU agenda on sustainable finance. In parallel, other developments, such as the so-called EU Taxonomy, which is a uniform classification system for environmentally sustainable activities, are keeping the financial services industry busy. Further initiatives will be implemented over the coming years and while institutions are preparing for the newly introduced regulations, sustainability-related changes to existing regimes, such as MiFID II, UCITS and AIFMD should not go unnoticed.