Understanding SFDR Compliance

The Sustainable Finance Disclosure Regulation (SFDR) is a regulation established by the European Union aimed at enhancing transparency in the financial services sector regarding sustainability-related information. It is part of the EU's broader sustainable finance agenda, which seeks to promote environmentally sustainable investments and tackle climate change.

Key Objectives

• Transparency: The SFDR improves the disclosure of sustainability risks and impacts related to financial products, assisting investors in making informed choices that consider environmental, social, and governance (ESG) factors.
• Standardization: The regulation aims to harmonize the way sustainability information is reported across the EU, creating a more uniform understanding of sustainable finance.

This regulation applies to financial market participants and financial advisers.

Financial Market Participants (FMPs):

• Insurance undertakings that make available an insurance-based investment product (IBIP).
• Investment firms which provide portfolio management.
• Institutions for occupational retirement provision (IORPs), with some exceptions. IORPs are included unless a Member State has chosen to apply Article 5 of Directive (EU) 2016/2341 or if they operate pension schemes with less than 15 members.
• Manufacturers of pension products. This includes both pension products and individual pension products.
• Alternative investment fund managers (AIFMs).
• Pan-European Personal Pension Product (PEPP) providers.
• Managers of qualifying venture capital funds registered in accordance with Article 14 of Regulation (EU) No 345/201327.
• Managers of qualifying social entrepreneurship funds registered in accordance with Article 15 of Regulation (EU) No 346/201327.
• Management companies of undertakings for collective investment in transferable securities (UCITS management companies.
• Credit institutions which provide portfolio management.

Breakdown of Entity Qualifications

• Size Thresholds:
  • From 30 June 2021, financial market participants exceeding 500 employees on their balance sheet dates must publish a statement on their due diligence policie.
  • From 30 June 2021, financial market participants that are parent undertakings of a large group exceeding 500 employees on a consolidated basis must also publish a statement on their due diligence policies.
• From 30 June 2021, financial market participants exceeding 500 employees on their balance sheet dates must publish a statement on their due diligence policie.
• From 30 June 2021, financial market participants that are parent undertakings of a large group exceeding 500 employees on a consolidated basis must also publish a statement on their due diligence policies.

Types of Financial Products:

• AIFs: As defined in Article 4(1)(a) of Directive 2011/61/EU.
• UCITS: As defined in Article 1(2) of Directive 2009/65/EC.
• IBIPs: Defined under Regulation (EU) No 1286/2014.
• Pension Products: This includes various individual and collective pension schemes.

Financial Advisers:

• Insurance intermediaries which provide insurance advice with regard to IBIP
• Insurance undertakings which provide insurance advice with regard to IBIPs.
• Credit institutions which provide investment advice.
• Investment firms which provide investment advice.
• AIFMs which provide investment advice.
• UCITS management companies which provide investment advice.
  
  Financial advisers must disclose whether they consider the principal adverse impacts of investment decisions on sustainability factors, taking into account their size, nature, and scale of activities.
  
  Exemptions: This regulation does not apply to insurance intermediaries providing insurance advice with regard to IBIPs or investment firms providing investment advice that employ fewer than three persons, though Member States can choose to apply the regulation to these entities.

Other entities:

• Entities that manufacture financial products.
• Entities that provide investment advice or insurance advice.
• Member States can apply this regulation to manufacturers of pension products operating national social security schemes.

The main requirement under the SFDR for investment funds is to provide transparent and accurate data regarding the fund's ESG performance. Therefore, a fund report under the SFDR needs to provide the correct disclosures based on the fund's classification. And while the reporting burden differs depending on how funds choose to classify themselves, compliance is based on the reporting performance, not on achieving a certain level of sustainability per se. To put it simply, you will not be penalised for not being sustainable as long as you provide transparent data documenting your performance.

This regulation includes several articles (mainly Article 6, Article 8, and Article 9) that specify different requirements for financial market participants and financial advisors regarding sustainability disclosures.

Main Article Classifications under SFDR

Article 6: Financial Products with No Specific Sustainable Investment Objectives

Description:
Applies to financial products that do not promote environmental or social characteristics.

Requirements:
Financial market participants must include in pre-contractual disclosures:

• How sustainability risks are integrated into their investment decisions.
• The results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available.

If a market participant does not consider the adverse impacts of investment on sustainability factors, they must provide a clear reason for this position (”comply or explain”)

The information to be disclosed is specified for different types of financial products and entities.

Article 8: Financial Products Promoting Environmental and/or Social Characteristics (Light Green Funds)

Description:
This article is for products that promote environmental and/or social characteristics.

Requirements:

• Participants must disclose how these characteristics are met, including the methodologies used to assess and measure them.
• It requires pre-contractual disclosures that detail the environmental or social performance indicators and how the underlying companies adhere to good governance practices.

If a financial product promotes environmental or social characteristics, or a combination of both, the following must be disclosed:

• How those characteristics are met.
• If an index is used as a reference (f.e. benchmarking), how this index is consistent with those characteristics.

Financial market participants must indicate where the methodology for calculating the index can be found

Article 9: Financial Products with Sustainable Investment as the Objective (Dark Green Funds)

Description:
Targets products that have sustainable investment as their primary goal.

Requirements:

• Requires detailed disclosures on how the investment objective aligns with sustainability goals.
• If an index is designated as a benchmark, disclosures must include how it supports the sustainable investment objective and how it differs from a broad market index.

→ If a financial product has a sustainable investment objective and an index is designated as a reference(f.e. benchmarking), the following must be disclosed:

• How the designated index is aligned with that objective.
• Why and how the designated index differs from a broad market index.

If no index is designated, an explanation of how the sustainable objective will be attained is required.

For products aimed at reducing carbon emissions, disclosures must indicate compliance with long-term climate goals, referencing frameworks like the Paris Agreement

Key Differences

• Article 6 focuses on general financial products without a sustainability emphasis, while Article 8 and Article 9 are specifically for products with environmental or social attributes, with Article 9 having stricter sustainability impact requirements.
• The disclosure depth increases from Article 6 to Article 9: Article 6's requirements are basic, Article 8 requires more detail on character promotion, and Article 9 necessitates the most thorough explanations concerning sustainable investment practices and metrics.

Additional Article Classifications under SFDR

Article 3: Transparency of sustainability risk policies

Description:
This article mandates financial market participants to disclose information regarding their policies on the integration of sustainability risks into their investment decision-making processes.

Requirements:

• Financial market participants must publish information on their websites about their policies on integrating sustainability risks into their investment decision-making processes.
• Financial advisors must publish information on their websites about their policies on integrating sustainability risks into their investment or insurance advice.

Article 4: Transparency of Adverse Sustainability Impacts at Entity Level

Description:
Obligates FMPs to publish on their websites a statements regarding how they consider principal adverse impacts of investment decisions on sustainability factors.

Requirements:

• Specific information to include in the statement
  • Policies on identifying and prioritizing principal adverse sustainability impacts and indicators.
  • A description of the principal adverse sustainability impacts, and actions taken or planned.
  • Summaries of engagement policies, where applicable.
  • A reference to adherence to responsible business conduct codes and international standards for due diligence and reporting.
• Clear reasons for not considering such impacts if applicable, particularly for larger entities (those with over 500 employees)

If they do not consider adverse impacts, they must explain why, including information on when they intend to consider such impacts.

Financial advisers must publish information on whether they consider the principal adverse impacts on sustainability factors in their advice, or explain why they do not.

Article 5: Transparency of remuneration policies in relation to the integration of sustainability risks

Description:
Financial market participants and financial advisors must include information in their remuneration policies on how those policies are consistent with the integration of sustainability risks. This information must be published on their websites.

• This information is to be included in the remuneration policies that financial market participants and financial advisers are required to establish and maintain in accordance with sectoral legislation

Article 7: Transparency of Adverse Sustainability Impacts at Financial Product Level

Description:
Details requirements for disclosures specific to specific financial products regarding their assessment of principal adverse impacts.

Requirements:

• Financial products must include clear explanations in their pre-contractual documentation about whether and how they consider PAIs on sustainability factors.
• A clear explanation of whether, and if so how, principal adverse impacts are considered for each financial product, applicable mainly for FMPs with fewer than 500 employees.

If a financial market participant does not consider adverse impacts, a statement to that effect and the reasons must be disclosed (”comply or explain”)

• Article 7 complements Article 4, which pertains to PAI disclosures at the entity level.

The requirements set out in Article 7 became applicable from 30 December 2022.

Article 10: Transparency of Promotion of Environmental or Social Characteristics and of Sustainable Investments on Websites

Description:
Financial market participants must publish and maintain information related to environmental or social characteristics for products under Articles 8 and 9 on websites.

Requirements:

• A description of the environmental or social characteristics or the sustainable investment objective.
• Information on the methodologies used to assess, measure, and monitor these characteristics or the impact of the sustainable investments.
• The information required by Articles 8 and 9.
• The information referred to in Article 11.
• This information must be clear, succinct, understandable, accurate, fair, not misleading, simple, concise, and easily accessible.

Article 11: Transparency of Promotion of Environmental or Social Characteristics and of Sustainable Investments in Periodic Reports

Description:
This article requires Financial market participants periodic reporting on how environmental or social characteristics are being met for Articles 8 and 9 products.

Requirements:

• For financial products promoting environmental or social characteristics, the extent to which those characteristics are met.
• For financial products with sustainable investment objectives:
  • The overall sustainability-related impact of the financial product using sustainability indicators.
  • A comparison between the financial product's impact and that of the designated index and a broad market index if a reference index is used.

The information is to be disclosed in annual reports or other reports depending on the entity and the financial product, including AIFMs, insurance undertakings, IORPs, managers of venture capital funds and social entrepreneurship funds, manufacturers of pension products, UCITS management companies, investment firms, credit institutions, and PEPP providers.

Article 12: Review of disclosures

Description:
Financial market participants must ensure that the information they publish is kept up to date. Amendments must be clearly explained on their website.

This requirement also applies to financial advisors.

Article 13: Marketing communications

Description:
Financial market participants and financial advisers must ensure their marketing communications do not contradict the information disclosed under this regulation.

Summary
While Articles 6, 8, and 9 define product classifications based on sustainability criteria, the additional articles (3, 4, 5, 7, 10, and 11) provide a comprehensive framework for entities to disclose their sustainability risk policies, adverse impacts considerations, and periodic evaluations

Summary of Key Articles:

• Article 6: No specific sustainable investment objectives (product-level, basic disclosures)
• Article 8: Promotes environmental/social characteristics (product-level, detailed disclosures)
• Article 9: Sustainable investment objective (product-level, most comprehensive disclosures)

• Article 3: Policies on sustainability risk integration (entity-level disclosures)
• Article 4: Principal adverse impacts at entity level (entity-level disclosures)
• Article 5: Transparency of sustainability risks (policy disclosures on how sustainability risks are measured and their impacts on returns)
• Article 7: Principal adverse impacts at product level (product-level disclosures)
• Article 10: Transparency of promotion of environmental or social characteristics on websites
• Article 11: Transparency of promotion of environmental or social characteristics in periodic reports.
• Article 12: Review of disclosures (regular updates and accuracy requirements)
• Article 13: Marketing communications (aligns marketing materials with sustainability disclosures)

The SFDR requires FMPs and financial advisers to publish a Principal Adverse Impact (PAI) statement on their website and describe PAIs in pre-contractual information.

PAIs highlight the sustainability risks associated with investments, which provide insights into how investment decisions negatively affect environmental and social factors. Under SFDR, financial market participants must disclose PAI indicators, which are categorized into "mandatory" and "additional" indicators.

There are 59 indicators identified as potential PAIs and all relate to negative sustainability effects on both entity and product level.

PAI indicators are grouped into two main categories:

• Environmental and climate-related factors (E)
• Social aspects, including labor rights, human rights, anti-corruption, and anti-bribery measures (S,G)

Disclosure requirements under SFDR include:

• Investee companies must report on 14 mandatory indicators — 9 focused on environmental aspects and 5 related to social and governance factors. Additionally, they must choose at least 1 environmental and 1 social indicator from a set of 33 optional indicators.
• Real estate assets are subject to 2 mandatory environmental indicators, with the option to report on further indicators selected from a pool of 5 additional metrics.
• Sovereigns and supranationals are required to disclose 2 key indicators and may voluntarily report on extra factors from a list of 8 additional indicators.

1. Pre-Contractual Disclosures:
   Provide an overview of a financial product’s sustainability goals, which are later assessed in periodic disclosures. Depending on whether the product falls under Article 8 or 9, FMPs must use the relevant template from Annex II or III of the Delegated Regulation.

2. Website Disclosures:
   Although there’s no mandatory format, specific guidelines outline the key elements to include. Firms must present details such as the product’s sustainability objectives, investment approach, and applied methodologies to ensure transparency for investors.

3. Principal Adverse Impact (PAI) Statement:
   Released annually, this report outlines any negative sustainability impacts associated with investments, incorporating both qualitative insights and quantitative data. FMPs with over 500 employees are required to report PAIs, while smaller firms can either “comply or explain” their non-compliance. Collecting data from investee companies on a quarterly basis is crucial to provide an accurate annual overview.

4. Periodic Disclosures:
   These reports evaluate how well the product has performed in meeting its pre-defined sustainability targets. They serve as a tool to highlight progress, achievements, and the level of adherence to the originally set goals.

Key Reporting Requirements

1. Policy Disclosures (Entity-Level Reporting) - Articles 3, 4, 5
   • Sustainability Risk Policies: Both financial market participants and advisors must publish on their websites information about their policies on integrating sustainability risks into their decision-making and advisory processes.
   • Adverse Impact Policies: Financial market participants must disclose whether they consider the principal adverse impacts of their investment decisions on sustainability factors. If they do not consider these impacts, they must explain why. If they do consider them, they must detail their due diligence policies, including how they identify, prioritize, and act on adverse impacts. Financial advisors must also disclose if they consider adverse impacts.
   • Remuneration Policies: Both must include in their remuneration policies how these policies are consistent with the integration of sustainability risks, and they must publish this information on their websites.
     
     
2. Pre-Contractual Disclosures (Product-Level Reporting) - Articles 6, 7, 8, 9
   • Sustainability Risk Integration: Financial market participants and advisors must disclose how they integrate sustainability risks into their investment decisions or advice and the likely impacts of these risks on financial product returns.
   • Adverse Impact Consideration: Financial market participants must explain if and how their financial products consider principal adverse impacts on sustainability factors. They must also state that this information is available in periodic reports.
   • Promotion of Environmental or Social Characteristics: If a financial product promotes environmental or social characteristics, disclosures must include how those characteristics are met and, if an index is used, how that index is consistent with those characteristics.
   • Sustainable Investment Objectives: If a financial product has a sustainable investment objective, disclosures must explain how the designated index is aligned with that objective or, if no index is used, how the objective will be attained.

Website Disclosures - Article 10

• For financial products promoting environmental or social characteristics or having sustainable investment objectives, financial market participants must publish on their websites a description of the characteristics or objective, methodologies used, and the information required by Articles 8, 9 and 11.

Periodic Report Disclosures - Article 11

• Financial market participants must include in their periodic reports the extent to which environmental or social characteristics are met, or the overall sustainability-related impact of financial products with sustainable investment objectives. This includes a comparison to a benchmark where relevant.

Review and Marketing - Articles 12, 13

• Review of Disclosures: Financial market participants and advisors must keep their published information up to date, with clear explanations for any amendments.
• Marketing Communications: Financial market participants and advisors must ensure that their marketing communications do not contradict the information disclosed under this regulation.

Reporting Approach in 10 steps

FMPs will first need to undertake a formal process to review, assess and categorize all their financial products into the Article 6, 8, or 9 categories. To accurately assess what the label of your product should be, product teams and portfolio managers should contribute to the review process. The outcome of the review process will determine the positioning of your fund on the market and will considerably influence your future investment policies. In general, follow this step-by-step guidance for the population of product level disclosures:

1. Identify Reporting Categories
   Classify financial products under Articles 6, 8, and 9, understanding that additional reporting requirements apply under Articles 5, 7, 12, and 13.
2. GAP analysis & Data collection
   Adopt procedures to gather and review all missing data required by the mandatory disclosures, reach out to your portfolio companies with requests for data.
3. Develop Policies
   Create clear policies on sustainability risk integration, adverse impact consideration, and remuneration that aligns with sustainability objectives.
4. Website Publication
   Ensure that the required information about your policies is published on your website in a clear and accessible manner.
5. Pre-Contractual Disclosure
   Prepare pre-contractual disclosures as described in Articles 6-9, including how sustainability risks are integrated, adverse impacts are considered, and how environmental or social characteristics or sustainable investment objectives are met.
6. Disclosure Preparation
   • Prepare disclosures for:
     • Entity-level sustainability risk integration policies (Article 3).
     • Adverse impact considerations (Article 4).
     • Product-specific disclosures based on product classification (Articles 6, 8, 9).
     • Specific disclosures regarding sustainability risks and their measurement (Article 5).
     • Regular updates to disclosures (Article 12).
7. Periodic Reporting
   Prepare periodic reports that include information on the extent to which environmental or social characteristics are met or the overall sustainability-related impact of financial products. Periodic templates as a part of your annual report by the 30th of June.
   
   The periodic templates should be considered together with your pre-contractual templates to ensure a unified approach (link the numbers generated and how pre-contractual layout commitments connect to the periodic report on actual achievements).
8. Use Standards
   Be aware that the ESAs are tasked with developing regulatory technical standards for much of the reporting under this regulation, and these standards must be adhered to once they are in place
   
   
9. Involve Stakeholders
   Engage with relevant departments (legal, compliance, sustainability) to align practices across the organization, ensuring comprehensive reporting and transparency.
10. Regular Compliance Checks
    Conduct periodic reviews and audits to ensure compliance with SFDR. Regularly update disclosures and marketing materials based on both internal audits and regulatory guidance.

Note: Remember to update your pre-contractual disclosures based on the actual numbers published in the periodic disclosures to ensure future alignment.

Link Annex 1
https://content.sustainova.com/assets/f3253f56-2864-41b1-b108-96b7c8ab4f9e
Annex I provides a standardized template that financial market participants must use to disclose how their investments negatively impact sustainability factors. It includes a detailed structure for reporting on PAI indicators.

Bonus - Reporting template

Guidelines on funds’ names using ESG or sustainability-related terms 
https://content.sustainova.com/assets/54e94cc5-5cee-4075-b556-67803b36fc20

ESMA Consolidated (Q&A) on the SFDR
https://content.sustainova.com/assets/951ce304-86ff-46c9-9cab-98d9e6a5d0e8

SFDR Real Estate Reference Guide 
https://content.sustainova.com/assets/72ea6eda-8678-4c6a-b9da-58e58a252cfe

Article 8 funds

• HV Capital’s latest fund, its ninth, is Article 8-approved. HV Capital is a generalist fund based in Germany. Its latest fund is worth €700m, and 30% of it will go towards climate and sustainability-focused companies.
• Speedinvest, one of Europe's most active seed-stage investors, classifies its funds as Article 8 funds.
• Early-stage investor Antler, which has offices around the world, has given all its European funds an Article 8 classification. Antler's Nordics fund is an Article 9 fund.
• ….

Article 9 funds

• AENU, an impact tech fund based in Berlin, is currently investing from its first fund, worth €100m, which is an Article 9 fund.
• Extantia, based in Berlin, is investing from an Article 9 fund at present. Extantia, which invests in decarbonisation technology, announced a €150m venture fund last year, plus a €150m fund-of-funds.
• Seaya Ventures, based in Spain, announced its latest fund, an Article 9 fund, last year. Seaya invests at Series A and beyond, focused specifically on southern Europe.
• ….

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🔗 Regulation (EU) 2019/2088