The Sustainable Finance Disclosure Regulation (SFDR) was introduced two years ago, in March 2021, aiming to harmonize the EU’s Environmental, Social and Governance (ESG) disclosures by investment firms. 

The broader goal is to link finance with sustainability.

According to SFDR, sustainable investment is: An investment in an economic activity that contributes to an Environmental or Social objective provided that the investment “Does Not Significantly Harm” (DNSH) any environmental or social objective and that the investee companies follow good Governance practices.

SFDR can be viewed as a ‘Risk Management’ tool since its goal is to identify and integrate sustainability risks into a firm’s investment process.  This integration is then reported at the company level and at the product level. 

The EU Taxonomy is a new EU legislation which defines key environmental activities and the related technical standards for six environmental objectives:

– Climate change mitigation

– Climate change adaptation

– 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

The introduction of EU Taxonomy Regulation has initiated changes to SFDR since the two pieces of legislation should be aligned. 

Both legislations aim to bring clarity regarding which economic activities can be considered sustainable with the goal of encouraging sustainable investing and preventing greenwashing. 

The Regulatory Technical Standards (RTS) for SFDR (also called SFDR Level 2) will help align the two legislations.  Level 2 came into effect in January 2023.  The final date to report is 30 June 2023, based on 2022 data. 

Investment firms that considered Level 1 requirements will need to update their existing PAI statements. Level 2 requirements should include additional qualitative disclosures and quantitative data (the PAI indicators).

Level 2’s mandatory reporting requires a set of PAI indicators focusing on climate and environmental adverse impacts as well as social impacts such as human rights and anti-corruption.

There is a set of 14 core indicators and 31 additional indicators.  Investment firms need to report on all 14 core indicators plus 2 additional (at least one climate-related and one social-related) indicators.

The 14 core indicators are:

Climate and Environmental Indicators

– Greenhouse Gas Emissions (GHG Emissions)

– Carbon Footprint

– GHG Intensity of investee companies

– Exposure to companies active in the fossil fuel sector

– Share of non-renewable energy consumption and production

– Energy consumption intensity per high-impact sector

– Activities negatively affecting biodiversity-sensitive areas

– Emissions to water

– Hazardous waste and radioactive waste ratio

Social and Governance Indicators

– Violations of UN Global Compact principles and OECD guides for Multi-National-Enterprises

– Lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD guides for Multi-National-Enterprises

– Unadjusted gender pay gap

– Board gender diversity

– Exposure to controversial weapons

Investment firms need detailed information from investments that are included in their fund portfolios. This poses a huge challenge for fund managers.

Also, each fund includes assets that likely vary by sector, size, and ESG maturity. This causes additional complications regarding the data collection process.

Finally, more details regarding the PAI indicators are still being modified.  Changes to definitions and requirements will affect the data requests from fund managers to their portfolio holdings.  Expect further clarifications in 2023 to the Level 2 RTS. 

Demetris Nicolaou, CFE | Industry Expert