On 10 March 2021, parts of Regulation 2019/2088, also known as the Sustainable Finance Disclosure Regulation (“SFDR”), came into force. Since then, the European Commission and the European Supervisors have failed to create clarity on how to comply with the new requirements deriving from SFDR and Regulation 2020/852 (“the Taxonomy Regulation”).
Both regulations are important pillars of the European Action Plan on Sustainable Finance. The ultimate goal is to help shift the capital flow towards more sustainable investments in the EU by improving sustainability-related disclosures and reducing greenwashing.
Since the adoption on 6 April 2022 of the SFDR Regulatory Technical Standards (in the form of a Delegated Regulation), the following additional guidance has been published:
- On 25 May 2022, ESMA published responses received from the EC to the SFDR questions raised by the ESAs on 16 May 2022
- On 31 May 2022, ESMA published a supervisory briefing with explanations of how the SFDR, taxonomy regulation and upcoming Delegated Regulation organisational rules, among other pieces of legislation, apply to funds and their management companies
- On 2 June 2022, the ESAs published additional clarifications on the draft RTS under SFDR (which is not consistent with the Delegated Regulation)
In this contribution, we will summarise the most recent developments and answer the following pressing questions:
- When do you have to comply with the SFDR Regulatory Technical Standards?
- How to choose a name for your financial product and how to determine its sustainability objective?
- How do you classify your financial products under SFDR?
- Are my financial products ‘taxonomy aligned’?
1. When do you have to comply with the SFDR Regulatory Technical Standards?
The European Commission announced that all financial market participants and financial advisors such as investment firms and alternative investment firm managers must comply with the SFDR Regulatory Technical Standards by 1 January 2023. The delay in the application provided everyone with sufficient time to gather the information necessary and adjust their practices to apply the specific requirements.
What if your financial product is no longer available to end investors?
There has been some discussion on whether you should comply with the SFDR if the financial products you offer are no longer being made available to new end investors. We wish to note in this respect that it has been clear from the start that financial products which continue to be available to end investors are subject to the SFDR.
In addition, the European Commission has clarified that even if financial products are no longer being made available to new end investors as of the application date of SFDR, these products may still be subject to the SFDR. If your product is ‘closed’ to new end investors but is still ‘active’ and has a certain level of sustainability ambition, the SFDR requirements apply. Accordingly, financial market participants offering these products are still required to comply with the SFDR Regulatory Technical Standards by 1 January 2023.
2. How to choose a name for your financial product and determine its sustainability objectives?
When choosing a name for your financial product, its sustainable objectives or characteristics must be clearly identified in the name. General expressions or claims must be avoided. A general ESG objective such as ‘sustainable’ without further explanation is therefore insufficient. For example, it should be specified that the objective is the ‘sustainable use of water and marine resources’. Accordingly, a fund name may not be misleading and should be supported by the fund objectives. In this example, a “sustainable water fund” reflects the objective. If the name of a product is not in line with the underlying factual activities, a competent authority may challenge it and liability can be incurred.
Principal adverse impact (PAI) reduction as sustainability objective
As earlier confirmed by the European Commission, a financial product with a certain level of sustainability may pursue the reduction of adverse impacts on ESG factors. The financial market participants can use the principal adverse impact indicators set out in SFDR to evidence the reduction of the adverse impact of its investments. These indicators are essentially a set of environmental, social and governance indicators and metrics to show the impact of the investments on carbon emissions, biodiversity, social violations and gender equality, for example.
Apart from the possibility to use these indicators on a product level, there is also a choice for smaller financial market participants to report on these indicators at an entity level or publish a ‘no-consideration statement’.
It has been clarified that if the financial market participant considers principal adverse impact indicators on a product level, it can still choose between the ‘consideration’ and ‘no-consideration’ statement at entity level. In the event of a no-consideration statement, no information related to the financial product pursuing reduction of these indicators can be included in the statement. The statement must also include a clear rationale as to why these indicators are not considered.
3. How do you classify your financial products under SFDR?
Financial products should be classified based on their sustainability-related ambitions. It could be difficult to determine whether your product (i) promotes environmental or social characteristics (“Article 8”), (ii) has sustainable investment as its objective (“Article 9”) or (iii) does neither.
The SFDR remains neutral in terms of design of the financial products. For example, it does not prescribe certain elements such as the composition of investments or minimum investment thresholds, the eligible investment targets. Neither does it determine eligible investment styles, investment tools, strategies or methodologies to be employed.
In order for a product to have a ‘sustainable investment objective’ it should almost exclusively make sustainable investments. Unfortunately, there is no quantitative threshold in place to determine the turning point between Article 8 and 9 funds. However, it is clear Article 9 products can only to a limited extent make investments other than sustainable investments. The classification of the financial product must be supported by clear data showing that financial market participants meet their sustainability ambitions disclosed in their sustainability objectives and product names.
Good governance practices are mandatory for ‘green’ funds
It is important to note that if a financial product has some level of sustainability ambition (Article 8 or 9), all the companies it invests in must adhere to good governance practices. If not, the product will not classify as an Article 8 or 9 product. The good governance practices only apply to investments in companies and do not apply to government bonds.
4. Are my financial products ‘taxonomy aligned’?
In addition to the disclosure requirement deriving from SFDR, the Taxonomy Regulation requires financial market participants to disclose the taxonomy alignment of their products. The Taxonomy Regulation provides clear quantitative criteria to determine whether an investment contributes to an environmental objective. Using these technical screening criteria, a financial market participant can determine whether an investment is considered ‘taxonomy aligned’. The meeting of the criteria is considered a factual matter: you can either meet or not meet the criteria.
Accordingly, even if the financial product does not aim to invest in taxonomy-aligned investments, it could still do so. A financial market participant is therefore required to always establish the taxonomy alignment of its investments. If the investments turn out to be taxonomy aligned, the financial market participant may be forced to reconsider its precontractual information and periodic disclosure obligations.
Data availability
Whether a financial product is taxonomy-aligned must be based on reliable data only. However, the lack of data availability and reliability has been one of the common issues of the sustainability regulations. In the guidance that has been provided, these issues have been addressed with regard to taxonomy alignment. This guidance may also offer help in relation to the data availability in the SFDR.
It is emphasised that the financial market participants have their own responsibility to obtain the data; the fact that information is not made publicly available is not considered a valid excuse. Accordingly, where a financial market participant fails to collect data, its pre-contractual and periodic disclosures must indicate that its product has zero taxonomy alignment. It is discouraged to make use of narratives as these may contradict the purpose of the disclosure. In the event narratives are used, they may not cause ambiguity nor can they include negative justifications for the lack of taxonomy alignment. Only in exceptional cases where no information can reasonably be obtained can complementary assessments and estimates be made. This must be all clearly documented and explained to the end investors.
On 10 March 2021, parts of Regulation 2019/2088, also known as the Sustainable Finance Disclosure Regulation (“SFDR”), came into force. Since then, the European Commission and the European Supervisors have failed to create clarity on how to comply with the new requirements deriving from SFDR and Regulation 2020/852 (“the Taxonomy Regulation”).
Both regulations are important pillars of the European Action Plan on Sustainable Finance. The ultimate goal is to help shift the capital flow towards more sustainable investments in the EU by improving sustainability-related disclosures and reducing greenwashing.
Since the adoption on 6 April 2022 of the SFDR Regulatory Technical Standards (in the form of a Delegated Regulation), the following additional guidance has been published:
- On 25 May 2022, ESMA published responses received from the EC to the SFDR questions raised by the ESAs on 16 May 2022
- On 31 May 2022, ESMA published a supervisory briefing with explanations of how the SFDR, taxonomy regulation and upcoming Delegated Regulation organisational rules, among other pieces of legislation, apply to funds and their management companies
- On 2 June 2022, the ESAs published additional clarifications on the draft RTS under SFDR (which is not consistent with the Delegated Regulation)
In this contribution, we will summarise the most recent developments and answer the following pressing questions:
- When do you have to comply with the SFDR Regulatory Technical Standards?
- How to choose a name for your financial product and how to determine its sustainability objective?
- How do you classify your financial products under SFDR?
- Are my financial products ‘taxonomy aligned’?
1. When do you have to comply with the SFDR Regulatory Technical Standards?
The European Commission announced that all financial market participants and financial advisors such as investment firms and alternative investment firm managers must comply with the SFDR Regulatory Technical Standards by 1 January 2023. The delay in the application provided everyone with sufficient time to gather the information necessary and adjust their practices to apply the specific requirements.
What if your financial product is no longer available to end investors?
There has been some discussion on whether you should comply with the SFDR if the financial products you offer are no longer being made available to new end investors. We wish to note in this respect that it has been clear from the start that financial products which continue to be available to end investors are subject to the SFDR.
In addition, the European Commission has clarified that even if financial products are no longer being made available to new end investors as of the application date of SFDR, these products may still be subject to the SFDR. If your product is ‘closed’ to new end investors but is still ‘active’ and has a certain level of sustainability ambition, the SFDR requirements apply. Accordingly, financial market participants offering these products are still required to comply with the SFDR Regulatory Technical Standards by 1 January 2023.
2. How to choose a name for your financial product and determine its sustainability objectives?
When choosing a name for your financial product, its sustainable objectives or characteristics must be clearly identified in the name. General expressions or claims must be avoided. A general ESG objective such as ‘sustainable’ without further explanation is therefore insufficient. For example, it should be specified that the objective is the ‘sustainable use of water and marine resources’. Accordingly, a fund name may not be misleading and should be supported by the fund objectives. In this example, a “sustainable water fund” reflects the objective. If the name of a product is not in line with the underlying factual activities, a competent authority may challenge it and liability can be incurred.
Principal adverse impact (PAI) reduction as sustainability objective
As earlier confirmed by the European Commission, a financial product with a certain level of sustainability may pursue the reduction of adverse impacts on ESG factors. The financial market participants can use the principal adverse impact indicators set out in SFDR to evidence the reduction of the adverse impact of its investments. These indicators are essentially a set of environmental, social and governance indicators and metrics to show the impact of the investments on carbon emissions, biodiversity, social violations and gender equality, for example.
Apart from the possibility to use these indicators on a product level, there is also a choice for smaller financial market participants to report on these indicators at an entity level or publish a ‘no-consideration statement’.
It has been clarified that if the financial market participant considers principal adverse impact indicators on a product level, it can still choose between the ‘consideration’ and ‘no-consideration’ statement at entity level. In the event of a no-consideration statement, no information related to the financial product pursuing reduction of these indicators can be included in the statement. The statement must also include a clear rationale as to why these indicators are not considered.
3. How do you classify your financial products under SFDR?
Financial products should be classified based on their sustainability-related ambitions. It could be difficult to determine whether your product (i) promotes environmental or social characteristics (“Article 8”), (ii) has sustainable investment as its objective (“Article 9”) or (iii) does neither.
The SFDR remains neutral in terms of design of the financial products. For example, it does not prescribe certain elements such as the composition of investments or minimum investment thresholds, the eligible investment targets. Neither does it determine eligible investment styles, investment tools, strategies or methodologies to be employed.
In order for a product to have a ‘sustainable investment objective’ it should almost exclusively make sustainable investments. Unfortunately, there is no quantitative threshold in place to determine the turning point between Article 8 and 9 funds. However, it is clear Article 9 products can only to a limited extent make investments other than sustainable investments. The classification of the financial product must be supported by clear data showing that financial market participants meet their sustainability ambitions disclosed in their sustainability objectives and product names.
Good governance practices are mandatory for ‘green’ funds
It is important to note that if a financial product has some level of sustainability ambition (Article 8 or 9), all the companies it invests in must adhere to good governance practices. If not, the product will not classify as an Article 8 or 9 product. The good governance practices only apply to investments in companies and do not apply to government bonds.
4. Are my financial products ‘taxonomy aligned’?
In addition to the disclosure requirement deriving from SFDR, the Taxonomy Regulation requires financial market participants to disclose the taxonomy alignment of their products. The Taxonomy Regulation provides clear quantitative criteria to determine whether an investment contributes to an environmental objective. Using these technical screening criteria, a financial market participant can determine whether an investment is considered ‘taxonomy aligned’. The meeting of the criteria is considered a factual matter: you can either meet or not meet the criteria.
Accordingly, even if the financial product does not aim to invest in taxonomy-aligned investments, it could still do so. A financial market participant is therefore required to always establish the taxonomy alignment of its investments. If the investments turn out to be taxonomy aligned, the financial market participant may be forced to reconsider its precontractual information and periodic disclosure obligations.
Data availability
Whether a financial product is taxonomy-aligned must be based on reliable data only. However, the lack of data availability and reliability has been one of the common issues of the sustainability regulations. In the guidance that has been provided, these issues have been addressed with regard to taxonomy alignment. This guidance may also offer help in relation to the data availability in the SFDR.
It is emphasised that the financial market participants have their own responsibility to obtain the data; the fact that information is not made publicly available is not considered a valid excuse. Accordingly, where a financial market participant fails to collect data, its pre-contractual and periodic disclosures must indicate that its product has zero taxonomy alignment. It is discouraged to make use of narratives as these may contradict the purpose of the disclosure. In the event narratives are used, they may not cause ambiguity nor can they include negative justifications for the lack of taxonomy alignment. Only in exceptional cases where no information can reasonably be obtained can complementary assessments and estimates be made. This must be all clearly documented and explained to the end investors.