By Alma Angotti, Alexandra Will
We continue to see a global push for clear standards on how to report sustainability metrics, with multiple jurisdictions and standard-setters requesting comment on more prescriptive requirements. For example, on April 6, 2022, the European Commission announced its adoption of the final Regulatory Technical Standards (Final RTS) for the Sustainable Finance Disclosure Regulation (SFDR)1. The Regulatory Technical Standards (RTS) provide details regarding the SFDR’s requirements for disclosures on products involving investments that contribute to environmental or social objectives. The Final RTS should provide clarity to financial industry players preparing for increased scrutiny from regulators of their sustainability disclosures, including concrete guidance on the data they should be collecting, and in what format, as well as the internal controls necessary to ensure the information they report is accurate and sufficiently detailed to meet the SFDR’s requirements.
The SFDR, which was passed in 2019 and became effective in March 2021, is a critical component of the European Union’s Sustainable Finance Framework and works in tandem with the Corporate Sustainability Reporting Directive (CSRD)—which applies to large EU companies and listed companies, in contrast to the SFDR, which applies to financial market participants and financial advisors—to bring greater transparency to sustainable finance. Under the CSRD, companies will be required to disclose their sustainability data. This, in turn, should facilitate more accurate SFDR reporting by investors. The SFDR and CSRD are both governed by the European Taxonomy, which established a classification system for economic activities that can be considered environmentally sustainable.
The SFDR imposes obligations on asset managers and financial advisors to disclose how environmental, social, and corporate governance (ESG) is integrated into their business, both at the entity and product level. The SFDR makes a distinction between products that promote environmental or social characteristics (Article 8 products) and those that purport to have a sustainable objective and do no significant harm (Article 9 products).
The Final RTS do not materially change any of the previously issued requirements. The Final RTS, which include 13 previously issued RTS and mandatory templates for disclosures on websites and for reporting certain pre-contractual and periodic information, establish a “single legal act” for sustainability disclosures. The RTS require firms to identify the sustainable objectives to which the underlying economic activities contribute and provide details regarding how and to what extent they qualify as sustainable. They also require that entities indicate whether those disclosures have been or, for pre-contractual disclosures, will be audited or assessed by a third party. The RTS provide specific guidance on how reporting entities should calculate and disclose the extent to which environmental activities of Article 8 and Article 9 products qualify as environmentally sustainable and the relevant key performance indicators. The entity must also provide accompanying narrative explanations for their disclosures, as set forth by the RTS.
In addition, the SFDR requires principle adverse impact (PAI) disclosures on potential negative externalities of financial markets participants’ investments on the environment or society. These include impacts on “environmental, social and employee matters, respect for human rights, anti‐corruption and anti‐bribery matters.” Notably, PAIs should include disclosure of financed emissions in accordance with a methodology aligned with the standard established by the Partnership for Carbon Accounting Financials, which could bring further consistency to financed emissions disclosures under various regimes.
It is anticipated that the RTS will apply as of January 1, 2023. Reporting should be carried out by June 30 of each year, and 2022 will be the first reference period. Risk of greenwashing has been prevalent in the rise of ESG-related financial products due to the lack of standardized reporting. The SFDR will go a long way to improve transparency into the degree to which investors’ funds are being used for environmental and social good. The RTS will further promote consistency and comparability in how this information is reported in an area where vague claims and data challenges have in the past impeded a clear understanding of a product’s environmental impact. Financial sector actors, however, may be required to change the way they do business, as the level of rigor required in disclosures on sustainable investments will affect how they engage with investees, their data collection and management processes, and their financial reporting processes.
Special thanks to Jorge Martinez-Blat for co-authoring this article.