A Deep Dive Into the New EU Sustainable Finance Disclosure Regulation

Words by Avery Reynolds

In March 2018, the European Commission released a plan for financing sustainable growth. The regulation was created to channel private investments towards  “climate-neutral, climate-resilient, resource-efficient and fair economy, as a complement to public money.” In the impact space right now, there is an issue of information and disclosures from government, private and public companies. Sustainable investing can be broken up into three categories ESG, sustainable, and impact/thematic. Each comes with its unique objectives and issues. SFDR exists under the broader European Commission’s Sustainable Finance Action Plan. The regulation targets many levels of the private sector. For example, they target financial market participants, financial advisers, and financial products.   

The Sustainable Finance Disclosure Regulation: 

The Sustainable Finance Disclosure Regulation (SFDR) is directed to increase transparency on sustainability issues and create industry-wide comparisons to prevent greenwashing. The regulation means that sustainability is no longer used as a branding attempt and instead to drive meaningful change within industries. SFDR is broken up into funds that do not integrate sustainability into the investment process (Article 6). Financial projects promote ESG characteristics and follow the good governance practices outlined by the EU (Article 8). Finally, Article 9 funds are financial products with sustainable investment as their objective and indices designated as a reference benchmark. Article 9 funds have positive scores under the UN Sustainable Development Goals (SDG) frameworks or have specific carbon reduction objectives, utilizing a Paris-Aligned Benchmark or a climate Transition Benchmark. 

EU Taxonomy: 

The EU Taxonomy serves as a classification system coupled with SFDR. For an investment to be Taxonomy-aligned, it must contribute to one or more of the six environmental objectives, comply with the relevant technical screening criteria, Do No Significant Harm (DNSH) to any other environmental objectives, and comply with minimum social safeguards. 

The six environmental objectives of the EU Taxonomy are: 

1. Climate change mitigation. 

2. Climate change adaptation. 

3. Sustainable use and protection of water and marine resources. 

4. Transition to a circular economy. 

5. Pollution prevention and control. 

6. Protection of healthy ecosystems. 

These two regulations (SFDR and EU Taxonomy) combine to be a powerful engine for transparency and change in the financial industry. Level 1 of both regulations has already been launched but they will go into full effect in January 2023.  

These regulations are essential to moving forward with sustainable investments. However, Boya Want, an ESG analyst at Morningstar, said that 23% of funds labeled Article 8 do not meet the criteria of an ESG fund. This means that nearly a quarter of funds have presented insufficient progress toward the ESG principles their funds endorse. One of the main issues plaguing both Asset Managers and the ESG industry at large is the lack of data availability. Managers use both repertory scoring systems along with scores providers by external vendors. This leads to a lack of standardization throughout the industry, along with data integrity issues.  

While SFDR and EU taxonomy currently only holds in the EU. It looks as if the US and UK will follow suit with similar disclosure regulations. In the new proposed SEC regulation, they will clearly define the types of ESG funds, such as integration, ESG-focused, and impact investing. Interestingly, the SEC does not define ESG, unlike the SFDR. This leaves room for the term to grow and evolve, as inevitably, the investment industry will. Similarly, the UK has proposed Greening Finance: A Roadmap to Sustainable Investing, which seeks to shift investments into green technology alongside other sustainability projects. Likewise, this regulation incorporates Sustainable Disclosure Requirements (SDRs) and will provide a framework to ensure all sustainability disclosure is consistent. The regulation, similarly to SFDR, also makes sure that asset managers and owners have to disclose how they integrate ESG factors into their portfolios.  

SFDR and EU taxonomy should help re-orient capital towards sustainable investments. It also will integrate a level of transparency into how sustainable factors are considered in the investment strategy. The regulation is a significant step into a sustainable future in the EU, and hopefully, countries like the US will follow suit. While the taxonomy regulation only holds in the European Union, it marks the beginning of a meaningful, sustainable transition. It proves that regulators and clients are calling for more sustainable options in the investment industry. It also heightens transparency and adds metrics to standardize the budding sustainable investment industry.