As concerns for environmental and social governance (“ESG”) increase, the European Union has introduced a new set of legislation to govern this new phenomenon. The EU Sustainable Finance Disclosure Regulation (“SFDR”) came into force on 10 March 2021 as a response to investors’ growing demands for clearer sustainability-related disclosure. As part of the EU’s wider legislative framework in relation to sustainable finance, the SFDR aims to minimise the disparity in information between investors and asset managers concerning:
- the integration of sustainability risks;
- the consideration of adverse sustainability impacts;
- the promotion of environmental or social characteristics; and
- sustainable investment.
The SFDR aims to achieve the above by imposing both pre-contractual and ongoing disclosure obligations on financial market participants and financial advisers (collectively referred to as “Asset Managers”). The European Securities and Markets Authority (“ESMA”), the European Banking Authority (“EBA”) and the European Insurance and Occupational Pensions Authority (“EIOPA”), which form together a joint committee, referred to as the “ESA”, are mandated to develop regulatory standards to keep up with the technological and regulatory developments in this area.
With the goal of gearing the financial market towards sustainability in mind, the SFDR has introduced several changes to ensure that information on a fund’s sustainability is clear and made available to investors, by setting out a comprehensive definition of “sustainable investments”, a new set of product categorisations and new disclosure obligations on Asset Managers.
Defining “sustainable investments”
Since the main objective of the SFDR is to streamline the obligation to disclose information around sustainability in investments, it is important to first define what product falls under the definition of “sustainable investment”.
The definition provided within Article 9 acts as a catch-all, capturing any products that have “sustainable impact” as their primary objective.
The Article sets out an obligation on the parts of the asset managers to clearly explain how the funds’ objective of being a “sustainable investment” is achieved, specifically, where a reduction in carbon emissions is cited as an objective, asset managers must disclose how this will be attained in line with the long-term global warming objectives set out in the Paris Agreement, an international treaty on climate change that came into force in 2016, with its goal being to limit global warming to preferably 1.5 degrees Celsius above pre-industrial levels throughout the 21st century.
Promotion of environmental or social characteristics
Whilst Article 9 covers almost all “sustainable investments”, the SFDR sought to distinguish those with a focus on environmental or social characteristics from the Article 9 products. Although the difference between the two categories are not obvious, it can nonetheless be said that Article 8 products focus on the maximization of a risk-return profile and the promotion of ESG characteristics more so than Article 9 products.
Put simply, products that “promote, among other characteristics, environment or social characteristics or a combination of those characteristics, provided that the companies in which the investment are made follow good governance practice” fall under the scope of Article 8 of the SFDR. The definition covers all financial products that have a different environmental or social ambition that might not qualify as a “sustainable investments” under Article 9. As evident, the SFDR is keen to capture all investments that touch on sustainability via one article or the other.
Products falling under Articles 8 and 9 are subjected to three types of disclosure obligations:
- disclosure via the website;
- pre-contractual disclosure (a newly introduced obligation that will be explored below); and
- periodic disclosure.
Introducing pre-contractual disclosures
Besides the product classification, the SFDR also introduced a new disclosure obligation.
Article 6 of the SFDR aims to increase the transparency of the integration of sustainability risks into the investors’ decision making by obliging Asset Managers to make disclosures before entering into contractual arrangements with investors. It sets out that asset managers must provide investors with:
- sufficient information on sustainability risks, in order to consider them within their investment decision making process; and
- any results of the assessment of the likely impact of sustainability risks on the financial returns.
Even in instances where the Asset Managers deem sustainability risks not to be relevant, there’s an obligation to provide a clear and concise explanation as to why the criteria under Article 6 do not apply.
Pre-contractual disclosure is most commonly made via the fund prospectus or the terms and conditions for portfolio management or advisory service. Article 6(3) further sets out how this might differ depending on the category of funds, citing the relevant EU directives that apply depending on the fund type, including alternative investment funds (“AIFs”) and undertakings for the collective investment in transferable securities (“UCITS”).
The aim is to ensure that investors receive information that is fair and clear before deciding whether to invest in a financial product, especially where environmental and/ or social characteristics are being promoted.
SFDR AND UK FIRMS
Since the UK is no longer part of the EU, there is no obligation for authorised firms in the UK to comply with the obligations under SFDR. However, UK firms that carry out cross-border businesses after the SFDR came into force should observe their obligations under the legislation when conducting businesses in those jurisdictions.
As climate change and other sustainability-related issues become a growing and more imminent concern of the European Union, the ESA is keen to play its part and take urgent actions by putting the SFDR in place to regulate the financial service sector, where ESG investments are concerned. Assets Managers dealing with European counterparties, including those that domicile in the UK, should observe these new rules on disclosures.
For more information, and any guidance or advice on the SFDR, Cleveland & Co External in-house counselTM, your specialist outsourced legal team, are here to help.