The European Union’s new Sustainable Finance Disclosure Regulation (SFDR) has gone live today as environmental, social and governance (ESG) becomes mainstream in financial services.
The new rules, which are part of the EU Action Plan, aim to tackle a long-running and well documented problem for the industry – the lack of standardisation. There is no hard definition of what constitutes a sustainable investment and no regulators to enforce it.
The result has been fund managers and ESG rating firms have devised their own definitions and methodologies which has led to concerns over greenwashing or that claims may be exaggerated.
The SFDR attempts to address this issue by establishing transparency requirements for financial market participants on the integration of sustainability risks and consideration of adverse sustainability impacts in their processes. They also need to disclose sustainability features of financial products.
For asset managers, it will divide their offerings into sustainable and non-sustainable and they will be subject to stricter reporting. There will be three categories: funds, which integrate sustainability risks into advice or portfolio management decisions; products, which actively promote environmental or social characteristics, and those that have sustainable investment as their objective.
Although ESG investing has gained traction, the pandemic accelerated the trend as companies with strong sustainable credentials have tended to outperform their conventional peers.
However, recent research from Morningstar, which examined 745 Europe-based sustainable funds, found that six out of ten delivered higher returns not just in the last year but over the past decade.
This helps explains the study by PwC which showed that 77% of institutional investors will stop purchasing non-ESG products within the next 24 months and by 2025, €7.6trn will be invested in ESG products—an increase from 15% today to 57% market share of European assets.
The SFDR is one of three key regulations on sustainable finance that will be implemented over the next two years.
It is intertwined with EU Taxonomy Regulation which provides the essential definitions of what constitutes environmental sustainability. Article 9 is of particular interest in that it sets out six environmental objectives, of which two – climate change mitigation and climate change adaptation – will come first.
The other one to watch is the Non-Financial Reporting Directive (NFRD), which includes more stringent and standardised requirements for how companies report non-financial information as well as disclose ESG data.
Companies have been required to include non-financial statements in their annual reports since 2018 but the EU will revise the NFRD to support implementation of the EU Taxonomy and the SFDR.
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