Overview of SFDR Updates: Regulatory Technical Standards

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  • Overview of SFDR Updates: Regulatory Technical Standards

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    The European Union’s Sustainable Finance Disclosure Regulation (SFDR) is established to facilitate ESG (Environment, Social, Governance) investing as it has become the mainstream of the world of finance and investing. According to Bloomberg’s analysis, the global sustainable financial assets under management (AUM) reached USD37.8tr by the end of 2021. The Global Sustainable Investment Alliance (GSIA) estimates that global ESG assets could surpass USD50tr by 2025, representing 36% of total AUM worldwide. The GSIA report also shows that the US and Europe are two leaders in sustainable investing assets, holding more than 80% of global sustainable investing assets from 2018 to 2020.

    Addressing Greenwashing through SFDR

    Driven by the market’s growing appetite for sustainable financial products, greenwashing has become a major risk in green investing. According to the EU Taxonomy Regulation, greenwashing refers to the practice of gaining an unfair competitive advantage by marketing products as environmentally friendly, when environmental standards have not been met. The term can also be used in a more generic sense to suggest that a product or service has or is provided by a firm that obtains credentials in immaterial ESG areas to conceal poor performance in ESG metrics that truly matter to them.

    In the context of investing, greenwashing can be categorized into two types: intentional greenwashing and expectation gap. Intentional greenwashing refers to the case in which asset managers exaggerate the sustainability characteristics and benefits of an investment product. Consequently, investors are misled by the claim and may invest in unsubstantiated projects or activities without real contributions to environmental or social issues. In cases where governmental bodies and regulators were involved to certify such green claims, investors’ confidence will also be impaired if the products with government green credentials turn out to be false. On the other hand, the expectation gap refers to the mismatch between the true extent of a financial product’s sustainability and investors’ expectation. Governments and regulatory bodies are working to address both types of greenwashing through the enforcement of sustainable finance disclosure. One of the milestones to curb greenwashing through disclosure is the European Union’s SFDR.

    Final Report of the Regulatory Technical Standards (RTS)

    The SFDR went into effect in March 2021. [For more details on the SFDR, please refer to EU SFDR Has Arrived: What it Means for All Investment Managers & Advisors.] To supplement the implementation of the SFDR, the European Supervisory Authorities (ESAs) also issued a draft of the Regulatory Technical Standards (RTS) in February 2021. The draft RTS specifies disclosure content, methodologies, and presentation at both entity and product levels under the SFDR for investment firms and their products and services. Then, on 22 October 2021, the ESAs amended the RTS and finalized taxonomy-related disclosures for financial products subject to the disclosure requirements under Article 8 and Article 9 of SFDR. The application date of the RTS was postponed to 1 January 2023.

    RTS Update: Article 9 Products

    According to the SFDR, Article 9 products are defined as products with sustainable objectives. The amended RTS further specified categories for such products, differentiating products that make investments to achieve either environmental or social objectives. Compared to the requirements outlined in the draft RTS in February, the new RTS requires asset managers to make clearer and more specific claims on the managed assets. In each case, the sustainable objectives will be identified by a percentage of such investments the product will make for pre-contractual disclosures or did make for periodic disclosures. In terms of those financial products claiming an environmental objective, the RTS will further classify such products into investing in taxonomy-aligned economic activities and/or non-taxonomy-aligned economic activities.

    RTS Update: Article 8 Products

    In terms of Article 8 products, the SFDR defines them as products promoting environmental and/or social characteristics without objectives of sustainable investing. The new RTS will categorize such products as those which commit to (or made) a minimum proportion of sustainable investments and those which will not (or did not) make any sustainable investments. Those Article 8 products committing to a minimum level of sustainable investments will be further divided in accordance with whether they have an environmental and/or social objective. Similar to Article 9 products with an environmental objective, such products are required to disclose whether they are taxonomy-aligned.

    RTS Update: Calculating the extent of Taxonomy-alignment

    The SFDR requires asset managers to provide both pre-contractual and periodic disclosures regarding the extent to which the investments attributed to the products qualify as environmentally sustainable under the Taxonomy Regulation. The RTS proposed that the pre-contractual disclosures of the extent of the taxonomy-alignment need to be represented in the form of a pie chart of a key performance indicator (KPI). In addition, the RTS specified that the default KPI for the calculation of taxonomy alignment in non-financial undertakings should be turnover. It also recommended capital expenditure (CapEx) or operational expenditure (OpEx) as alternative KPIs, depending on the features of the product.

    Market reaction on the Publication of SFDR and its RTS

    After the European Union released the SFDR in March 2021, investors’ interest in sustainability issues reached a peak. The new regulation also increased the number of financial products marketed as sustainable under the EU SFDR. According to Morningstar’s report, cash inflows into Article 8 and Article 9 products accelerated in the third quarter of 2021, capturing almost 57% of the reviewed fund universe’s total inflows, compared with 44% in the second quarter. Morningstar’s figure showed that USD4.63tr of cash flowed towards financial instruments with an ESG-related goal at the end of 2021, doubling after the introduction of SFDR.

    The transition to sustainable investing remains challenging for many investors and asset managers because this process demands a large knowledge pool and diversified skillsets. Seneca ESG provides a SaaS platform targeting problem settlements during the reporting and other aspects to sustainable investment for companies. Our experienced team will provide professional services to help companies with SFRD compliance, decarbonization, and sustainable investment. Contact us at info@senecaesg.com to get customized solutions for you.

    Sources:

    http://www.gsi-alliance.org/wp-content/uploads/2021/08/GSIR-20201.pdf

    https://about.bnef.com/blog/1h-2022-sustainable-finance-market-outlook/

    https://www.bloomberg.com/tosv2.html?vid=&uuid=72a43b64-8a53-11ec-ad84-537759724279&url=L2NvbXBhbnkv

    https://www.jpmorgan.com/insights/research/market-outlook-2022

    https://www.morningstar.co.uk/uk/news/216818/the-great-reclassification-how-sfdr-is-changing-funds.aspx

    https://www.reuters.com/markets/stocks/global-markets-esg-2021-12-17/

    https://www.spglobal.com/ratings/en/research/articles/220207-global-sustainable-bond-issuance-to-surpass-1-5-trillion-in-2022-12262243

    https://www.morningstar.co.uk/uk/news/217656/5-esg-themes-for-next-year.aspx

    https://www.lexology.com/library/detail.aspx?g=706660e3-8e7b-4b7e-937c-73077dbe9f62

    https://www.esma.europa.eu/sites/default/files/library/jc_2021_03_joint_esas_final_report_on_rts_under_sfdr.pdf

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