The EU’s New ESG Disclosure Rules Signal Direction for the Future

The EU’s new Sustainable Finance Disclosure Regulation (SFDR) regulations are here, and they signal future change for the rest of the world.

The Sustainable Finance Disclosure Regulation, considered by the European Commission as the basis of their action plan on sustainable finance, came into effect on 10th March 2021. Aiming to trigger behavioural change within the finance sector, these new rules require financial market participants and advisers to integrate sustainability risks into their internal processes. The rules aim to help the investment sector meet the goals of The Paris Agreement by stamping out greenwashing and driving capital towards environmental, social, and governance goals.

Who does SFDR apply to?

Those firms that are affected include financial advisors and EU Financial Market Participants (FMPs) including pension funds, insurance companies, venture capital funds, asset managers, banks, and credit institutions.

SFDR timeline

This is the first step in a process which will see further requirements coming to the fore in 2022. Here is a brief timeline on what we can expect to see from now until the end of next year:

• On 10th March, the three categories of the SFDR are implemented on a phased basis beginning with Level 1 SFDR

• By 20th June 2021, larger FMPs must disclose their Principle Adverse Impacts (PAIs)

• 31st December 2021 signals the end of the reporting period

• On 1st January 2022 the new reporting period begins with Level 2 Regulatory Technical Standards (RTS)

• 31st June 2022 is the reporting deadline for PAIs

• From 30th December 2022 onwards, the new obligation for disclosures of PAIs at product level take effect

For firms in Europe the race will be on to get systems up to scratch in time. Those outside Europe will be asking whether they really need to pay attention or not. The United Kingdom, for example, has chosen not to adopt SFDR after Brexit. However, the answer to the question of whether to pay attention is a resounding “yes”. UK firms need to pay attention to SFDR regulations in any instance where they are marketing and providing financial products to the EU.

ESG regulations outside the EU

The UK and many other territories around the world are planning their own versions of this legislation. Rules across the world may differ in detail, but the overall gist will be very much the same. More importantly, these rules are part of the wider picture in which everyone is steering towards a more sustainable version of capitalism. One of Joe Biden’s first moves as President was to rejoin the Paris Climate accord, and he recently hosted a virtual conference on climate change drawing involvement from the great leaders of the world.

In the UK, the government has brought forward its already ambitious targets on climate change. Prime Minister Boris Johnson has talked of investing heavily in renewable energies, and investors are increasingly showing an interest in the sustainability of their funds. This comes, in part, from a desire for greener and more sustainable investments, but also a growing recognition of the financial risks a lack of sustainability can bring; those funds that are over exposed to non-sustainable sectors such as oil and gas are opening themselves up to a number of financial and regulatory risks.

In a world where financial companies in the EU are upping their game on ESG reporting, other countries will need to follow suit. Information about products and culture will become a standard source of data for investors, and as they become accustomed to receiving such data, they will be more reluctant to work with those who do not offer it.

What should firms do now?

Firms can take steps to ensure they meet the regulatory requirements and ensure a smooth implementation of these new ESG policies by reviewing their light green (Article 8), and their dark green (Article 9) products. The latter are those products with a sustainable investment strategy and the former are those products that promote social or environmental characteristics but that don’t promote sustainability. Sustainable investments also fall into this former category. Firms should review any marketing documentation and assess whether any further product disclosures need to be made. Firms must also clarify which of their EU-regulated products or activities fall under SFDR rules. Lastly, a clear-cut understanding of how their current sustainability risk disclosures are made to clients and investors, and if there are any gaps relating to SFDR compliance.

Europe’s move is a key moment for the entire financial sector. It hints at what’s to come from other regulators and continues the move towards more granular reporting on ESG factors. Moving early will reduce the burden of compliance in the future and will help companies remain competitive in a more environmentally conscious world.