How fund managers should prepare for the SFDR’s regulatory technical standards

27 July 2022
Environmental, social and governance issues have become a priority not just for investors, but also regulators. In recent years, the EU has focused on orienting private investments toward sustainable finance, beginning with taxonomy regulation to more clearly define sustainable activities. It’s also developing ecolabels for financial products and setting climate change benchmarks.

The Sustainable Finance Disclosure Regulation, or SFDR, is the centrepiece of the EU’s push toward sustainable finance. The European Commission adopted the SFDR in 2019. The regulation went into effect in 2021, but it took more than a year for the commission to finalise the regulatory technical standards (RTS) that detail how funds can fulfil the obligations set forth in both the SFDR and the EU Taxonomy Regulation. The commission adopted the RTS in April 2022, and it goes into effect 1 January 2023.

In this evolving regulatory environment, fund managers must be proactive to reduce their firms’ compliance risks and ensure their investments and investment processes meet the sustainability criteria and disclosure and reporting obligations EU regulators have established.

Here’s what fund managers should know as they navigate this complex, changing landscape.

Moving toward sustainable finance: Understanding SFDR

The SFDR includes several high-level obligations for funds that are engaged in ESG or seek to integrate ESG into their investment processes.

These obligations include product-level and entity-level disclosures that classify a fund as either sustainable (under Article 9 of the regulation), partially sustainable (Article 8) or not sustainable (Article 6). These disclosures are designed to help investors make more informed allocation decisions — especially among those who want to invest in line with ESG principles. The regulation also aims to combat greenwashing, which has contributed to both deliberate and unintentional misclassification of investments that don’t actually fulfil ESG principles.

At the entity level, the SFDR requires firms to disclose:

  • Information on how they integrate sustainability risks into their financial advice or investment decision-making processes.
  • A policy statement on how they consider principal adverse impacts (PAIs) on sustainability factors.
  • Information on how their compensation policies align with the integration of sustainability risks.
  • Pre-contractual disclosures for how sustainability risk is integrated into their practices, including assessments of how ESG risk may affect the performance of financial products.

At the product level, the SFDR requires firms to disclose and provide:

  • An explanation of how their financial products account for PAI indicators.
  • Additional information for Article 8 products detailing how they promote environmental or social characteristics, as well as a disclosure on how they align with the EU Taxonomy Regulation.
  • An explanation for Article 9 products detailing how they meet sustainable investment objectives, as well as a disclosure on how they align with the EU Taxonomy Regulation.

The SFDR covers pre-contractual disclosures and disclosures in a firm’s reports, marketing communications and website. However, until recently, fund managers lacked clarity on exactly how they should disclose the required information. They’ve largely relied on the draft RTS and complied with the regulation on a best-effort or good-faith basis.

The release of the final RTS now gives fund managers actionable guidance they can use to ensure their firms are compliant with SFDR.

What the finalised technical standards mean for fund managers

The RTS is now final, barring objections from the European Council or the European Parliament.

The final standards provide templates for the Article 8 and 9 product-level disclosures required under SFDR and the PAI statement at the entity level, which details the potential negative effects of an entity’s investment decisions on the environment.

The final RTS mirrors the draft standards fund managers have used over the last year. Though the harm indicators that align with the PAI statement haven’t significantly changed, the commission will continue to require that funds use its mandated disclosure template for PAI reporting. Funds also must make Article 8 and 9 pre-contractual and periodic disclosures using the required templates.

But even with the finalised RTS, some open questions remain for funds. First, there still isn’t clarity on whether fund managers can exclude any financial products from their PAI reports, so it may be best for firms to err on the side of caution and ensure their reports are as comprehensive as possible. The commission also still hasn’t provided a standard definition or criteria for Article 8 and 9 products.

Despite these remaining questions, fund managers should prepare now for the RTS January 2023 effective date.

Next steps: How fund managers can prepare

Fund managers should begin familiarising themselves with the mandatory disclosure templates, including the PAI statement, and the information they require. They should then begin taking steps to obtain the requisite data and implement appropriate systems to maintain compliance.

Given that the PAI disclosure requires retrospective reporting from the 2022 calendar year, firms should begin gathering information from their current operating period to meet the initial June 2023 PAI reporting requirements.

Though SFDR specifically focuses on EU alternative investment fund managers (AIFMs) and other entities, certain rules will have a significant impact on non-EU based managers who provide portfolio management, risk management or non-discretionary investment advice to alternative investment funds (AIFs) in the EU. For example, if an EU-based AIFM has delegated the portfolio or risk management function to a non-EU portfolio manager — a standard structure in some jurisdictions, such as Luxembourg — the portfolio manager will be required to help the EU-based AIFM comply with the SFDR. While non-EU portfolio managers might not have a direct regulatory obligation to abide by the SFDR, they may be contractually required to do so by the delegating AIFM in the EU.

While the SFDR and RTS may present new complexities for fund managers, these regulations also offer an opportunity for firms to demonstrate how their investment choices align with ESG practices, providing a higher degree of transparency and certainty for investors looking to invest in ESG-focused or aligned funds. Laying the groundwork now to obtain the relevant data will streamline the disclosure process and help companies avoid the financial, regulatory and reputational risks associated with non-compliance.

Learn more about Vistra’s ESG data management and compliance services here, or get in touch using the form below.