The 2015 United Nations climate change summit in Paris (COP21) saw the first ever agreement under which virtually every country, including the UK, pledged to constrain their greenhouse gas emissions, with the aim of keeping average temperature increases well below 2˚C above pre-industrial levels. Globally, there has been growing recognition by Governments, central banks and regulators of the potential impact of climate change on financial services markets and the important role that financial services markets have on helping to combat climate change.

With increasing consumer and investor demand for more sustainable financial products and services, sustainability in the financial services sector is fast becoming a key regulatory priority worldwide. The EU is introducing a new set of rules for the asset management sector aimed at addressing environmental, social and governance (ESG) concerns through its Sustainable Finance Disclosure Regulation (SFDR) which will apply from 10 March 2021.

While the SFDR has not been adopted by the UK post-Brexit, the SFDR could still apply to UK firms, for example where:

  1. UK fund managers market funds into the EU under National Private Placement Regimes; and
  2. EU firms subject to the SFDR delegate the portfolio or risk management activities to a UK based fund manager.

It is therefore important for UK asset managers to be alert to the new EU requirements.

Who does the SFDR apply to?

The SFDR applies to 'financial market participants' which are defined as:

  • insurance undertakings which make available insurance-based investment products;
  • investment firms which provides portfolio management;
  • institutions for occupational retirement provision;
  • manufacturers of pension products;
  • alternative investment fund managers;
  • pan-European personal pension product providers;
  • managers of qualifying venture capital funds;
  • managers of qualifying social entrepreneurship funds;
  • management companies of undertakings for collective investment in transferable securities; and
  • credit institutions which provide portfolio management.

The SFDR also applies to financial advisers.

What disclosure rules does the SFDR introduce?

The SFDR introduces a wide range of firm-level ESG related mandatory disclosures which financial market participants and/or financial advisers need to make, including:

  1. publication on information about policies on the integration of sustainability risks in firms' investment decision-making processes / investment advice on firms' websites;
  2. publication and maintenance on websites of a statement on due diligence policies where financial market participants consider principal adverse impacts on sustainability factors[1] in their investment decision making processes;
  3. where they do not consider principal adverse impacts on sustainability factors, a statement on websites of financial market participants and financial advisers on why they do not and whether and when they intend to in future[2];
  4. including in remuneration policies information on how those policies are consistent with the integration of sustainability risks[3] and publishing such information on websites; and
  5. pre-contractual disclosures by financial market participants which describe the manner in which sustainability risks are integrated into investment decisions and the results of the assessment of the likely impacts of sustainability risks on the returns of the financial products they make available. Where firms do not deem sustainability risks to be relevant, reasons must be given.

The SFDR also introduces a number of product level disclosures including:

  1. clear and reasoned explanations of whether, and if so, how a financial product considers principal adverse impacts on sustainability factors for each product where a financial market participant has made a firm-level disclosure that it considers principal adverse impacts on sustainability factors;
  2. for financial products which promote environmental or social characteristics, and assuming that the companies in which investments are made follow good governance practices, information on how those characteristics are met and, if an index has been designated as a reference benchmark, information on whether and how the index is consistent with those characteristics;
  3. for financial products which have sustainable investment as their objective and where an index has been designated as a reference benchmark, information on how the designated index is aligned with that objective and an explanation as to why and how the designated index alighted with that objectives differs from a broad market index. Where no index has been referenced but sustainable investment is its objective, there should be a clear explanation on how that objective is to be attained;
  4. website disclosures by financial market participants for each financial product which promotes environmental or social characteristics, or which has sustainable investment as its objective which:
    1. describe the environmental or social characteristics or the sustainable investment objective; and
    2. information on the methodologies used to assess, measure and monitor the environmental or social characteristics or the impact of the sustainable investments selected for the financial product, including its data sources, screening criteria for the underlying assets and the relevant sustainability indicators used to measure the environmental or social characteristics or the overall sustainable impact of the financial product; and
  5. website disclosures by financial market participants for each financial product which promotes environmental or social characteristics or which has sustainable investment as its objective:
    1. describing the extent to which environmental or social characteristics are met; and
    2. for financial products which have sustainable investment as an objective:
      1. the overall sustainability-related impact of the financial product by means of relevant sustainability indicators; or
      2. where an index has been designated as a reference benchmark, a comparison between the overall sustainability-related impact of the financial product with the impacts of the designated index and of a broad market index through sustainability indicators.

Together, the European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA) and European Securities and Markets Authority (ESMA) (the ESAs) have been mandated to develop draft regulatory technical standards (RTSs) to further specify the content, methodologies and presentation of information in relation to sustainability indicators with regard to climate, social, employee, human rights, anti-corruption and anti-bribery matters, as well as to specify the presentation and content of the information to be disclosed in pre-contractual documents (e.g. prospectuses), annual reports and on websites.

While the SFDR applies from 10 March 2021, meaning that firms will have to comply with its high level principles from that date, the ESAs have only so far published draft RTSs on the content, methodologies and presentation of disclosures under the SFDR. The European Commission is expected to endorse the RTS within three months of publication (4 February 2021) with the application date of the RTS currently being proposed for 1 January 2022.

In terms of marketing, financial market participants and financial advisers will need to ensure that all marketing communications do not contradict the information disclosed pursuant to the SFDR. Again, the RTS will determine the standard presentation of information on the promotion of environmental or social characteristics and sustainable investments.

What should firms subject to the SFDR be doing?

It is clear that there is much to do if firms are to satisfy the new disclosure requirements of the SFDR. Firms need to carefully evaluate whether they consider principal adverse impacts of sustainability factors when giving advice or providing portfolio management services. While firms can state that they do not consider these factors, they should be prepared to give a good reason why, as regulators and investors alike will be paying close attention.

Different requirements apply for financial market participants and financial advisers but firms should consider:

  • updating or creating new policies in relation to the integration of sustainability risks in portfolio management services and investment advice;
  • whether they have any products which promote environmental or social characteristics or have sustainable investment as their objectives;
  • updating remuneration policies;
  • updating websites with firm level and product level disclosures;
  • updating pre contractual documentation including prospectuses and KIIDs;
  • integrating sustainability risks into overall risk management frameworks;
  • incorporating sustainability factors into due diligence processes; and
  • incorporating sustainability factors into product governance processes.

If you require any assistance with understanding your obligations under the SFDR, we are here to help.

[1] Environmental, social and employee matters, respect for human rights, anti-corruption and anti-bribery matters.
[2] Note: Financial Market Participants exceeding on their balance sheet dates the criterion of the average number of 500 employees during the financial year will be required to consider principal adverse impacts from 30 June 2021
[3] An environmental, social or governance event or condition that, if it occurs, could cause an actual or a potential material negative impact on the value of the investment