Since its implementation in March 2021, the Sustainable Finance Disclosure Regulation (SFDR) has become a cornerstone in the EU's efforts to promote greater transparency in financial markets, requiring in-scope entities to demonstrate their commitment to sustainability. 

What is the SFDR and Who’s in Scope?

The SFDR is an EU regulation designed to enhance transparency in the financial markets by standardizing sustainability-related disclosures. The ultimate goal of SFDR reporting is to ensure that investors have access to clear and consistent information about the ESG claims made by financial products.

The scope of the SFDR includes mainly 2 types of entities:

1. Financial market participants: Manufacturers of financial products such as asset managers, venture capital funds, private equity funds etc.

2. Financial advisers: Entities that provide investment advice, including investment advisors, insurance companies, and similar firms.

In terms of geography, the SFDR affects EU-based entities but also non-EU based entities if they market products within the EU and/or to EU investors.

Understanding Product Classifications: Articles 6, 8, and 9

One of the most crucial elements of the SFDR is the classification of financial products based on their ambition level of ESG consideration. Products fall into three main categories:

• Article 6: ​These products do not integrate ESG or sustainability-related strategies into their investments. They represent the baseline classification, covering all financial products that do not actively promote sustainability.

• Article 8: Often referred to as "light green" funds, these products promote environmental and/or social characteristics but do not have a sustainability objective. However, they may choose to allocate a percentage of their portfolio to sustainable investments.

• Article 9: Known as "dark green" funds, these products have sustainable investments as their objective. They are required to allocate 100% of their investments to sustainable investments, as defined under SFDR article 2 (17).

As defined under SFDR article 2 (17), a “sustainable investment” refers to an investment in an economic activity that contributes to an environmental and/or social objective, provided that such investment does not significantly harm any of those objectives and that the investee companies follow good governance practices. This makes Article 9 requirements particularly challenging, as these products must demonstrate meeting the requirements of 100% sustainable investments. Consequently, Article 9 products tend to be less common than Article 8 products in the financial sector.

Further Distinctions within Article 8: Light Green vs. Medium Green

Although the regulation itself does not mandate a formal split within Article 8, the industry has informally created a distinction over the past few years due to the broad range of financial products that fall under this classification. The two emerging subcategories are:

• Article 8: ​Referred to as "light green" funds, these products promote environmental and/or social characteristics without committing to sustainable investments (0% sustainable investments).

• Article 8+ : Referred to as "medium green" funds, these products promote environmental and/or social characteristics AND also allocate a percentage of the portfolio to sustainable investments. Since they incorporate some elements of Article 9 funds, their ambition and reporting requirements are more complex than those of standard Article 8 products.

Reporting Levels and Types of Disclosure Requirements

The SFDR has two main overarching reporting levels: entity-level and product level. For each of these reporting levels, the disclosure requirements come in three different forms: pre-contractual disclosures, website disclosures, and periodic disclosures.

See below a visual representation of these reporting levels and the associated disclosures.

Entity-Level Disclosures

The purpose of entity-level disclosures is to provide a comprehensive overview of the entity’s overall sustainability strategy and how ESG factors are integrated into the investment process. Entity level disclosures take the form of website disclosures and consist of three key types of sustainability information:

• Sustainability risk policies: Entities must disclose their policies on integrating sustainability risks into their investment decision-making processes.

• Consideration of Principal Adverse Impact (PAI) indicators at entity-level: Entities must provide information on how they consider the Principal Adverse Impact (PAIs) of their investment decisions on sustainability factors. Note: entity-level PAI reporting is mandatory only for large entities with > than 500 employees, with reporting deadline June 30th of each year.

• Remuneration policies: Entities must disclose their remuneration policies, specifically detailing how these policies align with the integration of sustainability risks.

Product-Level Disclosures

Product-level disclosures require specific information for each financial product, aimed at informing investors about the product’s ESG ambition and strategy. For entities managing multiple funds, separate product-level disclosures must be prepared for each fund. These disclosures apply to funds classified as Article 8 and Article 9, and they take three main forms:

• Pre-contractual disclosures: ​These provide information of the sustainability strategy of the financial product, binding for investment decisions​. Typically, this document is usually drafted as part of pre-investment documentation and distributed internally​.

• Website disclosures: These provide key sustainability information of the product (subset of pre-contractual information) and shall be publicly available on the website​​. These disclosures should be published in a dedicated section, ideally below the "Entity-level" disclosures, and kept regularly updated.

• Periodic disclosures: These provide a summary of the financial product's performance related to the SFDR, similar to a periodic report. Prepared annually, this document is typically shared with end-investors alongside the fund’s annual report. Additionally, periodic disclosures often include the results of the ESG metrics tracked by portfolio companies, such as PAI indicators if the fund decides to consider and report them at the product level.

To comply with the SFDR, financial entities shall fulfill the disclosure requirements outlined above, following the templates provided by the EU in Annexes I to V (For more information, link here).

Principal Adverse Impacts (PAIs) indicators

While most SFDR reporting requires qualitative information from financial entities, the regulation also introduced a key quantitative component in the form of Principal Adverse Impact (PAI) indicators — ESG metrics designed to standardize sustainability reporting. These indicators are crucial as they require to demonstrate how investments might mitigate any potential harm.

PAI indicators cover environmental and social metrics and are structured in three tables under Annex I. Examples include GHG emissions (Scope 1,2,3), unadjusted gender pay gap, and board gender diversity.

In terms of compliance, mandatory PAI reporting falls in two primary cases:

• At the entity level, for large financial entities with more than 500 employees.

• At the product level, for Article 8+ and Article 9 financial products that commit to sustainable investments and must meet the "do no significant harm" (DNSH) criteria, as outlined by SFDR definition requirements. 

How to Prepare for SFDR Reporting

Financial entities must take proactive steps to prepare for the SFDR reporting. Key actions include:

Evaluate current ESG status: Assess your entity's existing ESG status and outline the necessary steps to establish an effective ESG reporting process that aligns with your fund’s sustainability strategy.

Train teams on SFDR requirements: Ensure that all relevant team members are well-informed about the SFDR regulation and equipped to initiate the SFDR journey.

Comply with disclosure requirements: Ensure all required disclosures are prepared (pre-contractual, website, and periodic disclosures).

Implement a data collection process: Collect data for the sustainability performance of portfolio companies - starting with PAI indicators - for your first reporting cycle.

Summary

SFDR reporting is achieved by meeting disclosure requirements, but the regulation offers flexibility in how firms fulfill these. While the SFDR mandates the structure for disclosures through templates, it leaves room for interpretation regarding the specific content that constitutes compliance. Funds must clearly explain how they fulfill the requirements of their chosen classification - Article 8, 8+, or 9 - and ensure that portfolio companies provide the necessary data to align with the fund’s ESG strategy. 

Finally, the SFDR is continuously evolving, with ongoing consultations and reviews from the EU aimed at improving reporting efficiency. More updates might come in 2025, so stay tuned!

At Atlas Metrics, we understand how challenging it can be for funds to navigate SFDR regulatory requirements.