The Sustainable Finance Disclosure Regulation (SFDR) and Its Impact on the U.S. Market
Europe has implemented new ESG regulations through the Sustainable Finance Disclosure Regulation (SFDR). Learn more about SFDR and its impact on the U.S. market and investors.
In December 2019, the European Union (EU) made a giant step towards the regulation of sustainability-related disclosures with the advent of the Sustainable Finance Disclosure Regulation (SFDR). Those disclosures began taking effect on March 10, 2021, for all EU financial market participants.
Although non-EU companies are not obligated by law to disclose sustainability-related data, we believe this shift in the industry will impact U.S. markets and set the standard for the future. As the EU unveils more SFDR next steps, we are taking a closer look at what exactly SFDR is, how this new regulation will impact the U.S. market, and what this means for investors.
The demand for ESG investing sets the stage for EU sustainable regulations
Sustainable and ESG investing are one of the fastest-growing investment strategies across the world, and especially in the EU. In 2010, assets under management in European sustainable funds were around EUR 112 billion. In 2020, that number has grown almost ten-fold to EUR 1,101 billion. This growth occurred across all asset classes and products from equities to ETFs to separately managed accounts. Not only that, but asset managers launched over 500 new European sustainable funds across the year.
Image Source: Morningstar
The COVID-19 pandemic escalated this growth with everyone from investors, to asset managers, to companies stepping up their commitment to sustainability. Additionally, COVID-19 shed a light on the harsh realities of ESG risk unpreparedness. As a result, investors are increasingly prioritizing sustainability-focused funds while divesting from high-carbon emitters.
As more and more pressure mounted from investors for common standards across the sustainable finance industry, the EU realized that the best way to continue this forward momentum is through regulation that forces capital to flow into a more sustainable economy. In 2020, the EU Sustainable Finance Action Plan brought this regulation to life by officially launching three main components — the Sustainable Finance Disclosure Regulation (SFDR), an extended Benchmark Regulation, and the Taxonomy Regulation.
These regulations are part of the implementation plan of the Paris Agreement, the UN 2030 Agenda for Sustainable Development, and the EU goal of a net-zero economy by 2050. They also mark a big step in the industry as a whole for enforcing and synchronizing sustainability requirements.
Goals of the Sustainable Finance Disclosure Regulation (SFDR)
The goals of the EU Sustainable Finance Action Plan are to:
- Reorient capital flows towards a more sustainable economy focused on sustainable growth
- Manage and mainstream sustainability risk management stemming from climate change and other pressing social and environmental issues
- Foster transparency in the financial market with a greater focus on long-term sustainability impact
The Sustainable Finance Disclosure Regulation (SFDR) is one piece of the puzzle of these larger goals. Specifically, SFDR’s focus is on increased sustainability transparency through greater standards of reporting and disclosure.
One of the biggest concerns of the SFDR is eliminating “greenwashing” or funds or products marketed as sustainable when they aren’t. With SFDR, all funds, sustainable or non-sustainable, need to disclose their ESG considerations — or lack thereof — to potential investors. Starting in 2022, these disclosures will be mandatory.
The goals of this increased transparency are two-fold:
- Raise the bar for ESG and the management of ESG risk: Not only does this stop greenwashing, but it also sets a standard for what ESG and sustainability mean in the industry. Firms will have to step up their game for how they operate their business to not only comply with SFDR but to remain relevant in an increasingly ESG-focused market.
- Improve investor’s ESG experience: With more opportunities to compare and contrast investment decisions according to their values, investors will be able to make more informed investment decisions. As they do, this may drive more investment dollars into sustainable investments. This increases the growth of the sustainable economy.
SFDR classifications and disclosures
As part of the SFDR disclosures, there is a new set of requirements for companies, financial service providers, and financial products that service the EU. These requirements center on three main aspects:
- Sustainability risks: What ESG events or conditions, such as climate change, could impact the value of an investment.
- Principal Adverse Impacts (PAI): Any negative sustainable impact of an investment decision on sustainability factors such as poor water or waste management practices or contribution to fossil fuel emissions.
- Accuracy of their sustainability marketing claims: Anyone promoting ESG characteristics or sustainable investments must disclose the accuracy of their statements.
Below are key dates for the SFDR, including a timeline for the implementation of the above requirements:
Image source: J.P. Morgan Asset Management
To help investors effectively compare and contrast, the SFDR establishes three different classifications of investment products. Each classification has specific requirements of the above disclosures for each. These categories may help investors differentiate between the different kinds of sustainable investing.
All European funds will need to fall into one of these three classifications when it comes to their sustainable and ESG considerations:
- Article 6*: This is the catch-all category of investment products. These are products that don’t integrate sustainability considerations, don’t consider the sustainability risks relevant, or do not meet the criteria for Article 8 or 9.
- Article 8: These are products that are promoting environmental or social characteristics but don’t necessarily have sustainable investing as their core objective.
- Article 9: These are products that have sustainable investment as their core objective. This means they are investing in companies that clearly show positive sustainable outcomes as part of their business model.
Image source: Morningstar
* Under SFDR, products in Article 6 that do not integrate any sustainability considerations will have to face an uphill marketing challenge. They will have to answer to why they do not consider sustainability risks or PAI. Additionally, under MiFID II amendments, these products won’t be recommended to the ever-increasing amount of clients who are expressing an interest in ESG. This is the kind of regulation that makes pursuing sustainability considerations not just a moral obligation, but a financial one.
Scope of impact
The SFDR applies to all EU financial market participants. This includes portfolio managers, fund managers, pension providers, and financial advisors. Below is the impact of these regulations across a few different players in the EU financial sector:
- Asset managers: Will have to disclose their policies at both the firm and product level. In the future, they will have to further break down how they consider Principal Adverse Impacts (PAI).
- Advisors: All advisors will have to explain how they consider these factors, including their ranking and selection methodology, to their clients as part of their investment advice. This includes explaining the potential impact of sustainability factors on returns of financial products they advise.
- Larger firms: In the future, they will be required to disclose how they consider Principal Adverse Impacts (PAI).
Image source: Morningstar
SFDR implications on the U.S. market
SFDR does not directly apply to the U.S. financial market. However, there are instances in which U.S. financial market participants will need to comply with SFDR.
Even if you aren’t directly affected by these regulations, SFDR is changing the future of ESG investing. This kind of regulation ignites the current conversation in the United States around developing a set of standards to measure and encourage ESG investing. This has implications for everyone, not just the EU financial market.
U.S. financial market participants affected by SFDR
- All asset managers that raise money in the EU, even if they are based in the United States
- Investment managers or advisors based outside of the EU who market or hope to market their products to EU clients
- Any firm in the United States that also offers funds in Europe will now have to disclose its sustainability risks and PAI
U.S. ESG data providers to share more SFDR data solutions
With SFDR, U.S. third-party data providers, such as MSCI, Sustainalytics, and the Institutional Shareholder Services group of companies (ISS), will start to collect and disseminate information about SFDR disclosures into their data, rankings, and research. This means that U.S. investors could turn to MSCI or another data provider for information on how their U.S.-based fund is comparing to its European counterpart when it comes to ESG.
Many of these data providers may likely work to fill any gaps that they don’t already cover from these new regulations in the hopes of supporting clients who want to meet the EU ESG data requirements.
U.S. companies may start reporting more on SFDR requirements
There is a lot of crossover between funds in the United States and Europe. This is going to raise the bar for sustainable investing in the United States. We foresee that this could even pressure U.S.-based funds that have no legal obligation to meet the new regulations to start improving their disclosure policies.
The standard has been set and for many non-EU companies, this could lead to an obligation or an opportunity to step up. As a result, U.S.-based firms who are holding themselves to the higher standards of SFDR requirements will be able to differentiate themselves from those who aren’t disclosing their ESG risk information. This could attract further capital from investors who have a demonstrated interest in ESG.
This shift in disclosure and impact reports is already happening in the United States. The SFDR has the opportunity to move that momentum forward a little bit faster. According to Morningstar, “more U.S.-based fund managers are issuing impact reports detailing proxy voting and engagement, and the net impact of their holdings. This is an emerging best practice.”
Increased U.S. ESG-related regulations
The EU regulations come amid several U.S. ESG-related changes. Including those from a new administration that is putting in place more ESG-related regulations. These changes include:
- The Securities and Exchange Commission (SEC) has signaled support “to create a system for obtaining environmental, social, and governance disclosures by companies.”
- The Labor Department has indicated that they will not be enforcing two Trump administration rules that discouraged sustainable investing, including one rule that discouraged ESG funds as part of 401(k) plans.
- The Commodity Futures Trading Commission (CFTC) put out a report in September 2020 with recommendations for financial regulators about managing climate risk in the U.S. financial system. The report stated, “Climate change poses a major risk to the stability of the U.S. financial system and to its ability to sustain the American economy.”
- The SEC’s acting chair created a new position of Senior Policy Advisor for Climate and ESG.
- The U.S. Federal Reserve has created two new panels — a Financial Stability Climate Committee and a Supervision Climate Committee — to assess climate-related financial risks.
- On April 7, U.S. climate envoy John Kerry announced that President Biden is planning to issue an executive order on climate disclosure. While the details are still being worked out, this is a big move for the United States and more closely aligns us with the EU’s plans for SFDR.
Although the Trump administration overturned nearly 100 environmental regulations during his time in office, the Biden administration has promised a different course of action. Biden and his team have made it clear that ESG is a priority for the United States alongside increased climate change action.
While the United States does not currently have plans to put a U.S. equivalent of the SFDR in place, we are already heading in that direction as a country. The influence of SFDR will continue that momentum.
The impact on investors
Now that we’ve outlined what SFDR is and the impact it could have on U.S. markets, the question becomes: why should investors care?
The new regulations are good news for investors everywhere and here’s why:
- Improved ESG options and analysis: We know that investors care about ESG investing and having more opportunities to invest according to their values. ESG options are increasing as a result. However, it's complicated to navigate your options. With new regulations setting the standard for disclosure, investors will have a much easier time comparing and contrasting sustainable investment products and features.
- Increased transparency: With SFDR, investors won’t live in the dark when it comes to which funds and companies are supporting the ESG objectives that they claim to support. Even for funds outside of the EU, SFDR raises the bar for everyone. A firm’s lack of transparency could be a future turn-off in the industry.
- Quality data and information: Knowledge is power, especially in the financial industry. Quality information can lead to improved financial performance and a better understanding of the impact of your investments. Investors will have a much bigger window into the measures of their portfolio, analysis of risk, and achievement of sustainable objectives over time. Not only that, but SFDR has the opportunity to standardize this data across the entire industry.
- Improved risk management: As part of quality data and information, investors will have greater access to potential sustainability risks that could pose a threat to their investments. Having the opportunity to protect yourself against future risks is a major plus for investors given the future of climate change is so uncertain.
- Puts control in the investors’ hands: SFDR marks the standard of disclosure in the industry. Investors will get accustomed to this level of disclosure. This means that investors can actively pick and choose the advisors, managers, and funds that are meeting their new standards. The global financial industry will have to learn to meet these demands or get left behind.
The big takeaway
While this regulation might be in the EU, the potential impact of SFDR extends far beyond country borders. The SFDR is a move in the right direction for sustainable investing. It’s an exciting opportunity in the financial sector for those who are ready to take on the challenges and the opportunities of ESG.
This move to measure impact helps increase the chances of sustainable objectives actually being achieved. Plus, investors have more of a say in how their investments impact the world around them. The regulation gives the power to the investors, allowing them to compare and contrast their sustainable investment options and help capital flow towards a more sustainable economy.
Under the Biden administration — and with increasing demand from investors — ESG investing in the United States will get a tailwind of support from SFDR. Expect to see changes that impact the broader financial market and not just the EU.
At OpenInvest, our partnership with ABN Amro enables us to provide customized SFDR reporting solutions to European and other clients.