Carbometrix

The Sustainable Finance Disclosures Regulation (SFDR): the pioneering EU regulation with global impact

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Historically, investors in private markets have faced significant challenges in accessing reliable and standardized climate and carbon data from their assets. This can be attributed to two key factors:

  • Climate considerations have only recently gained prominence since the signing of the Paris agreements in 2015, leading to evolving reporting standards;

  • Unlike public markets, where climate reporting has become more standardized (e.g through the Extra-Financial Performance Declaration for instance), private markets have been operating with less stringents disclosure requirements. 

To address these challenges, the European Commission implemented in March 2021 the Sustainable Finance Disclosures Regulation (SFDR). Its main objective is to provide investors with reliable and comparable information on their investment options and to enable market participants to assess the sustainability commitments of investors, thereby reducing the risk of greenwashing. 

Objectives of the SFDR

The SFDR has been built on two pillars: 

  • Transparency: Aiming to strengthen the obligations for disclosing non-financial information.

  • Comparability: Focused on standardizing the disclosed non-financial information to ensure it is comparable across the market.

The ultimate objective of the SFDR is to enable investors to redirect their investments toward more sustainable assets and finance the transition to a low carbon economy.

Who is concerned by the SFDR?

The SFDR applies to all "financial market participants" established in the EU, selling products in the EU and/or investing within the EU. As a consequence, asset owners and asset managers operating  in the EU are directly concerned by the regulation and must disclose a certain number of mandatory information. Companies with less than 500 employees have lighter obligations.

Overall, thousands of financial institutions worldwide are required to comply with the SFDR.

The SFDR in practice

The SFDR defines two main obligations for investors:

1/ Principal Adverse Impacts (PAIs)

Financial institutions are required to demonstrate the 'Principal Adverse Impact' (PAI) that their investments have on sustainability factors such as greenhouse gas emissions, water and energy consumption, human rights and inclusion. In total, 13 PAIs must be addressed, among which 8 are directly linked to energy or climate issues.

2/ Asset classification

To ease the comparison between financial products, the SFDR categorizes investment funds into three types:

  • Article 6: Funds with no specific sustainability objectives, 

  • Article 8: Funds with a sustainability objective but no binding criteria.

  • Article 9: Sustainability-focused funds with binding sustainability criteria. 

When raising a fund, investment companies must disclose whether it is classified under Article 6, 8 or 9, and manage the fund according to the related criteria.

👉 For more information on the SFDR, see our detailed article here

Implication of the SFDR for Limited Partners and their stakeholders

By strengthening the transparency and standardization of disclosed information on the market, the SFDR empowers Limited Partners (LPs) to set ambitious climate targets, select their General Partners (GPs) based on these targets and communicate clearly their commitments. 

The SFDR's dual classification of financial products -Article 8 for those promoting environmental or social characteristics and Article 9 for those with sustainable investment objectives -further pushes LPs to categorize their investments transparently, directly influencing capital allocation decisions. As so, more and more Limited Partners, specifically in Europe, ask their General Partners to raise article 8 or 9 funds to comply with their global responsible investment policies.

Beyond the compliance requirements, the SFDR can be used by Limited Partners as a strategic tool to drive sustainability across their portfolio. PAIs are now another criteria LPs use to compare the ESG performances of a GP between another, and decide to invest in one rather than another. For instance, Norway’s Government Pension Fund Global has intensified its focus on investments that align with a low-carbon economy, divesting from companies with poor ESG scores, and pushing for greater sustainability disclosures from its portfolio companies. These actions are not only fulfilling regulatory obligations but also reflecting a broader trend where LPs are increasingly prioritizing sustainable investment strategies as a means to mitigate climate risk, thus enhancing long-term returns, and meet the growing global expectations to reach Net Zero.

Despite the SFDR's crucial role in enhancing transparency around environmental and climate commitments, it has faced criticism. Specifically, Articles 8 and 9 have been flagged for their vague qualifications, which some argue do not adequately ensure that investments are truly driving the transition to a low-carbon economy. Critics, including the Dutch Pension Federation and Norwegian pension fund KLP, have expressed concerns that current investments are too focused on assets already deemed green, rather than supporting transitional solutions that would foster broader sustainability efforts. These voices are calling for further measures to better channel investments into projects that actively contribute to the low-carbon transition.

The future of the SFDR: towards a global generalization?

Despite criticisms, the SFDR marks a significant advancement in the financial sector's push towards sustainability, driving the transition from voluntary to mandatory disclosures. The EU remains at the forefront of climate and environmental regulation with initiatives such as the SFDR for financial institutions and the CSRD for companies. Meanwhile, similar efforts are beginning to emerge globally:

  • The UK announced in 2020 that it would become the first country to make Task Force on Climate-related Financial Disclosures (TCFD)-aligned disclosures mandatory for certain businesses, including banks, insurers, asset managers, and listed companies (see our article on TCFD / ISSB);

  • In Canada, financial regulators have introduced guidelines for incorporating climate risks into financial institutions' risk assessments and are considering making TCFD disclosures mandatory for large financial institutions.

  • In the United States, states like California along with numerous financial companies have introduced climate risk disclosure policies inspired by international frameworks such as TCFD and Principle for Responsible Investment (PRI), promoted by the United Nations (see our article on PRI)

As climate and environmental reporting continues to evolve, we can expect that, much like accounting standards became globally standardized in the 20th century, climate and environmental information will also become normalized worldwide in the years to come.

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