Sustainable finance disclosure regulation: What it means for investors

Sustainable finance disclosure regulation: What it means for investors

The EU has an action plan for sustainable finance. But what exactly does it entail?

Theresa Bender

Jul 21, 2021

·

15

min read

Do you have money invested into a fund or any other financial product on the capital markets?

No? Then you should definitely start investing! Just take a look at our tips for newbies to avoid mistakes when you start. 😉

Yes? Then you should know about a new EU regulation which already got partly implemented at the beginning of the year. Even though this regulation has a high impact not only on financial market participants like asset managers but also on private investors, not many people know about it.

Read on as we’re going to give you all the information you need to leverage this new regulation!

The Speed Read:

1. In order to strengthen sustainability in the financial sector and to encourage and provide opportunities for private investors to invest sustainably, the European Union has published its Action Plan on Sustainable Finance. It includes 10 different legislative initiatives to promote sustainability in the coming years. One of these initiatives is the Sustainable Finance Disclosure Regulation (SFDR).

2. The SFDR has introduced three categories for funds which can be used like a sustainability certificate or bio-label for financial products. The regulation distinguishes between "Article 6 products" which do not attach particular importance to sustainability, "Article 8 products" which support sustainability in their investment process and "Article 9 products". These have sustainability as an active goal and are therefore the "greenest".

3. Currently, almost one in four euros invested in a fund in Europe is invested sustainably — i.e. in an Article 8 or Article 9 product.

4. There are significant differences between fund managers in terms of how sustainable their offering is: some managers have been able to declare 100% of their funds as sustainable, others only as few as 1.5%.

In 2018, the EU Commission published its Action Plan on Sustainable Finance. The Commission, therefore, underlined the importance of sustainability considerations in relation to capital investments and committed to creating a level-playing field for sustainable financial markets across the whole EU.

Explained: Sustainable finance

What exactly does sustainable finance mean and why is it important to pay attention to sustainability in the financial sector? The European Commission defines sustainable finance as follows: "Sustainable finance refers to the process of taking environmental, social and governance (ESG) considerations into account when making investment decisions in the financial sector, leading to more long-term investments in sustainable economic activities and projects." This means that people (e.g. you as an investor) or companies (such as banks or insurance companies) who are active in the financial market consciously take into account not only possible returns but also the impact on the environment (like mitigation of climate change), social conditions (like the existence of inequality, human rights considerations) and the governance of public and private companies (management structures, remuneration policies) when making investment decisions. The importance of sustainable finance thus stems from the impact of sustainable investment, e.g. that it can help to slow down climate change. If private and institutional investors decide to give their money only to climate-friendly companies, the climate-unfriendly companies will experience liquidity problems and thus have difficulties in their business activities and may even be forced out of the market. In short, with your investments, you can decide whether you support sustainable companies or let coal giants live on.

This action plan is a comprehensive legal initiative and includes 10 legislative measures to achieve the following three sustainability goals:

1. Redirecting private capital towards sustainable investments (e.g. through a standardized taxonomy, labeling of environmentally friendly financial products, disclosure);

2. Integrating sustainability into risk management (inclusion of ESG risks in ratings, investment regulations at banks and insurance companies, etc.);

3. Promoting transparency and long-termism (through increased disclosure, incentives for sustainable corporate governance, etc.)

The three goals promoted by Sustainable Finance Disclosure Regulation
SOURCE: EUROPEAN COMMISSION

As you can see immediately, the focus of the action plan is on promoting sustainability in the financial sector and doing this for the private investor. Investing in sustainable financial products is supposed to be easier for all of us through more transparency and the inclusion of ESG risks in business processes, so that private money flows into "good" and/or what we like to call "green" financial products.

In this article, the initiative we want to take a closer look at today is the so-called Sustainable Finance Disclosure Regulation (SFDR), which is part of the action plan we just discussed (and which has an unnecessarily complicated name — we know 😅).

But even though these legal terms sound extremely boring and dry at first, the idea behind them is very important, and informing yourself about them is essential if you want to continue investing your money in the capital markets.

Furthermore, part of the SFDR was already implemented in March this year, so you can already leverage the regulation to make better and more educated decisions!

A shift towards green products and more transparency?

Explained: Company disclosures

With the Sustainable Finance Disclosure Regulation in place, companies are now legally obliged to make disclosures. This means that they must make relevant information available to the public within a specified period of time. According to the Corporate Finance Institute, relevant information, in this case, includes “any and every piece of information, including facts, figures, dates, procedures, innovations, and so on, that can potentially influence an investor’s decision”. A disclosure can therefore contain negative as well as positive news about a company and thus influence an investor's decision to buy the share or bond of that company. This forces companies to be more transparent, which makes it more difficult to misuse investors' money or to engage in insider trading (i.e. since the information is available to everyone, there are no insiders). In addition to mandatory disclosures required by law, various companies voluntarily disclose additional information to put themselves into a certain light while increasing firm value along with it.


So now, let's take a closer look at the Sustainable Finance Disclosure Regulation.

We already know that it is part of the EU Initiative for Sustainable Finance. But what exactly does it state and what are the implications for private investors like you?

Sustainable Finance Disclosure Regulation: The goals

In addition to the EU Action Plan, the SFDR will contribute to fulfilling the European Green Deal, which aims for the EU to be carbon neutral by 2050 by “[pushing] around €1 trillion into green investments over the next decade”. The European Commission especially tries to incentivize private investors to invest more environmentally friendly and, hence, help mitigate climate change through financial levers.

It is hoped that greenwashing, which is still seen as one of the biggest issues for sustainable investment, should be prevented this way and more transparency regarding actual sustainability in financial products should be in the meantime enabled across the whole Union. This is intended to give a competitive advantage to those companies that offer truly sustainable products.

The goals of the SFDR are therefore very ambitious for new regulation. But how are they to be achieved? Glad you asked:

Sustainable Finance Disclosure Regulation: The strategy

Let us note, first of all, that because the SFDR was passed by the European Commission, the new regulation has been applicable to all companies in the European Union since March 2021. Simply said: fund managers in all 27 nations have to comply with the new standards!

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Furthermore, even for companies that do not have their registered office directly in the EU, the new law often applies in a roundabout way — e.g. because their subsidiaries are located in the Union.

Thus, the SFDR naturally has a major advantage over individual country initiatives such as those of the German BaFin (The Federal Financial Supervisory Authority) or similar: it covers an extremely large number of market participants at once, which makes it really powerful.

So, the first goal we’ve talked about — incentivizing private investors to invest in a more environmentally-friendly way — can be reached because the SFDR has to be adapted by simply every fund manager in the European Union.

Regarding the second goal — the mitigation of greenwashing and the increase in transparency — that should be achieved by requiring companies to disclose both the intended positive sustainability effects as well as possible negative externalities caused by their financial products, more precisely through the funds they’re offering.

If you’re interested in the official wording, the regulation says, that it “lays down harmonized rules for financial market participants and financial advisers on transparency with regards to the integration of sustainability risks and the consideration of adverse sustainability impacts in their processes and the provision of sustainability‐related information with respect to financial products”.

In order to follow these rules, fund companies are basically obliged to classify each of their funds into one of three “green” categories depending on the sustainability objective of the fund. This means that the SFDR will basically make asset managers reveal the different levels of sustainability they use for each of the funds they offer.

Three different shades of green

The three categories provided by the SFDR are referred to by the articles within the regulation in that they are described: Article 6, Article 8, and Article 9.

Article 6:

👎 Article 6 covers funds that do not integrate any kind of sustainability into the investment process and could include stocks that are currently being excluded by ESG funds — think of everything which isn’t that climate-friendly or not sustainable in another way: tobacco, weapons, coal, etc. In the future, these funds can still be sold in the EU but since they have to be labeled as Article 6, they are officially classified as “non-sustainable”. As the world is accelerating towards a greener economy, this could have an effect on how easily asset managers can sell their funds.

Article 8:

🌎 Article 8, also known as “green funds”, promote “(...)environmental or social characteristics, or a combination of those characteristics (...)”. These funds integrate ESG or social characteristics in their investment approach, for example by excluding sectors.

Article 9:

🌿 Article 9 covers the most sustainable funds which are therefore also called “dark green funds”. These funds then actively target “a financial product [that] has sustainable investment as its objective” and where an index has been designated as a reference benchmark. The big difference with Article 8 funds is that Article 9 funds pursue a clear sustainable investment objective with each of their investments. For example, the Robeco Smart Energy Fund states its objective as: “The aim (...) is to provide long term capital growth while at the same time aiming for a better sustainability profile compared to the benchmark by promoting certain ESG (...) characteristics and integrating sustainability risks in the investment process”.  In contrast, Article 8 funds often pursue materialistic investment objectives such as "the fund aims to achieve as high an increase in value as possible as an investment objective".

In the future, these articles are to be used as a "stamp" for financial products (e.g. like an organic label for fruits and vegetables) in order to simplify private investors' decisions on the financial market.

Article 6, 8, and 9 of the Sustainable Finance Disclosure Regulation
SOURCE: MORNINGSTAR RESEARCH

The more sustainable a fund is — Article 6, 8, or 9 — the stricter are the disclosure requirements. This again will hopefully help to mitigate greenwashing: Simply from a marketing perspective, for example, it would be best for an asset manager to classify all their funds as Article 9 (i.e. dark green) because they would seem so sustainable. Since the European Commission doesn’t want this to happen they, therefore, require a higher level of detail (like, a lot of detail!!) for Article 8 and 9 funds, asset managers who are greenwashing would, hence, be exposed through their disclosures.

Examples, please!

Ok, enough with these laws! Let's move on to the actual implementation -- the SFDR has been in force in Europe since March. So who is truly sustainable and offers Article 9 funds and who is rather pretending to be super green?

The good news first: according to a study conducted by Morningstar, almost one in four euros in Europe is already invested sustainably (i.e. in an Article 8 or Article 9 fund)! Not bad, isn’t it?

In their study, Morningstar analyzed almost 50% of all Luxembourg funds (Luxembourg is the largest location for funds in the whole of Europe), which is over 5,600 funds. What they found is really interesting:

Article 8 and 9 fund assets as a % of total fund assets in the scope of Sustainable Finance Disclosure Regulation

SOURCE: MORNING STAR BASED ON ASSET MANAGERS DISCLOSURES

While smaller asset managers such as Robeco, Swisscanto, or SPP have classified an extremely high proportion of their funds as Article 8 or 9 — for example, Robeco has declared 98% of its funds as sustainable — one can be surprised by some of the major asset managers, like Blackrock, UBS and JP Morgan that exhibited much lower ratios: 17%, 15%, and 1.5%, respectively.

“Why is that?” you may ask.

Well, some asset managers, like Robeco, have a long history with sustainability. Investing environmentally and socially friendly is at the core of their business model which makes it easy for them to follow the new rules on sustainability disclosure — they would’ve done it anyway!

In simpler terms: it’s easier for some asset managers to classify their funds as sustainable if they actually are.

For some other companies, well — maybe they weren’t that sustainable after all. 🤷‍♀️

Conclusion

The introduction of the SDFR will (finally!) establish sustainability standards in the European financial markets, which will make greenwashing more difficult and enforce greater transparency.

The regulation makes it relatively easy to create comparability within the entire European Union. If you want to invest in a Finnish fund, for example, you can do your analysis in the same way as for a German fund (at least at the sustainability level). Also, Articles 6, 8, and 9 can be used as an additional metric in making investment decisions (apart from the normal financial metrics).

Through this combination of finance and sustainability, the European Union takes another important step towards fulfilling the European Green Deal and the Paris Climate Agreement. However, it must still be kept in mind that these laws alone will not be enough; measures in other sectors are unavoidable. The communication of these new regulations to private investors also leaves much to be desired. There is no active marketing of the SFDR and its benefits and private investors have no choice but to inform themselves.

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