With the application of the Level 2 requirements of the Sustainable Finance Disclosure Regulation (SFDR) and the Taxonomy Regulation’s product disclosure rules approaching, the pressure is on for firms to ensure full compliance.
SFDR and the Taxonomy Regulation
The SFDR is a regulation introduced to increase transparency for sustainable investment products in defining relevant disclosures.
The Taxonomy Regulation defines which economic activities count as environmentally sustainable. They aim to avoid providing false or misleading information about investment products’ environmental soundness.
It will also help investors identify eligible products better when pursuing an investment strategy oriented towards ESG criteria.
The interested parties
The Taxonomy Regulation already applies to all companies that are required to publish non-financial statements, such as significant capital market-oriented corporations with more than five hundred employees.
In 2023, the capital market orientation ceases to exist as a limiting factor for large companies, and commercial partnerships equivalent to these companies will also be affected.
Starting in 2026, the regulation will apply to small and medium-sized capital market-oriented companies.
For the SFDR, Level 1 disclosures are also applicable. These comprise disclosures at the entity level for Financial Market Participants (FMPs) and Financial Advisors.
FMPs, according to the regulation, are insurance companies making available insurance-based investment products, investment firms providing portfolio management, occupational retirement provision institutions and manufacturers of pension products and fund managers or banks if they provide portfolio management services. Level 2 disclosure came into effect on 1 January 2023.
Disclosure obligations under both frameworks
The Taxonomy Regulation classifies an economic activity as sustainable when it contributes to at least one of six defined environmental objectives and if it does no significant harm to any of the other objectives.
These six objectives are climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems.
The disclosure obligations differ between those for financial and non-financial undertakings.
In other words, there is an SFDR Taxonomy Disclosure and an NFRD Taxonomy Disclosure for non-financial undertakings.
Companies falling under the scope of the SFDR must disclose how Taxonomy-eligible or non-eligible their products are. This includes the disclosure of products with environmental or social characteristics (Art. 8 SFDR) and sustainable investment as their objective (Art. 9 SFDR).
SFDR disclosure in practice
Under the SFDR, firms must disclose how their investment decisions may adversely impact sustainability factors, including how they intend to mitigate these impacts.
Vice versa, they need to disclose how an ESG event could negatively impact investments and align their remuneration policies with sustainability risk management. They have to establish procedures to identify and prioritise Principal Adverse Impacts (PAI) and describe these PAI and counter-actions, including how they aim to prevent them in the first place.
On top of this entity-level disclosure, they must provide disclosure at the product level. This includes pre-contractual information, which will be familiar from MiFID, and is similar to the entity-level information for all products.
According to articles 8 and 9 of the SFDR, additional information is required for products. This, in turn, includes periodic reporting obligations on the two Taxonomy goals as discussed above – such as how some ESG objectives are met on a benchmark comparison basis. At the same time, there is no harm to other of the six ESG objectives.
Furthermore, the company website must disclose the categorisation attributes of Art. 8 and Art. 9 products, including their metrics and how they are monitored.
European Union implications
The financial sector’s ESG footprint has, indeed, only minor impacts attributable to the maintenance of its operations – leaving aside factors such as office buildings’ energy consumption or the impact of employees commuting there.
However, a significant impact is generated through the process of investing, and it is no secret that people are increasingly considerate of ESG factors. Moreover, it would be wrong to imply that ESG regulation is a financial sector-specific issue or that its reach would be regionally limited.
In that context, the Corporate Sustainability Due Diligence Directive (CSDDD) or the Corporate Sustainability Reporting Directive (CSRD) will encompass a broad corporate universe.
The CSDDD, in addition to defining onerous new due diligence obligations for companies, also stipulates clear responsibilities for their management and supervisory boards. And it will not just apply to around 13,000 companies based in the EU. Depending on where revenues are generated, or specific production or service processes are located, it applies to approximately 4,000 companies from third countries.
And it doesn’t end there. On March 2023, the US Securities and Exchange Commission proposed that climate-related disclosure become a mandatory reporting element for registered companies.
The industry should no longer consider ESG disclosure a means of marketing or an annoying chore; rather, it must accept it as an integral part of the corporate culture.
About the Author: Thibault Gobert is the Head of Liquidity Pool at Spectrum Markets.