Demystifying EU Sustainable Finance Regulations: SFDR, NFRD and EU Taxonomy
21st June 2021*
2021 brought significant changes to the EU Regulatory Compliance, it increased both the scope and depth of required sustainability reporting. Introduction of new regulations, such as Sustainable Finance Disclosure Regulation (SFDR), the EU Taxonomy as well as updates of existing ones, such as Non-Financial Reporting Directives (NFRD) to be replaced by the Corporate Sustainability Disclosure Directive (CSRD) aim to improve the overall transparency of disclosed information and prevent ‘greenwashing’ through more detailed reporting and assurance of reported information.
In this article, we will briefly review the three legal instruments that are part of the EU Action Plan on Sustainable Finance focusing on its’ applicability and key requirements.
1. SFDR – Sustainable Finance Disclosure Regulation
SFDR brings a broad package of legislative tools designed to reorient capital towards more sustainable businesses. We can divide the SFDR disclosure into two key parts:
1) Level 1 Disclosure (in force from 10th Mar 2021)
- explanation of how the manager of a financial product takes sustainability risks and adverse impacts on sustainability (PAIs) into account,
- definitions to classify investment funds and mandates into three categories (Art. 6, Art. 8, Art. 9) that reflect the level of transparency with regards to the sustainability of investments
2) Level 2 Disclosure (in force from 1st Jan 2022)
- Principle Adverse Impacts (PAIs) – a set of 18 mandatory and 46 voluntary indicators that qualifying firms will need to report on, as well as rules on disclosure on specific characteristics depending on the nature of the fund manager
- more details on the content, methodologies and presentation of disclosures set out in SFDR Level 1
The precise requirements are complicated and vary depending on the size of the firm and other factors. For more information, please contact us at firstname.lastname@example.org. We would be happy to set up a call to go through the SFRD requirements in more detail.
What is the scope of the SFDR?
- Financial market participants (FMPs): investment firms, including asset managers which offer portfolio management services, pension providers and insurance-based investors, as well as qualifying venture capital and social entrepreneurship activities.
- In-scope financial products: investment and mutual funds, insurance-based investment products, private and occupational pensions, and both insurance and investment advice.
Implications for Investors and other FMPs
Critical to the SFDR reporting process will be the collection and aggregation of data. Investors will need to collect data from their investee companies and map the aggregated fund level position into the relevant SFDR categories.
Implications for Businesses
Businesses (investee companies) will need to provide outlined set of data to their investors including climate-related metrics and metrics considering labor and human rights starting from January 2022.
In addition, large product manufacturers (those with 500 or more employees) will have to disclose, at the entity level, their due diligence and engagement policies regarding the consideration of PAI arising from sustainability factors and, from 1 January 2023, for each product they manage.
It is recommended for companies to have established data collection processes in place by the end of 2021, so they are ready to provide accurate data to their investors for SFDR reporting in 2022.
Additionally, all large and listed companies on an EU regulated market (except listed micro-entitles), will need to report their sustainability data according to NFRD and upcoming CSRD (see more details below).
Corporates that currently are out of scope but consider raising funds in the capital market in the near future are encouraged to start reporting along the CSRD.
2. NFRD – Non-Financial Reporting Directive
NFRD is the EU legal framework for regulating the disclosure of non-financial information by corporations. It was adopted in 2014 and is mandatory since 2018.
CSRD – Corporate Sustainability Reporting Directive proposal significantly enhances the scope of the existing NFRD rules and sets out in far greater detail the non-financial information that entities should report. Key changes introduced by CSRD:
- extends the scope to all large companies and all companies listed on regulated markets (except listed micro-enterprises) and Non-EU corporates listed on an EU regulated market
- requires the audit (assurance) of reported information
- introduces more detailed reporting requirements, and a requirement to report according to mandatory EU sustainability reporting standards
- requires companies to digitally ‘tag’ the reported information, so it is machine readable and feeds into the European single access point envisaged in the capital markets union action plan
3. EU Taxonomy
The EU Taxonomy Regulation provides a framework to be followed in screening investments to determine whether they are environmentally sustainable and requires further disclosures which need to be made in addition to those set out in the SFDR and NFRD/CSRD. It is becoming effective from 01 January 2022.
EU Taxonomy is a common European classification system for environmentally sustainable activities. It defines six environmental objectives, and an economic activity as sustainable if this activity contributes at least to one of these objectives without, at the same time, doing significant harm to any of the other objectives.
The EU sustainable finance regulations described above require reliable, granular, and comparable data. Data collection and reporting processes are likely to be very intensive for investors, their investee companies within the SFDR and listed/large companies that will be required to disclose more detailed information under the CSRD.
When it comes to the SFDR disclosure, even in the case of the ‘Blue Chip’ companies, publicly available data is incomplete and very different from the live data which makes it unreliable. In the case of small caps, the situation is even more complex, as they were not required to disclose ESG data before, so there is no data readily available.
Considering that the first EU Sustainable Finance regulations are approaching quickly with SFDR Level 2 disclosure kicking off in January 2022 – now is the time to get ready. Please see key steps to start with:
1. Scoping exercise
Determine which regulation and what articles within it apply to your organisation and products.
2. Gap Analysis
Review your current sustainability and risk management strategy and policies to determine what actions are needed to comply with the new regulation. Create an action plan for your sustainability risk policy, due diligence policy, remuneration policy and communication strategies.
3. Automate data collection process and overcome data challenges
SFDR, NFRD/CSRD and EU Taxonomy reporting will require disclosure of both quantitative and qualitative data across multiple metrics at the company, entity, fund or even product level. Apart from providing all required information, it is also essential to provide insights on the data sources, quality and ensure that data from multiple sources is equal and comparable. In addition, CSRD requires audit of reported information.
Considering the above requirements, in addition to the data challenges, it is definitely time to review your current processes. The first step is to evaluate how these regulations affect you and how to capture data effectively and with real time transparency in mind.
Please feel free to contact Turnkey team for more information on how our advisory services combined with our suite of ESG software solutions can support you through this increasingly complex reporting landscape.
*An important update made to the SFDR on 8th of July 2021:
The European Commission wrote to Parliament and Council explaining that it plans to delay the implementation of the first phase of the SFDR new reporting rules until July 2022, from the original January 2022 deadline. See more information here.
Environmental, Social & Governance (ESG) Tracking & Metrics – A Better Way Forward