SFDR Unpacked: Mastering Compliance with ARKK

The Sustainable Finance Disclosure Regulation (SFDR) is considered a significant milestone in the European Commission's mission to integrate sustainability into financial markets. However, the implementation of SFDR has not come without challenges, whether they be related to demystifying disclosure requirements, the availability and quality of ESG data, or uncertainty around definitions and methodologies that should be used to assess relevant investments. The European Supervisory Authorities (ESAs) recently proposed amending the Regulatory Technical Standards (RTS) under SFDR. In this post, we’ll break down the key changes.

On 4 December 2023, the ESAs published a Final Report setting out draft amendments to the RTS under the EU’s SFDR. The report was published in response to a mandate by the European Commission to review the framework for principal adverse impact (PAI) indicators and introduce disclosures of financial products’ decarbonisation targets.

Who Is Impacted?

The impact of these changes depends on the type of product that financial institutions offer to their clients.

Article 8 products promote environmental or social characteristics but do not have as their objective sustainable investment. Financial market participants (FMPs) offering Article 8 products will need to transmit information from the existing pre-contract template to the new template, which is intended to be more readable for investors.

Article 9 products specifically contribute to an environmental or social objective. FMPs offering Article 9 products will be subject to further changes. For example, FMPs will be required to explain the thresholds and criteria used to establish that sustainable investments do not significantly harm environmental or social objectives and detail how these are determined.

Changes concerning the SFDR Templates

The Article 8 and Article 9 SFDR templates contained in Annexes II to V of the SFDR have been streamlined by simplifying the language and restructuring the information provided to avoid repetition. In an attempt to make the disclosures more comprehensible, the ESAs have proposed the introduction of a dashboard to provide key information on the first page of the Annexes. Four essential elements have been included in the dashboard: (i) sustainable investments; (ii) taxonomy-aligned investments; (iii) PAI consideration; and (iv) greenhouse gas (GHG) emissions reduction targets.

The update requires that all disclosures be in machine-readable format, with information marked up using XBRL markup language.

Changes concerning the GHG Emissions Reduction Targets

The draft RTS introduces additional obligations if a financial product includes greenhouse gas reduction in its investment target. Disclosures should be made in the pre-contractual information (Annex II and III), the periodic reports (Annex IV and V), and on the website. FMPs will be asked to provide information about what the product aims to achieve, how the investment strategy is contributing to its progress, potential delays in achieving its targets and, where relevant, the actions pursued.

GHG emissions reduction targets must be set based on all relevant investments, including, among others, asset classes such as: (i) listed shares and corporate bonds; (ii) sovereign bonds; (iii) corporate loans; (iv) commercial real estate; and (v) mortgages and car loans.

Changes concerning the PAI Framework

The revised RTS proposes the addition of new mandatory and opt-in social indicators, which were not as comprehensively covered in the SFDR as the environmental indicators. The new mandatory social indicators include “exposure to companies active in the cultivation and production of tobacco” and “employees earning less than an adequate wage", among others, while the new optional social indicators include “interference in the formation of trade unions or elections of workers representatives", “excessive use of non-guaranteed hour employees in investee companies” and a “lack of grievance/complaints handling mechanism for consumers/end-users of the investee company”.

The report also introduced changes to the existing PAI reporting framework. FMPs should disclose what share of the adverse impact was based on data from the investee company and what was estimated or subject to reasonable assumptions. All formulae for calculating PAI will be adjusted to reflect the changes in the indicators and new formulae will be created.

Other Changes

It is also worth noting that the ESAs published their Final Report at a time when the European Commission was actively seeking feedback on its consultation on the SFDR framework, which closed on 15 December 2023. This is a first step in the Commission’s fundamental review of the SFDR to assess shortcomings and explore potential changes. In light of any changes that may arise, the ESAs decided not to change the basis on which the PAI indicators are calculated and not to make or suggest any long-term revisions to the do no significant harm (DNSH) disclosure rules. The proposal does, however, include a requirement to disclose the thresholds and criteria for the PAI indicators that the financial product uses to determine that its sustainable investments comply with the DNSH principle in the website disclosure.

What Next?

The European Commission has until March 2024 to review the Final Report and decide whether to endorse it or make amendments. Once endorsed, a draft Delegated Regulation will be sent to the European Parliament and the Council for review and approval, usually within 2 to 4 months. The Final Report does not make reference to an application date but market expectations suggest that it will not be before 1 January 2025.

The SFDR Annexes will need to be recast to reflect the updated templates and in a machine-readable format once the proposed changes outlined in the Final Report take effect. SFDR Annex disclosures in relation to sustainable investments will need to be reviewed and potentially enhanced. For fund managers, now is the time to start thinking about what additional information might be needed from investee companies or issuers and what reporting solution is required to facilitate the transition.

ARKK is a specialist (i)XBRL software and service provider that helps companies mitigate risk with our regulatory reporting solutions. Our team is eager to address your SFDR concerns and discuss how we can help in simplifying your regulatory reporting process to save costs and increase efficiency.