Regulation(EU) 2019/2088 on sustainability‐related disclosures in thefinancial services sector, more commonly known as the EU Sustainable FinanceDisclosure Regulation (‘SFDR’), is one of the legislative outcomes of theEuropean Commission (‘EC’)’s action plan on financing sustainable growth.

The primary objective is to enhance transparency regarding fundmanagers’ investment strategies, mitigating the risk of greenwashing. Under the SFDR’s classificationsystem, funds are categorised as either article 6, 8, or 9, based on theirspecific characteristics and level of sustainability. Each category prescribes differentreporting requirements.

This article is an introductory guide to the SFDR and therequirements it lays down for fund managers. We will help you understand theintricacies of the SFDR so that you can do the reporting yourself with theassistance of 414’s tool.

If you would like to dive deeper into the SFDR, click on thelinks to other articles within our knowledge centre.

Happy learning!  

‍

Scope and Structure

‍

The SFDR is divided into Level 1 and Level 2 requirements. Level 1 requirements are those applicable to all fund managers, without distinction. Level 2 requirements demand an added reporting effort to fund managers whose products have a closer link with sustainability (Article 8 and 9 funds).

Within this framework, financial products can be divided inthe following categories:

·     Article 6: funds not integrating sustainability into their investment process.

·     Article 8: funds which promote environmental or social characteristics.

·      Article 9: funds which target sustainable investments in particular.

For further detail on product classification, check this article.

In comparison to Article 8 funds, which focus on promoting environmental or social characteristics while adhering to good governance practices, Article 9 funds go a step further by actively seeking to make a positive impact on society or the environment through sustainable investments.At the core of their offering, Article 9 funds have a non-financial objective, setting them apart as more dedicated forerunners in sustainability.

Both Article 8 and Article 9 funds are consideredESG-aligned, demonstrating their commitment to environmental, social, and governance considerations. However, Article 9 funds take sustainability to aneven higher level, earning the distinction of being categorized as ‘dark green’,signifying their deeper dedication to sustainable practices.

Another relevant classification is that between ‘entity’ and ‘product’ level, distinguishing between reporting requirements for the fund manager and for each fund.

‍

Principal Adverse Impact Indicator (PAI) framework

‍

The EC established a set of PAI indicators to measure the the negative effects an investment decision might have on sustainability factors. These include environmental and social factors, but also employee and human-rights matters, as well as anti-corruption and anti-bribery.

PAI indicators are used by Article 8 and 9 funds as evidence of their commitment to monitor and improve their impact on sustainability factors. Fund managers must either measure and disclose the PAI indicators of their funds or provide a reasonable explanation as to why they do not (‘comply or explain’).

When disclosing the PAIs, fund managers must publish a PAI Statement, where they include a table with the indicators and their comments regarding the results, the actions taken and planned, and a historical comparison between each reporting year, if applicable.

PAIs can be divided in mandatory and voluntary, and the methodology used for measuring them can be found in the Commission Delegated Regulation (EU) 2022/1288.

‍

Consideration of Sustainability Risks

‍

The SFDR requires all Fund-Managers, regardless of their sustainable ambition, to publish a sustainability risk disclosure, explaining how they incorporate sustainability risks—such as the impact their investments may have on environmental, social, and governance (ESG) factors—into their decision-making processes. This includes considerations when selecting portfolio companies, engaging with them, and assessing their broader sustainability impact. 

The SFDR further requires Fund Managers to have a remuneration policy that incorporates the consideration of sustainability risks into the remuneration of their employees.

Furthermore, an ESG policy takes a complementary perspective: it focuses on how sustainability risks, if poorly managed, can directly affect the profitability of investments. Factors like regulatory shifts on emissions, fines for non-compliance with reporting requirements, and reputational damage can have significant financial consequences. While not mandatory under theSFDR, an ESG policy is a critical tool for fund managers to anticipate and mitigate these risks effectively, ensuring better fund administration and long-term value creation.

We moreover recommend integrating sustainability risks in the engagement policy with portfolio companies, to support them in addressing the identified risksand improving their PAI indicators for the following reporting period.

414 specialises in assisting financial entities with SFDR compliance. Our tool enables private equity investors to measure all sustainability indicators of their portfolio companies and prepare disclosure documents at both entity and product levels. Additionally, we offer advisory services on sustainability reporting matters and provide tailored guidance throughout the reporting process.

‍

The EU Taxonomy Regulation

‍

The EU Taxonomy and the SFDR are interconnected. The Regulation relies on the fund classification established by the SFDR to prescribe specific reporting requirements to Article 8 and 9 funds.

Fund managers of an Article 8 or 9 fund must disclose how they are promoting or contributing to sustainability characteristics, in line with one of the six environmental objectives provided in the EU Taxonomy Regulation. In particular, fund managers must express in the pre-contractual disclosure and the periodic disclosure the proportion of the fund which is aligned with the sustainability criteria, usually by relying on KPIs (turnover, CapEx and OpEx).

These funds must also prove that they do no significant harm(‘DNSH criteria’) to any of the remaining environmental objectives and that they comply with minimum social safeguards.

The underlying reasoning behind these disclosures is that if a fund claims to be environmentally sustainable, it must prove so by complying with the EU Taxonomy criteria (the TechnicalScreening Criteria or ‘TSC’).

It must be noted that social objectives have not yet been integrated in the EU Taxonomy and, therefore, funds which exclusively promote or contribute to social objectives are left out of this framework and can reasonably decide not to disclose these figures. If you would like to know more about the development of a social taxonomy, check out this article.

414 can assist you in identifying and disclosing your eligibility and alignment with the EU Taxonomy Regulation.

‍

‍